Oct. 31 (Bloomberg) -- It had been a topic of such intense speculation, and for so long, that when China did finally raise interest rates, the move was something of an anti-climax.

The central bank's decision last week to raise the benchmark one-year lending rate by 27 basis points to 5.58 percent ``will have as much impact on the Chinese economy, as putting a bicycle in front of a speeding locomotive,'' said researchers Bob Prince and Jason Rotenberg of Bridgewater Associates, a Westport, Connecticut-based money manager.

How will a tiny increase in interest rates curb overheating when draconian measures to cut bank lending to aluminum, auto, cement, steel and real-estate companies have had only a limited impact on the economy since they were introduced in April?

Fixed-asset investments in China increased 28 percent from a year earlier in September. The much-touted deceleration in the economy -- gross domestic product grew 9.1 percent in the third quarter, down from 9.6 percent in the previous three months --was merely due to a statistical base effect, according to Dong Tao, an economist at Credit Suisse First Boston in Hong Kong.

People's Bank of China can't put the inflation genie back into the bottle with a token increase in rates, when consumer prices have been rising uncomfortably close to a seven-year high of 5.3 percent for four months.

Monetary Policy

Still, the interest-rate decision isn't without its significance. To six strategists surveyed by Bloomberg News, the rate move came as a signal that the Chinese currency will be allowed to trade more freely by the end of next year.

The clue lies in what the central bank can -- or can't -- do next. One argument is that now that the political debate on the merits of raising interest rates has been resolved, the central bank, which last increased rates nine years ago, can come up with more and bigger increases.

That won't be easy. Monetary policy in China is compromised by the yuan's peg of 8.3 to the dollar. If the Chinese interest rates rise too much too fast, more foreign capital will flow into China. The central bank will have to buy the incoming dollars to hold the peg, adding more liquidity in the banking system, and aggravating the inflation problem.

``A flexible exchange rate is needed,'' says Lehman Brothers economist Rob Subbaraman, ``in order to have policy independence in moving interest rates.'' Net inflow of overseas capital into China that wasn't linked to business investments rose to $9 billion in the third quarter, up from $3 billion in the previous three months, Subbaraman estimates.

Impossible Trinity

Government controls on money coming into the country and leaving it aren't nearly as strict as they need to be for China to avoid facing up to the reality of ``impossible trinity,'' an economic principle that says no country can simultaneously keep its exchange rate fixed, its monetary policy independent and its capital markets open to the world.

Put another way, bets on a stronger yuan aren't off just because China has decided to raise interest rates.

``China is excessively cheap and highly productive,'' said Bridgewater's Prince and Rotenberg. ``The problem will eventually be rectified by a substantial exchange rate adjustment.''

That should be music to the ears of U.S. Treasury Secretary John Snow, who has been calling for China to let the yuan's value be determined by the market. The yuan is seen as much as 40 percent undervalued -- and an unfair trading advantage -- by many U.S. manufacturers, and some lawmakers.

Protecting Savers

The U.S. trade deficit with China reached $124 billion last year, and is expected to be higher this year.

What's encouraging is that the People's Bank of China also decided to remove the ceiling of 9.03 percent from one-year bank lending rates. Giving banks freedom to charge more for riskier loans is a good way to ensure that efficient private borrowers aren't deprived of credit even as unprofitable state-owned enterprises use their connections to borrow cheaply.

Still, if the exchange rate, and not the interest rate, will have to be the critical weapon in the fight against inflation, then why raise lending rates at all?

According to Jonathan Anderson, UBS AG's economist in Hong Kong, the lending rates have been raised because deposit rates had to be increased to 2.25 percent for one year, from 1.98 percent. Policy makers are concerned ``at the prospect of deposits potentially leaving the banking system in favor of other assets or the sidewalk cash market,'' Anderson said.

Property Bubble

Chinese households are borrowing too much against their future earnings to preserve their wealth, says Andy Xie, Morgan Stanley's chief economist for Asia. ``Ten years ago, Chinese people bought refrigerators and TVs to hedge against inflation,'' says Xie. ``Property is now the hedge.''

Property is also the big worry. ``Anecdotal evidence suggests borrowers are currently committing between 40 percent and 60 percent of their monthly income to mortgage repayments,'' says Kenneth Tsang, head of research for Greater China at real estate brokerage Jones Lang LaSalle Inc.

By signaling that mortgage rates should rise, the Chinese central bank may be trying to prick the property bubble now, before it bursts with disastrous consequences for the economy.

To contact the writer of this column: Andy Mukherjee in Singapore at amukherjee@bloomberg.net.

Last Updated: October 30, 2004 18:18 EDT