China surprises with first rate rise since 2007


Reuters | Oct 19, 2010 | 6:29pm IST

China’s central bank surprised the world on Tuesday with its first increase of interest rates in nearly three years, a move that reflects its concern about rising asset prices and stubborn inflation. It said it was raising benchmark rates by 25 basis points, taking one-year deposit rates to 2.5 percent and one-year lending rates to 5.56 percent.

China central bank The impact was felt by global markets across the board. Oil prices fell, stock markets turned negative in Europe and the dollar rose as investors were caught off guard by the tightening step. "The interest rate rise is entirely outside of market expectations," said Zhu Jiangfang, chief economist at CITIC Securities in Beijing. "The recent rise in headline inflation has put the real rate into negative territory. And I think that’s why the central bank needs to raise interest rates in such a hasty way," he said.

Although announced by the People’s Bank of China, the decision to increase rates would have received approval from the highest echelons of Chinese power, with Premier Wen Jiabao likely signing off on it. Once a consensus has been forged in Beijing to raise or cut rates, past experience shows that moves often come in bunches.

In the view of some, it is about time for China to embark on a more aggressive tightening cycle. To date, it has relied on lending restrictions and banks’ reserve requirements to keep growth from boiling over. "Fundamentally, policy rates are just too low for an economy that’s growing around 10 percent. To avoid bigger distortions, China needs to start moving rates to more appropriate levels," said Rob Subbaraman, an economist with Nomura in Hong Kong. "China’s economy looks as though it’s decoupling from other major economies, and its policies should as well," he said.

DEBATED BUT UNEXPECTED

A number of leading economists, including some advisers to the central bank, have urged an increase in deposit rates to keep savers’ returns in positive territory. China reported consumer inflation of 3.5 percent in the year to August and economists expect that the pace climbed to 3.6 percent in September.

Still, the increase in rates is surprising given that several top leaders have recently expressed confidence that inflation is under control, and have said that higher rates would potentially suck in speculative capital from abroad. "They did it now likely because Thursday’s GDP and CPI data is too strong for them," said Dariusz Kowalczyk, senior economist at Credit Agricole CIB in Hong Kong.

China is due to report third-quarter GDP and a suite of economic data for September on Thursday. The consensus forecast is that economic growth slowed to 9.5 percent year-on-year last quarter, down from 10.3 percent in the second quarter. Economists polled by Reuters last month had expected an extended period of interest rate stability in China, with no increase until the second quarter of 2011. Propelled in part by these expectations of low rates, Chinese asset prices have shown signs of taking off.

The Shanghai stock index, a laggard for much of this year, has jumped nearly 16 percent in the past nine trading days. And despite a months-long campaign to clamp down on the real estate market, housing inflation has started to perk up again. "This is a bucket of cold water for the market," said Zhang Yuheng, an analyst with Capital Securities in Shanghai. "The hike itself is not a big one, but the psychological impact is big as the expectations for more rate hikes will appear."

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