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Global Economics

China: The Latest Interest Rate Hike

The fifth increase this year sends a strong signal to markets that Beijing is willing to take more aggressive action to slow down inflation

The People's Bank of China raised interest rates again, four days after China announced that August's inflation index rose to a 11-year high. Starting Sept. 15, the benchmark one-year lending rate will rise to 7.29%, from 7.02%. The one-year deposit rate will rise to 3.87%, from 3.60%.

The markets had expected the Chinese central bank to raise interest rates for a fifth time before the end of this year. China's policymakers' most recent rate hikes—coming three weeks since the last increase—coupled with other measures taken last week, have sent a strong signal to the financial markets that Beijing is willing to take more aggressive action to keep inflation under control.

China's central bankers have seen inflation rise higher than their original forecasts primarily due to soaring food prices. Earlier this week, China reported that the monthly inflation rate for August rose 6.5% to its highest level since December, 1996.

Negative Interest Rate Environment

In the first eight months of this year, inflation rose 3.9%, which is higher than the Chinese bank's original one-year deposit rate of 3.6%. Chinese who leave their money in bank deposits have seen any expected earnings from interest rates eaten away by inflation. The central bank is concerned that this is encouraging people to withdraw their money and invest it in real estate and stocks, fueling asset bubbles in these two sectors.

"This negative interest rate environment is not conducive to a healthy development of the Chinese economy or the financial markets. That's the reason the PBoC hiked interest rates five times in a row this year," says Ha Jiming, a Beijing-based economist with China International Capital Corp.

Even before the latest rate hike, the People's Bank of China exhibited signs that it was getting more serious about reining in inflation.On Sept. 6, China's central bank raised the banks' reserve requirement ratio 50 basis points to remove excess liquidity from the banking system. The central bank also issued 150 billion yuan worth of central bank bills to commercial banks—to punish banks whose loan growth has been too fast—by giving them lower-than-market yields.

Expecting Further Tightening

While economists applaud the Chinese central bank for relying more on market-oriented tools to prevent the economy from overheating, some argue that allowing the yuan to appreciate at a faster pace against the dollar would be more effective in taming inflation. However, Beijing has been loath to let the Chinese currency appreciate faster than the 5% annual increase expected by the markets, lest they be seen as caving to threats from Capitol Hill.

So for now, economists expect the Chinese central bank to further tighten monetary policy in the coming months. In a research note, Goldman Sachs (GS) economist Hong Liang wrote, "Going forward, we expect the monetary authority to implement more tightening measures including one more 27-bp interest rate hike, more aggressive withdrawal of liquidity (possibly through further RRR hikes), and stepped-up moral suasion on commercial banks to curb lending."

Chi-Chu Tschang contributed this article to BusinessWeek Online from Beijing.

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