Q+A-Why did China raise rates and what’s next?

By Simon Rabinovitch and Kevin Yao

BEIJING, Oct 20 (BestGrowthStock) – China surprised markets on
Tuesday with its first interest rate increase since 2007, the
clearest tightening step it has taken since the country’s
stunning recovery from the global financial crisis.

Here are some questions and answers about the significance
of the move.
(For more stories on the rate move and global market reaction,
see [ID:nN19266020]

WHY RAISE RATES NOW?

All explanations are unavoidably post-hoc, since virtually
no analysts or traders saw the rate increase coming.

Most economists think that worries about inflation and
asset prices drove the decision. Although there is no evidence
that inflation is getting out of control, consumer prices have
been rising faster than Beijing’s 3 percent annual target and
making for negative deposit rates in real terms.

The government’s credibility in managing inflationary
expectations was at stake. Months-long efforts to cool the real
estate sector had showed signs of coming undone, with people
once again concluding that property was a far better investment
and even a safer store for their wealth than bank deposits.

The People’s Bank of China made clear in the nature of its
rate rise that it wants savers to lock up more of their cash in
banks for longer periods. At the short end, it kept rates
unchanged on demand deposits. But at the longer end of time
deposits, it bumped rates up by 60 basis points.

IS THIS THE START OF A TIGHTENING CYCLE?

Many economists, though not all, believe Beijing has now
kicked off a cycle of rate increases. But as with so much in
China, this is seen as likely to be gradual, so that
policymakers can take time to gauge the impact of tightening.

For example, UBS expects three rate hikes in 2011, Mizuho
Securities forecasts two before the middle of next year and
Deutsche Bank believes there will be two over the next 12
months.

To some extent, asking whether a tightening cycle has
started misses the point. China began tightening policy late
last year, and the rate rise is simply an intensification of
that.

After a surge in bank loans in 2009, Beijing has kept a lid
on credit growth this year through strict lending quotas. It
has also raised reserve requirements for all banks three times
to lock up more of their cash, while pushing through a fourth,
targeted reserve increase for six major banks last week.

Many economists had discounted the possibility of a rate
increase so soon, because they believed that China preferred
such measures that control the quantity, not the price, of
money.

Peng Wensheng, chief economist with CICC in Beijing, said
this preference was still very much in place, with inflation
set to peak soon and easy money in developed economies still
constraining China. Instead of further rate hikes, he said the
government would return to relying on reserve requirements,
lending controls and open-market operations.

WHAT DOES THIS MEAN FOR THE YUAN?

In a fully open economy, higher rates would normally
translate into upward pressure on the currency. But China is
far from fully open and it has repeatedly sworn off major
appreciation in its management of the yuan’s exchange rate.

The yuan (CNY=CFXS: ) had been rising at a fast clip by
Beijing’s standards, gaining almost 3 percent against the
dollar over the two months before the rate increase.

The central bank decisively broke that trend on Wednesday,
setting the yuan’s exchange rate sharply lower. Some traders
now believe that the government will put the brakes on
appreciation to ward off capital inflows.

Moreover, higher rates mean the central bank has less need
to push for currency appreciation as a tightening tool.

Nevertheless, China still faces heavy pressure from the
United States, Europe and others to allow for a stronger yuan,
so there could be a resumption of gradual appreciation of 3-5
percent a year before long.

WHAT ABOUT CAPITAL INFLOWS?

Part of the reason the rate rise caught the market off
guard was the belief that Beijing would not want to increase
its rate differential over the United States and risk sucking
in hot money.

Officials are undoubtedly worried about capital inflows,
but the decision reveals a calculation that rising asset prices
rather than widening rate differentials are the main attraction
for investors chasing higher yields.

China’s capital account is already carefully controlled and
the coming months could bring more measures to thwart
speculators.

But the government will avoid draconian steps, as indicated
by recent comments from Yi Gang, a central bank vice governor,
that capital controls could be harmful and therefore should be
limited.

WHAT DOES IT SAY ABOUT DATA DUE THIS WEEK?

China reports third-quarter GDP and a batch of September
data on Thursday. On the heels of the rate increase, the market
chatter is that there could be upside surprises, particularly
in consumer price inflation.

Analysts polled by Reuters had forecast that inflation
edged up to 3.6 percent in the year to September from 3.5
percent in August, but some now say it could be closer to 4
percent. [ID:nTOE69D042]

Leaving the specific numbers to one side, the rate rise is
more important in what it says about how the government is
reading the data.

When he was a central bank vice governor, Zhu Min described
interest rates as a “heavy-duty weapon” in managing the
economy. China has long been gun-shy, keeping rates steady even
as its economy roared ahead after the global financial crisis
and those in its tow, from South Korea to Australia, raised
their rates.

China’s top leaders would have signed off on the rate
increase. In so doing, they have delivered a strong vote of
confidence in the Chinese economy and its resilience despite
sputtering recoveries in developed markets.
(Editing by Jacqueline Wong)

Q+A-Why did China raise rates and what’s next?