Excess Liquidity, Inflation and the Yuan Appreciation: What Can China Learn from Recent History?

This paper analyses the issues of excess liquidity, inflation and the exchange rate appreciation currently evolving in China. In mapping the co-movement between excess liquidity and inflation and developing a dynamic model, the paper shows that excess liquidity, ignited by dramatic capital inflows, is a significant driver for consumer price inflation in China during the last decade. In addition, the article compares the dynamic paths of inflation and interest rates between China and the United States and reveals marked changes in their differentials over recent years. Associating these findings with the evolving appreciation of the yuan against the dollar, the paper advises a slowdown in the rate of RMB appreciation. Instead of quick appreciation, the paper proposes more flexibility in the RMB exchange rate regime combined with alternative capital control measures to rein-in excess liquidity and curb ongoing inflation in China.