China surprises markets with interest rate hike

 
City A.M. Reporter
China's central bank surprised markets with its first increase of interest rates in nearly three years, a move that reflects concern about resurgent asset prices and could mark the start of a more aggressive phase of monetary tightening in the world's fastest-growing major economy.

The People's Bank of China 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 per cent.

If there was ever any doubt about China's role in driving the stuttering global economic recovery, the impact was felt by markets across the board. Oil and gold prices tumbled, stocks turned negative in Europe and the dollar jumped.

"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.

Some analysts said the rate increase also suggested a deal was in place between China and the United States to strengthen the yuan and put an end to worries about a currency war of competitive devaluations ahead of upcoming Group of 20 meetings.

But others said just the opposite was the case – with higher rates, Beijing can afford to rely less on currency appreciation to keep the economy on an even keel.

Finance ministers of the G20 major economies will aim to tackle the currency strains in a meeting in South Korea starting on Friday. The country also hosts a G20 leaders' summit in November.

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.