China: Rate Hike for a Hot Economy

The mainland's central bank raises interest rates for the third time in less than a year to try to put a lid on China's hyperactive economy

Beijing's financial mandarins have tried ever-so-carefully to calibrate just the right amount of credit tightening to prevent China's $2 trillion-plus, high-speed economy from overheating—without going too far and engineering an unwanted slowdown. It has been difficult, given the massive liquidity sluicing through the economy, and China's still-undeveloped financial markets.

That explains the move by China's central bank on Mar. 17, when mainland and world markets were closed, to hike interest rates for the third time since April, 2006. It was a modest move: The People's Bank of China increased a key benchmark, one-year interest rates, by 27 basis points to 6.39%. The one-year deposit rate was nudged up by the same amount, to 2.79%.

When markets reopened on Mar. 19 in Asia, the Chinese yuan hit a new high of 7.73 against the dollar, the highest level since China abandoned its fixed dollar peg back in mid-2005. The betting is that China may be prompted to raise interests again later in the year, and the U.S. Federal Reserve will hold steady or possibly cut interest rates.

Understatement of the Year?

The narrowing interest rate differential could make the Chinese currency, and the prospect of more appreciation in the future, more attractive to currency traders. President Hu Jintao's government is also under heavy international pressure to let the yuan—widely viewed as undervalued— rise in order to cool China's export growth and massive global trade surplus—which hit $177 billion last year.

The strong economic data out so far this year, plus the possibility that China's official investment data is understated, prompted Standard Chartered Bank on Mar. 19 to forecast another rate hike of 27 basis points in May or June. "Everyone is suspicious that they (the government) are understating the investment activity," says Standard Chartered economist Stephen Green. "Initially, we were thinking one hike" but the bank decided to revise that, he says.

A flurry of robust data for February probably played into the move by the central bank which posted its announcement on the PBOC Web site shortly after the close of the National People's Congress meetings (see, 3/5/07, "China Congress Puts People First").

Fear of Inflation

China's surprising 51% year-on-year spike in exports, a nearly 18% advance in M2 money supply growth, a 2.7% increase in inflation, and a 18.5% jump in industrial production were evidence that the economy was heating up again and prompted the central bank to make the move, according to some economists.

Another concern: inflation, particularly the run-up in food prices which is always a concern in populous, developing economies such as China and India (see, 3/13/07, "Chindia: High Food Prices Take a Bite"). China's consumer price index shot up 2.7% in February vs. 2.2% the month before, and an increase in food prices played a big role.

However, Lehman Brothers (LEH) economist Mingchun Sun in Hong Kong, and most other economist aren't terribly worried about runaway inflation taking hold of the Chinese economy. "It will peak at 3% in July, but then come down below 2% by the end of the year," he says. He and others argue that China had a strong harvest last year and that much of the price pressure on wheat is coming from drought conditions in Australia.

The PBOC has more room to tighten if it chooses to. Average interest rates are still only about 3% in an economy that is clocking about 10% growth per year.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE