Why did China raise rates and what`s next?

Beijing: 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.

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 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 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.

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.

Bureau Report

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