The interplay between a rising CPI and bubbling real estate and stock markets are undermining the effectiveness of monetary policies. And at the core of all of these problems is the yuan's exchange rate.

Premised on the expectation of continued, steady appreciation, the undervalued yuan has directly contributed to the inflows of hot money hungry for Chinese assets, worsening the "double-surplus" in current and capital accounts, and bloating China's foreign exchange reserves. All contribute to excess liquidity, which itself provides positive feedback in the bubbling real estate and stock markets. Under these circumstances, monetary policies are only of limited use.

Not only does the yuan need more flexibility in its exchange rate, its valuation should also reflect its development. Only when this foundation is established can the usual monetary and financial intervention tools deliver the desired results.