Surprise surprise! China raises interest rate in unexpected times

Contributed by Qihan Li

Sources: VOA news, FT, WSJ

China’s decision to raise the interest rates of its central bank by 0.25 percentage points has caught the world by surprise.  The raise brings China’s one-year lending rate to 5.56% and one-year deposit rate to 2.5%. It comes at a time of heated discussions regarding RMB’s exchange rate, and the state of the Chinese economy. While China’s recent GDP figures will make any developed nation jealous, (10.3% for the second quarter, 9.5% projected for the third quarter) many scholars in China are still concerned with low domestic demand.  Within the blogosphere and major publications, economists disagree on the ultimate effects of the hike, but most agree on its intentions: to combat domestic inflation and market bubbles.

The year-to-year CPI figure stands at 3.5% in August so the hike in interest rate is interpreted to prevent rises in prices.  Despite the uncertainties regarding consumers’ reactions, what is certain is that small businesses that have taken recent loans will be directly affected, as they will need to pay more in interest.  This may particularly hurt export-oriented companies because the evaluation of RMB has already reduced their competitiveness in foreign markets. On the other hand, state-own enterprises will largely be unaffected since most of them have good capital flows. The effects on the overall economy will be much more difficult to evaluate.  While fewer individuals will borrow money to invest in commodities or real estate, it may not prohibit wealthy private or corporate investors to continue to invest in real estate as a hedge to high inflation.  Earlier policies to cool off the real estate market have somewhat worked but have not changed the general speculation. The effectiveness of this move is to be seen.

On the issue of exchange rate, as Ian previously mentioned, a drastic evaluation will dramatically hurt China’s export industry.  There have been concerns regarding the inflow of hot money due to this hike, pressuring the RMB to appreciate. However, because the RMB is controlled by the People’s Bank of China, the correlation between a higher interest rate and RMB’s exchange rate may be relatively low. This is nonetheless an important aspect to look out for in the upcoming months.