While energy and food prices have been retreating in recent weeks, inflation has developed into a real problem here in China. Inflation for 2008 through July is running at 7.5%, well above the government’s target.

The Chinese economy relies primarily on exports and investment. Total fixed asset investments in 2008 through June totaled 6.8 trillion RMB, or 52% of total GDP. Other economies tend to range from 20% to 30%. This staggering investment has allowed China to become the world’s primary supplier of manufactured goods.

However, China’s economic success comes at a price. They have developed an enormous trade surplus and amassed huge amounts of currency reserves. Consequently, there is considerable pressure from the rest of the world to further appreciate the yuan.

As the yuan continues to rise in value, it attracts additional investment capital, further perpetuating the cycle. The People’s Bank of China must then inject more money into the system and it is this ever-surging liquidity that drives up prices.

Despite surging retail sales and prices, there is plenty of room for more consumption in China. Of course there is a huge population here and a rapidly growing middle-class, but retail sales are just 38% of total GDP. Compare that to 70% in America and you get a pretty good idea of the potential.

The Chinese have historically been savers, but attitudes are starting change. The younger generations are quite comfortable using credit. Last year, Chinese banks issued 43 million credit cards. In 2003, the number of cards issued was just 3 million. Many young Chinese professionals are proud owners of ‘candlestick’ (high-rise) apartments thanks to mortgage loans.

The skyline of every Chinese city is a sea of construction cranes as far as the eye can see. Homebuyers borrow from the banks and pay developers for their apartments. Those developers redeposit those funds back into the banks and they are subsequently lent out again. This leveraging of funds creates additional liquidity in the system, driving prices ever higher.

The Chinese have a strong cultural affinity for gold ownership. However, they have only had the right to legally own gold since 2002. In America, we’ve had the privilege since 1975.

Writing from China I don’t have all my research resources at my fingertips, so I’m relying on data several years old. In 2005 Americans owned 1.7 grams of gold per person. In China they owned less than 1/10 of one gram per person. Given the price risks in China stemming from the liquidity explosion, more and more Chinese will be turning to gold as a means to preserve their newfound wealth. Given the ever tightening supply fundamentals, this potential source of demand is likely to drive prices significantly higher in the years ahead.