Chinese bond rates have surged to their highest levels in almost six years, with the benchmark on 10 year bonds hitting 4.2%. Rising inflation has been the main culprit, despite government efforts to bring the inflation rate under control.

Chinese Bond

The Central Bank is so far declining to inject additional cash into the system. The September inflation rate hit 3.3% YOY, up from 2.6% in August. The Central Bank did step up purchases of foreign currencies in September, with hopes of cooling the surging currency. Foreign currency purchases have not yet been released for October.

Chinese housing market continue to rise

Inflation has been a tough issue for the Chinese government to control. Despite attempts to cool off the housing market, for example, property prices continue to rise in major cities across China. This is putting pressure on the government as people become discontent with rising costs. Already, the Chinese government must contend with thousands of small protests per year. As costs rise, protests may grow more frequent.

At the same time, goods and services are also growing more expensive. While hundreds of millions of Chinese have seen their fortunes improve in recent years, many hundreds of millions more remain poor. As inflation increases, China’s middle class may be able to afford the price increases, but poorer Chinese individuals will struggle to keep up.

Labor cost in China

China has a small social safety net, though the government has been working to build it up. Wages also remain low in manufacturing industries and other low-skill sectors. This is largely by government design. China relies on the continuous inflow of workers from rural areas to meet the demand of manufacturing companies for cheap labor. The Chinese government has been trying to keep labor costs low in order to preserve the country’s cost advantages.

With the Yuan slowly rising, however, it may only be a matter of time before China loses its advantage. The Chinese government wants to position the Yuan as a global currency and alternative to the U.S. Dollar. In order to do so, however, it must liberalize Yuan trading and allow market forces to set prices. While the Yuan used to be pegged to the Dollar, it is now allowed to float within a narrow trading ban.

For the currency to take the next step, however, trading may have to be liberalized completely. Most analysts expect the Chinese government to allow the Yuan to float in the years to come. If it does so, there is a serious risk that the value of the Yuan could jump sharply. This would hurt Chinese exports and could restrict growth. As such, the Chinese government will most likely take a slow path towards liberalizing the currency and try to maintain stability.

Chinese government’s risks

All of these issues make the inflation issue even more complex for the government. By working to actively keep labor costs low, the Chinese government runs the risk of creating a large section of its population that will not be able to afford basic living costs. On the other hand, if it lets labor costs rise too quickly, there is a risk that the country could lose jobs. Either scenario is bad for working class Chinese citizens and poses a risk to the country’s stability.

The Chinese government is trying to address the issue by lowering housing costs, building up its social safety net, and ramping up its efforts to protect Chinese citizens. For example, the Chinese government recently blasted Starbucks for charging higher prices in China than elsewhere in the world. Currently, China supports some of the highest profit margins for Starbucks Corporation (NASDAQ:SBUX), a situation which the government has criticized sharply.

With the economy continuing to expand, inflation and rising costs may be inevitable. So far the government’s efforts to control housing prices have largely failed. At the same time, some Western companies are adopting a negative outlook on China, owing to the government’s continued interference with market forces and the high risks involved. The Chinese government is also seen by many as favoring domestic companies. If China pushes too hard, it could lose crucial foreign investments.