China's currency, the renminbi, has embarked on a fast track of appreciation due to the combined impact of domestic inflation and a weakening greenback.
The People's Bank of China (PBoC) set the yuan central parity rate at 7.1452 against the US dollar on Wednesday, marking the fourth consecutive day of new highs. China ended its peg to the dollar and switched to a basket of major currencies in July 2005.
Since the start of this year, the yuan has risen 2.11 percent relative to the US currency, after climbing 6.9 percent in 2007. Analysts are expecting an appreciation of 7-10 percent in 2008.
The faster appreciation of the renminbi coincided with a jump in domestic inflation which hit 7.1 percent in January over a year earlier as devastating snow storms ruined crops and made it difficult to transport foodstuffs. The Consumer Price Index may climb further in February, as the impact of the blizzards continued to unfold.
Regulators are increasingly using their foreign exchange tools to help fight inflation, analysts said.
In theory, a more expensive yuan will cut the cost of imports, thus help reduce inflation. In addition, it will result in fewer exports, which in turn decreases the amount of renminbi the PBoC has to pump into the financial system, as well as offering more goods for domestic sale.
A faster rise in the yuan value seemed like the tool-of-choice when the PBoC, eager to keep inflation in check, faced a dilemma in using another tool -- higher interest rates.
China has raised the interest rate six times since the start of 2007. Further hikes at a time when the US rates are falling will attract more unwanted capital inflows, thus worsening the current conditions.
Foreign Direct Investment (FDI) in the country more than doubled from a year earlier to $11.2 billion in January, official figures showed. Analysts believe an increasing amount of hot money is entering the country in the form of FDI.
Rising borrowing costs will also eat into the profits of firms that face a drop in foreign demands due to a possible global economic slowdown.
Adding to the pressure for the yuan to appreciate, the greenback is on a steady downward trend. The US Federal Reserve is widely expected to cut the federal funds rate further in March to avert a recession, a move that will make the US currency become even more unattractive.