China Rate Increase a Responsible Move to Tame Inflation

China yesterday (Tuesday) accelerated its campaign against surging inflation by raising interest rates for the third time since mid-October in advance of reports expected to suggest prices are racing ahead at the fastest pace the nation has seen in 30 months.

The benchmark one-year lending rate today will increase to 6.06% from 5.81%, the People's Bank of China (PBOC) said on its Website. The one-year deposit rate will rise to 3% from 2.75%.

The move was hardly cheered by investors, but most analysts believe it was the appropriate action to take considering the country's torrid inflation.

The interest hike came on the final day of China's weeklong Lunar New Year holiday and before a report next week that may show consumer prices rose 5.3% in January.

Commodity markets fell after the central bank announcement on concerns the hike might slacken demand in the country that helped guide the world out of the recent financial crisis.

Three-month copper fell below $10,000 a ton, U.S. crude oil futures prices dropped and emerging-market stocks posted losses as China joined India, Indonesia, Thailand and South Korea in boosting rates this year.

These losses could be followed by even more disquietude as investors worry about the effect higher rates will have on global economic growth.

"If inflation stays high in February, the central bank will be forced to increase interest rates on a continuous basis," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "Investor confidence will be seriously hurt by expectations of aggressive policy tightening."

Of course, while tighter policy may have tapped the brakes on the Chinese economy and taken a toll on the domestic stock market - which has dropped 12% since hitting a 2010 high in November - Fitz-Gerald thinks the long-term effects will be moderate.

"Ultimately the raising of interest rates will be viewed as a sign of adult supervision and strength," said Fitz-Gerald. "Real interest rates remain negative, which means that Chinese monetary policy actually has a stimulative effect."

As China struggles with a property market bubble and surging food prices on the heels of a drought that's crimping supplies, Beijing's goal is to hold inflation at 4% this year. But the economy is flush with cash after money supplies jumped more than 50% in two years and China's world's-biggest foreign exchange reserves climbed by a record $199 billion in the fourth quarter to $2.85 trillion.

Banks extended $1.2 trillion (7.95 trillion yuan) in new loans last year, exceeding the government's targeted maximum of $1.13 trillion (7.5 trillion yuan). And new lending may have surged to $181 billion (1.2 trillion yuan) in January alone, according to the median estimate in a Bloomberg survey of analysts.
In response, Beijing has raised reserve requirements on banks seven times over the past year and ordered them to lend less.

Beijing also has imposed a series of controls targeting property prices that have stayed stubbornly high. Acutely aware of polls that say the public is angry about unaffordable housing, the country's leaders have said they will not tolerate property inflation and speculation.

"The rate hikes, while ostensibly about controlling inflation, are actually part of a much broader program designed to crack down on speculation and hoarding, while giving the Chinese people reason to keep money in banks rather than shifting into property and equities," said Fitz-Gerald.

In yesterday's move, the central bank raised long-term rates for savings deposits by 45 basis points for five-year terms, 20 basis points higher than for lending. China's one-year deposit rate will climb to 3.25% by June, economists forecast in December.

Isaac Meng, a Beijing-based economist for BNP Paribas SA (PINK ADR: BNQPY), told Bloomberg he expected "accelerated tightening" that would see rates rise by as much as another 1.5 percentage points.

But while more interest rate hikes this year are likely to slow China's economy some, it still is expected to keep humming along at a rate more developed economies can only view with envy. China's gross domestic product (GDP) will grow by 9.3% in 2011, according to a Reuters poll, down from a red-hot 10.3% last year.

Still, that Beijing is tightening the reins on its economy at a time when U.S. and Eurozone interest rates are at record lows is a mark of confidence that the world's second-largest economy is on solid ground, according to Fitz-Gerald.

"In the end, the move will be seen as a sign of strength, with solid growth momentum allowing policymakers to raise rates. Global markets should respond positively to such moves aimed at controlling inflation," he said. "Isn't the action China's now taking exactly what everybody wishes Team Bernanke would do here to counter the more than $14.1 trillion in inflationary kindling now stacked up outside the door?"

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