The screws are tightening, but it’s not torture yet

CHINESE interest rate rises are, it seems, rather like coffee. The effect gets smaller with each extra dose. When the People’s Bank of China (PBoC) first announced an interest rate increase in mid-October last year, the trade-weighted dollar strengthened 1.7 per cent. The second rate rise, announced on Christmas day, produced a smaller reaction, but still something. Yesterday, however, the PBoC raised interest rates by a further 25 basis points and the markets barely budged. Only the Australian dollar dipped back, by about 0.5 per cent against the US dollar.

Yet the World Bank estimates that a 1 per cent drop in Chinese growth would cut global growth by 0.5 per cent. Are traders a little too sanguine about China’s tightening shift?

Probably not. As Stephen Gallo, head of market analysis at Schneider Foreign Exchange said: “It’s only 25 basis points. A 50 or 100 basis point rise might have had an effect, but not 25.” Gallo argues that while earlier rate rises signalled a significant reversal of China’s monetary stimulus, markets mostly interpreted yesterday’s rise as part of an ongoing (and anticipated) trend of tightening. As a result, the implications for commodity prices, and for China sensitive currencies such as the Australian and Kiwi dollars, were small.

Kit Juckes, a foreign exchange strategist at Societe Generale, said much the same thing: “It’s going to take a lot more than this to shake us out of stupor . . . China’s monetary policy is not tight. An interest rate rise is just plain sensible.” Juckes argues that the reactions to rate hikes in December and October actually provided traders “a chance to get stuck in” and buy commodity currencies. Yesterday’s surprise move thus failed to change much.

As Richard Wiltshire of ETX Capital said, “The fact that the PBoC has successfully delivered two interest rate increases in three months should serve to answer some doubt about the Chinese government’s ability to ‘fine-tune’ the economy in 2011.” Wiltshire even suggests that the Chinese government perhaps ought to really be tightening further. “The Chinese authorities have been reluctant to tighten monetary policy because they are worried about the rising financial burden on projects started under the stimulus, and about capital inflows.”

But Gallo argues that further rate hikes are now quite likely. “Traders are making a mistake if they’re don’t see this as an appetiser,” he said. “The Chinese are deeply worried about inflation, and especially food price inflation. They’re going to control it as best they can.” Gallo argues that it is very risky buying into currencies like the Australian dollar, at least in the short run. “By the second quarter, the Aussie could drop to $0.97.” But that seems unlikely to happen all that soon. Traders will just have to keep watching – sometimes kicks can take a while to get going.