China's Rate Hike Is Just the Beginning

China's surprise decision to raise interest rates for the first time since 2007 was as much a political move as an economic one. Policymakers are worried that economic growth plus food, labor, and property prices all threaten to get out of hand. The government also wants to show riled-up Chinese consumers that it is doing something about the ever-higher inflation rate, which could hit 3.6 percent in September—the fastest pace in almost two years. "This sends a signal from the Party to the people that they are concerned," says CLSA Asia-Pacific Markets China analyst Andy Rothman.

The trick is getting the balance right. "Beijing would like slightly slower but better-quality growth"—maybe around 8 percent, Rothman says, rather than his estimate of more than 10 percent for 2010. A massive rate hike, though it could smother inflation, would send property prices plunging and dent gross domestic product. Hence the fairly tame rise in the benchmark one-year lending rate to 5.56 percent from 5.31 percent, Meanwhile, savings deposit rates will go to 2.5 percent from 2.25 percent—enough to juice savers' income yet not enough to offset fully the effects of inflation.

The rate hikes will pressure banks to curb lending. New loans in September reached 596 billion yuan ($89 billion), higher than the 450 billion yuan consistent with meeting this year's lending quota, as Capital Economics economist Mark Williams pointed out in an Oct. 19 note to investors. Earlier efforts to cool the property market, including tougher down-payment requirements and more loan restrictions, have not paid off. That's why analysts expect more rate hikes to boost the quality of loans. Deposit rates are expected to go up, too, since consumers don't want to see inflation eat away at their savings forever.

The bottom line: China's surprise rate hike may be the first step in a long process to curb lending and inflation, without sacrificing growth.

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