SINGAPORE, Nov. 1 (UPI) -- Last week, Chinese authorities surprised the market by hiking their key interest rates for the first time in nine years. The hike is now viewed as one of many to come in the next few months as China starts tracking the U.S. Federal Reserves much more closely. But while there is some speculation that the rate hike could lead to greater pressure for the renminbi to revalue, the authorities are more likely to wait until the banking sector's problems are on the mend before tackling a change in currency policy.
Already, officials are warning that China could face stronger inflationary pressure due to rising cost of raw material and oil. China faced "relatively big pressure in price increases," a Chinese daily quoted the head of the National Bureau of Statistics, Li Deshui, as saying on Monday.
Consumer inflation slowed to 5.2 percent in September from a seven-year high of 5.3 percent in the previous two months, but producer prices continued to rise during the period, pointing that consumer inflation is more likely to have paused only.
"China raised interests rate to cool an overheated economy. This is a welcome move after the limited successes of administrative measures to cool the economy. The current environment of negative real interest rate has introduced grave distortions in the economy that will lead to
another wave of bad debts, in my view," said Andy Xie, chief economist at Morgan Stanley.
"I think that this rate hike is the first of many to come. China will likely track the Fed rate hikes in the coming months and this approach offers the best chance for China to achieve a soft landing," Xie added.
That said, economists do not agree on the timing of the next rate hike. While Hong Liang, China economist at Goldman Scahs believe it will take place within the next three months, DBS Bank economist Chris Leung said another rate hike is unlikely to take place, either before or after the release of fourth quarter GDP data in late 2004 or January 2005.
"The current rate hike cycle is likely to be implemented as a series of small increases of 25 basis points to 30 basis points. This would safeguard the interest of the Big Four Banks, which have purchased an enormous amount of treasury debts in the past 5 years, and help steer the economy towards a more sustainable GDP growth path of around 7-8 percent," Leung wrote in a recent research note.
"We think this is the beginning of a long process of normalizing interest rates. We look for 200-300 basis points in hikes in the coming 12-18 months," said Dong Tao, Asia chief economist at CSFB.
Last Thursday, the Chinese central bank raised the one-year lending rate to 5.58 percent from 5.31 percent in an effort to cool growth, which has slowed in recent months, but still remains at a robust 9.1 percent in the third quarter.
Economists believe the rate hike will be more effective in combating inflationary pressures than the administrative controls in place so far. Raising interest rates will also ease worries that China may overheat "again" as these administrative measures are pulled back.
Yet, they also agree that the rate hike alone will not be sufficient as it is too small to derail China's robust economy and demand.
For now, the market appears to be divided into two camps: those who think that the central bank's move is a substitute for an adjustment to the renminbi peg, and those who see the move as representative of a continuation of market-based reforms and likely to attract further capital inflows, which will in turn lead to greater pressure for the renminbi to revalue. But on majority, analysts believe the first option prevails.
Leung believes it is premature to draw conclusions for the exchange rate regime from the hike. "China still needs to get its macroeconomic policy sequence right, i.e. clean up the banks first. It is illogical to induce a big policy change without getting the banking sector ready," Leung said.
Pieter Van Der Schaft, economist at Barclays, also does not believe the rate hike imply a currency revaluation is looming as "this would only lure more speculative inflows into China." The authorities still very much desire to internalize their measures to curb growth and inflation, and not allow potentially greater interest rate volatility -- which they see as detrimental to the banks -- by revaluing the renminbi as well, he said.
"The exchange rate regime is unlikely to change in the foreseeable future. A sudden change in the exchange rate could lead to another wave of massive speculation, leading to much greater damage to China's financial system," said Xie.
"The exchange rate reform can take place when first China's economy has landed, second the Fed funds rate is sufficiently high to dampen speculation, and thirdly) the market expectation of renminbi has become realistic," Xie added.
All economists agree that the scrapping of the upper limit on lending rates reflected a desire on the part of the authorities to adopt a more market-based approach. It is one of the first times the communist government allows banks to use free-market considerations in lending.
As such, it could help stabilize China's banking system, which is burdened with non-performing loans issued to failing state businesses.
"The complete removal of ceiling on bank lending rates carries more implications than the eventuality of rate hikes, which are more or less expected by the market. It looks like interest rate liberalization will speed up at a faster pace from now on," said Leung.
