The recent debate in India over the inflation vs growth led me to probe the topic a bit deeper and find out why China continues to enjoy low inflation rate, high FDI inflow, high current account surplus and high GDP growth. Their overheating occurs at 11% while ours starts at 9% itself. Why is that so? Considering the huge inflow Chinese economy has in term of foreign capital, and the fact that yuan is kept down artificially, how come they do not have the issue of inflation on account of money supply growth?
The answer lies in rate of real GDP growth. Inflation is the difference between growth of money supply and growth of real GDP. To some extent these two have different drivers. Money supply for example can grow due to govt spending using printed money, foreign capital inflows and increased lending by banks domestically. Real GDP grows on account of investment and consumption. Hence there are no obvious reasons why money supply should always grow any faster or slower than the real GDP. Given this, and a similar rate of money supply growth, an economy with higher real GDP growth will be able to accommodate more of the money supply increase than one without. This to extent explains why Chinese inflation remains low despite the strong build-up of forex reserves, while India is forced to choose between inflation and exchange rate - because the expected money supply increase by holding exchange rate constant will lead to excessive inflation.
The question is not inflation vs growth - it is a choice of steady state real GDP growth rate that we want to run with. If we run with 10%+, we will need to worry much lesser about the exchange rate because we can build reserves with the surplus and hold the exchange rate low without causing money supply growth in much excess of real GDP growth. On the other hand, if we stick to a lower growth rate of 8%, we will be forced to choose either inflation or exchange rate - and in choosing inflation control and letting exchange rate be, we will reduce the export growth. China has mastered the art of exchange rate control without inflationary worries. Since Chinese growth is 10%+, they can hold the exchange rate low, let the money supply increase at 3-4% above real GDP growth and then further sustain the GDP growth on account of exports and sustain the FDI inflow on account of investment demand.
The solution: attack supply side bottlenecks on priority. Channelize foreign money inflow into infrastructure growth - and do it very very very aggressively. Also let the inflation be where it wants to be in the short term and target exchange rate instead to bolster exports. As the supply side infrastructure bottlenecks ease and industry invests in capacity and the economy starts exporting significantly, real GDP growth will climb up easing the inflation pressures in a manner far more sustainable than increasing interest rates and squeezing credit supply.
I fully support inflation control through increased supply of goods instead of controlled demand!