Why China Has a Point About Quantitative Easing

Another round of quantitative easing could cause inflation in the emerging markets.

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The United States and China are again locked in a familiar debate over currency manipulation. In the past, the United States has claimed that China keeps its currency, the yuan, at artificially low levels, which gives it unfair trade advantages. A weaker currency makes for cheaper exports, and the massive trade deficit that the United States shares with China has become a major talking point for politicians on Capitol Hill. This time around, China is pointing its finger at the United States over its plans to pursue another round of quantitative easing.

In its simplest form, quantitative easing is nothing more than the Federal Reserve printing more money. The Fed has hinted that it plans to purchase treasuries to push interest rates even lower. That is supposed to spur more lending, which in turn should help kickstart the economy. The federal funds rate is virtually zero, so the Fed can't lower rates any further. Quantitative easing is one of the few tools that the Fed has left.

[See China's Rate Hike: Winners and Losers.]

Another round of quantitative easing would dilute the value of the dollar because more dollars will be in circulation. Since the dollar is still considered the world's reserve currency, many products, most notably commodities, are priced in dollars. If the value of the dollar goes down, the price of commodities will also go up. That's why China is concerned.

China's trade minister Chen Deming was recently quoted in a Chinese newspaper as saying: "Uncontrolled printing of dollars and rising international prices for commodities are causing an imported inflationary 'shock' for China and are a key factor behind increasing uncertainty."

September's inflation rate in China rose to 3.6 percent up from August's 3.5 percent. The government's official target is 3 percent. The inflation rate is watched closely in China because the Chinese economy is dependent on commodities. "Their whole economy revolves around buying raw materials and putting them to work," says Chuck Butler, president of EverBank World Markets. "Those raw materials and commodities would get more expensive, and so therefore they're chasing higher prices with the same amount of goods, which is inflation."

[See What China's Currency Reform Means For Investors.]

In September, Brazil's finance minister, Guido Mantega, likened the situation to an "international currency war." The United States as well as the U.K. and Japan have all kept interest rates at historically low levels in hopes of spurring economic activity. James Dailey, manager of TEAM Asset Strategy Fund (symbol TEAMX), says the actions of the developed markets could have large ramifications for their emerging markets counterparts.

"Domestic priorities of the Chinese will shift away from jobs towards fighting inflation," he says. Dailey says food prices account for 50 percent of the average consumer's household budget in China. "The next major issue is going to be fighting inflation in emerging markets," he says.

Both sides may share some of the blame in this currency debate. "You have the U.S. on one side lecturing the Chinese about free markets at the same time that [the U.S. is] intervening in just different ways," Dailey says. "The hypocrisy is fairly thick on all sides."

Who will come out on top? "Ultimately, [these currencies are] all going down in real terms versus hard assets because all the major countries or currencies are devaluing," Dailey says. He believes the big winner will be precious metals like gold and silver, which have already benefited from global uncertainty. Some gold bugs even view gold as a type of currency in itself because of its intrinsic value. Both metals have reached historic highs in recent weeks. Year-to-date, SPDR Gold Shares ETF (GLD) is up 22 percent, while ETFS Physical Silver Shares ETF (SIVR) is up 42 percent.

[See Gold May Rise, But Is It Safe?]

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