Our biggest export: Inflation

Canada, our biggest trading partner, is letting its currency rise. The Canadian dollar, the loonie, has reached parity with the U.S. dollar and on some days exceeded its value by a few cents. That's a huge upward move -- a 61% gain -- for the Canadian currency, which was worth just 62 U.S. cents in 2002. (The Canadian dollar is called the loonie because, natch, it has a picture of a loon on it.)

That's a boon for Canadians who want to go on a shopping spree in the United States, but it's not such great news for the Canadian economy. Canada is on a pace, as of July, to export $550 billion in goods to the U.S. this year. That's about 50% more than China, our second-largest trading partner. And the number looms even larger when you remember the relatively small size of the Canadian economy: At $550 billion, exports to the United States were on track to make up about 40% of Canada's GDP in 2007. (Canada's economy measured $1.2 trillion at the end of 2006).

With the U.S. dollar falling against the Canadian dollar, everything that Canada exports to the United States becomes more expensive. That sends some U.S. customers scurrying to look for cheaper sources of supply, perhaps inside the United States. And it makes some customers shut their wallets completely.

Economic growth in Canada, which came in at 2.6% in 2006, was forecast to drop to 2.3% or 2.2% for 2007 when economists made their projections last December. Forecasts now predict that the economy will slow even more to a 2% annual rate of growth in the third quarter of 2007.

China takes action

China has opted to intervene in the financial markets to keep its currency stable. In July 2005, when China reformed its exchange-rate system to let the yuan move in a bigger price range against the U.S. dollar, it took 8.28 yuan to buy a dollar. On Oct. 2, it took 7.51 yuan to buy a dollar. That's a move of just 9.3%. Over the same period, the Canadian dollar gained 23.5% against the U.S. dollar, and the euro gained 18% against the U.S. dollar.

Why did the Chinese currency stay so cheap relative to the dollar (and get cheaper versus the euro and Canadian dollar)? The Chinese central bank conducted massive dollar-buying sprees to keep the value of the dollar up versus the yuan.

Without intervention, the huge influx of U.S. dollars into the Chinese economy due to China's trade surplus with the United States would have depressed the value of the U.S. dollar against the Chinese yuan. Dollars would have been in such great supply relative to demand that the price of the currency would have dropped.

But the People's Bank of China, the country's central bank, took steps to make sure the drop was orderly and relatively minor. The bank bought U.S. dollars in China for yuan, removing some of the huge supply of dollars and keeping the price of the yuan from rising too rapidly against the dollar.

Just as choosing to let its currency rise cost the Canadian economy growth, trying to stabilize its currency comes with its own set of costs for China. By buying dollars for yuan, the People's Bank was injecting huge amounts of yuan into its domestic economy. The bank tried to remove as much of that injection as it could -- central bankers call this operation "sterilization" -- by selling government bonds for yuan. That had the effect of removing yuan from the economy.

But it's just about impossible to run a completely successful sterilization; you never manage to sop up all the extra money. And in China that extra money has contributed to runaway growth in China's money supply.

The runaway train in China

When money supply grows faster than a country's economy, the result is inflation, which is exactly what is happening to China's economy.

Consumer inflation grew at a 4.4% annual rate in June. Food was the big culprit, with the prices of eggs and pork jumping 20% from last year's prices. In response, the People's Bank ordered its fifth interest-rate increase since April 27, 2006. The 0.27-percentage-point increase on one-year bank-deposit interest rates and on commercial lending took the rate paid on deposits to 3.33%. The one-year lending rate climbed to 6.84%.

In August, the bank raised rates again. That didn't work. In September, the government reported that inflation for August had come in at a 6.5% annual rate.

So on Sept. 14, the People's Bank raised interest rates again, to 3.87% on one-year bank deposits and 7.29% on commercial loans. Nobody expects this latest rate increase to have much effect on the runaway train that China's economy has become. And you don't have to be a mathematician to see that since June inflation has climbed 2.1 percentage points, while the interest rate on a commercial loan has gone up just 0.6 percentage point. The government has clearly lost ground to inflation.

The People's Bank recently seemed to admit as much. At the end of September, the bank forecast 4.6% growth in consumer inflation for 2007 and an increase to 5% in 2008.

Continued: Why does this matter?

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