People’s Bank of China Lifts Key Interest Rates: First Move of Cycle

October 19, 2010

China’s one-year lending rate and one-year deposit rate were raised by 25 basis points each, effective October 20, to 5.56% and 2.5%, respectively.  This first rate increase since December 10, 2007 is subject to varying inferences.  Enhancing the state of confusion over today’s action, Chinese central bank officials over the past month had been expressing satisfaction with a modest policy tightening that had not until now involved the coarse instrument of interest rates, consisting instead of higher reserve requirements, administrative guidance, and a variety of steps aimed at specific industries.  So the rate hike involved an element of surprise.  The move comes one day before the release of a slew of economic indicators including 3Q GDP growth and September consumer prices, producer prices, retail sales, industrial production and fixed asset investment.

As a step to contain inflation, today’s rate increase might herald a faster yuan appreciation, which is another way to tighten monetary policy.  Alternatively, Chinese central bank officials may be boosting interest rates as a substitute for a rising currency.  Beijing officials resent foreign criticism of their comparatively inflexible forex policy.  Reportedly, they would like a quid pro quo of lessening Fed quantitative easing in exchange for their ascent to steeper yuan appreciation.

The People’s Bank in 2007-08 proved highly aggressive in moving its interest rate.  This history also sows uncertainty regarding follow-up moves in the period ahead.  China’s key interest rates remain well below cyclical highs of 7.47% on the lending rate, which was also a 9-year peak, and 4.14% on the deposit rate reached after a sixth and final increase in 2007 undertaken in the final month of that year.  At the time of that last rate increase, CPI inflation stood at 6.9% compared to 3.5% now.  PPI inflation was at 4.6%, similar to 4.3% currently.  M2 growth was 18.5% then and is at 19.2% now.  Chinese bank lending has not slowed as much as officials desire, having shot up 596 billion yuan in September, 19% more than assumed.  Retail sales growth was at 18.8% versus 18.4% as of August 2010.  Exports had posted on-year growth of 22.8% versus a more recent 12-month advance of 25.1%.  China’s reserves of $1.455 trillion toward the end of 2007 have ballooned further to $2.65 trillion as a result of intervention to suppress yuan strength. 

China’s peak interest rate levels were retained for nine months.  In five subsequent moves, the lending rate was slashed 216 basis points and the deposit rate was cut 189 bps in the space of a mere three month between September 15, 2008 and December 22, 2008.  After the yuan was first unfrozen against the dollar in July 2005, it was allowed to rise 3.4% in the first year, 9.4% over the course of two years to July 2007, and was up by a total of 21.4% in July 2008 whereupon it was again tied to the dollar and not allowed to change for the ensuing two years.  A second un-freezing of the yuan was announced by officials on June 19 of this year, but for two months that was close to phantom policy change as the currency still barely moved.  More flexibility has been permitted during the past two months, however, and yuan is now 2.7% above its mid-June level, which represents an annualized 8.4% pace of appreciation. 

Officials in other countries remain suspicious that a faster rise of the yuan and today’s rate increase boil down to political posturing ahead of next month’s Group of Twenty summit in Seoul, South Korea.  From July 2005,  yuan appreciation amounts to 4.3% per annum, and that is not nearly as much as U.S. lawmakers seek.  The hope all along has been that the interests of Chinese and foreign officials would converge as domestic inflationary pressures build in China.  Any change in Chinese objectives is apt to be pretty incremental.  A slowdown of Chinese growth beyond 9.0% would be unintentional, and at desired near-double digit speeds of overall growth, China is unlikely to rotate the composition of expansion away from net exports and toward personal consumption quickly enough to satisfy the government’s critics.  Protectionist frictions are likely to intensify in 2011, and an inverse correlation between the dollar and share prices is likely to continue.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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