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China's Surprise Rate Hike: What it means

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1 China's Surprise Rate Hike: What it means on Wed Oct 20, 2010 7:13 am


Wed, Oct 20, 2010, 7:01AM EDT - U.S. Markets open in 2 hrs 29 mins

..China's Surprise Rate Hike: What It Means

by Daniel Gross, Yahoo! Finance
Tuesday, October 19, 2010

Mike Santoli, columnist at Barron's, talks to Daniel Gross and Aaron Task about China's rate hike.

On Tuesday global stock markets got up on the wrong side of the bed thanks to news from an unexpected source: the People's Bank of China. The nation's central bank, analogous to the Federal Reserve in the U.S., announced it would raise rates on one-year loans and deposits by .25 percent, or 25 basis points.

Why is the People's Bank of China raising interest rates?

Central banks raise interest rates when they are concerned about inflation, or if they are worried that credit or the economy at large is expanding at an unsustainable pace. Higher interest rates make money more expensive, and thus should cut down on borrowing activity. China's economy is growing very rapidly, at a 10.3 percent annual rate in the most recent quarter, and inflation is running above the official target of three percent. For a country that has to make up as much ground as China does, no rate can be too fast. But housing markets, especially in coastal cities, have been raging. With observers fretting about bubbles, China's central bank has taken efforts to discourage real estate lending and choke off inflation. Raising interest rates is one way to do that.

Why would global stock markets react negatively to this news?

Two reasons. First, think about the changing shape of the world's economic geography. The U.S. (the world's largest economy), Japan (until recently the world's second-largest economy), and the European bloc (which rivals the U.S. in size) are all growing very slowly. China, now the second-largest economy in the world, accounts for a huge amount of growth and demand. While it exports a great deal, it also imports massive quantities of everything from nuts grown in California to copper mined in Chile. The Chinese domestic market has also finally emerged as an important source of sales; General Motors sells more cars in China than it does in the U.S. So any hint that the Chinese juggernaut might be showing signs of slowing is bound to be seen in a negative light by investors who are concerned about growth.

Second, it was a surprise. Markets hate surprises. As a general rule, monetary policy in the U.S. and Europe is conducted with a certain amount of transparency. Officials use speeches and statements to telegraph their intentions, so as not to surprise investors and markets. In China, government bodies keep information very close to their vest and don't face the same type of pressures that western central banks do to give notice about their actions. Since the markets for Chinese currency are very tightly controlled, the People's Bank of China doesn't feel the need to communicate openly about its intentions.

What are the effects of such an increase on China's economy?

The impact of this rate increase lies as much in its symbolism as in its practical effect. Boosting the rates by 25 basis points is like tapping the brakes gently on a freight train running at 90 miles per hour -- it can only slow it down a bit. But it does signal that China's central bank is sufficiently concerned about some issues in its economy to take action.

The exchange rate of China's currency, the yuan (the Renminbi is the official name of the currency, while the yuan is the main unit of currency), against the dollar, has been a contentious issue between the U.S. and China. How does this move affect the exchange rate?

In theory, raising interest rates in China should make the yuan stronger against the dollar. All things being equal, money flows toward countries with higher interest rates (like China) and away from countries with very low interest rates (like the U.S.). But despite intense pressure from the U.S. government, China has remained committed to keeping the yuan trading in a stable range against the greenback. China prefers a weak currency because it makes Chinese goods cheap for American consumers and makes American-made goods expensive for Chinese consumers -- which encourages exports and the consumption of domestically produced goods.

Daniel Gross is economics editor and columnist at Yahoo! Finance.

Follow him on Twitter: @grossdm. Email him at grossdaniel11@yahoo.com.


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