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China raises rates with inflation on the rise

China raised interest rates on Tuesday for the second time in just over six weeks, intensifying a battle against stubbornly high inflation that threatens to unsettle global markets.

business Updated: Feb 08, 2011 20:04 IST

China raised interest rates on Tuesday for the second time in just over six weeks, intensifying a battle against stubbornly high inflation that threatens to unsettle global markets.

The timing was a surprise, coming on the final day of China's Lunar New Year holiday, but investors have long expected more monetary tightening as Beijing struggles to rein in price pressures and ward off a property bubble.

Benchmark one-year deposit rates will be lifted by 25 basis points to 3%, while one-year lending rates will also be raised by 25 basis points to 6.06%, the People's Bank of China said. The changes go into effect on Wednesday.

Although annual inflation slowed in December, analysts polled expect it to have picked up to 5.3% in January, the fastest pace in more than two years, on the back of soaring food prices.

"It is the first interest rate rise in the Year of the Rabbit, but it will not be the last," said Xu Biao, an economist with China Merchants Bank in Shenzhen, referring to the country's new year, which began last week.

"If inflation stays high in February, the central bank will be forced to increase interest rates on a continuous basis," he added. "Investor confidence will be seriously hurt by expectations of aggressive policy tightening."

Fearing tighter monetary policy will dampen demand in a country whose growth helped lift the world out of the global financial crisis, commodity markets fell after the central bank announcement.

Three-month copper fell below $10,000 a tonne and US crude futures prices dropped.

The MSCI world equity index held on to gains, trading up 0.15%, but the FTSEurofirst 300 index was down 0.3%, turning negative after China's move.

For now, however, Chinese officials have insisted that inflation will be controllable and domestic investors have priced in only gradual tightening.

Chinese stocks could, in fact, rise slightly when the market re-opens on Wednesday to catch up with Asian counterparts that have rallied during China's week-long holiday.

Tightening cycle
This is the third rate increase since China began a monetary tightening cycle in earnest in October.

Wary of raising rates too high, China has leaned most heavily on quantitative tools in its tightening, forcing banks to lock up more of their deposits as reserves seven times over the past year and also ordering them to lend less.

Beijing has also imposed a slew of measures to target property prices that have stayed stubbornly high. The country's leaders, acutely aware of public anger over unaffordable housing, have said they would not tolerate property inflation and speculation.

"I didn't think it (China's rate hike) would happen today, but it doesn't matter whether you think it will happen today or tomorrow. You know that interest rates are going up," said Mike Lenhoff, chief strategist at Brewer Dolphin in London.

Excessive cash in the economy, partly stemming from China's huge trade surplus, is a root cause of fast-rising prices and Beijing hopes that higher rates will encourage savers to keep more of their money in banks and also weigh on demand for mortgage loans.

Anti-inflation talk from the central bank in recent months has primed investors for more policy tightening and, even with the latest move, many believe further tightening is in the cards.

Economists forecast in December that China's one-year deposit rate would climb to 3.25% by June.

A stronger currency would be another weapon against inflation, reducing the cost of imported goods.

But Beijing is expected to keep the yuan to its path of gradual appreciation, frustrating critics from the United States to Brazil who say an undervalued exchange rate gives Chinese firms an unfair advantage in global trade.

Sign of strength
While tighter policy may have tapped the brakes on the Chinese economy and taken a toll on the domestic stock market, which has dropped 12% since hitting a 2010 high in November, analysts believe the country's slowdown will be moderate.

China's economy is likely to grow 9.3% in 2011, according to a Reuters poll, down from a pace of 10.3% in 2010 that many feared was unsustainable.

If anything, that Beijing is tightening policy at a time when US and euro zone interest rates are at record lows is a mark of confidence within the country that its economy, the world's second-largest, is on solid ground.

"Global markets may begin to see the frequent rate hikes as a sign that growth slowdown in China is inevitable, which could briefly weigh on market sentiment," said Dariusz Kowalczyk, economist with Credit Agricole-CIB in Hong Kong.

"But in the end, the move will be seen as a sign of strength, with solid growth momentum allowing policymakers to raise rates. And in the end global markets should respond positively to such moves aimed at controlling inflation," he said.