China rate hike surprises markets

By Howard Schneider
Washington Post Staff Writer
Tuesday, October 19, 2010; 11:08 PM

China's unexpected decision to raise interest rates could heighten tension over its economic policies, highlighting the divide between the strong growth that has taken hold in some parts of the world and the laggard performance in the United States and Europe.

The increase by the People's Bank of China was small but unexpected, jolting U.S. financial markets with concerns that China may try to slow its economy to counter inflation even as the developed world worries about the potential for renewed recession.

The hike in the benchmark interest rate to 5.56 percent reflected worry in Beijing about a recent boom in bank credit and a spike in property prices, and many analysts saw it as driven by purely domestic concerns that both should be tempered.

U.S. stocks fell in response to the decision as well as to worse-than-expected results from tech staples IBM and Apple, overwhelming positive news that U.S. housing starts had edged slightly higher in September. The Standard & Poor's 500-stock index, a broad measure of U.S. markets, fell 18.81, or 1.6 percent, to 1165.90.

China's central bank is not the only one among the world's faster-growing nations to switch to policies aimed at making sure growth does not get out of hand. In recent months, India, Brazil and Australia have begun raising rates, while nations such as South Korea and Indonesia have signaled that their rates may be raised soon.

Those moves stand in contrast to the discussion in the United States, where the Federal Reserve is weighing whether to pump more money into the financial system to stimulate the economy.

China's action, however, is of particular note. The country is now the world's second-largest economy, and its near 10 percent annualized growth has been an important prop to the global economic recovery.

While the United States and developed countries struggle to boost growth and demand, China and other faster-growing nations have been working to manage an inflow of foreign capital as overseas investors turn to emerging markets for higher returns.

In other places, such as Brazil, the influx of money has caused local currencies to appreciate. But in China, efforts to closely manage the exchange rate - and keep its exports competitively priced - means officials have had to intervene steadily in currency markets.

Rising interest rates may draw even more outside capital into China - putting further pressure on the renminbi to rise in value.

Finance ministers from the Group of 20 major economic nations are gathering in South Korea this week, and ongoing tension over currency is expected to be a central point of discussion.

A U.S. Treasury spokesman said the agency had no comment on the Chinese rate decision.

The Obama administration has urged China to relax its currency policy to let the renminbi rise in value based on market forces, and the International Monetary Fund also has expressed concern that imbalances between major exporting nations and debt-laden importing countries are not evening out as hoped.

Trying to battle inflation by raising interest rates may signal that the renminbi won't be rising in value by as much as the United States and other nations hope. A rising currency increases the purchasing power of local consumers, makes imports cheaper, and is one tool that can help restrain rising prices.

The Chinese currency has been appreciating at a faster pace in recent weeks, but analysts at the Treasury and elsewhere say they will watch closely to see if the increase continues after the current round of G-20 meetings, once international attention turns elsewhere.

In research notes on China's currency and interest rate policies, the consulting firm Capital Economics said the small rise in interest rates would have little effect on China's economic performance, but argued that the recent rise in the renminbi would soon "run out of steam" - in part because of concern about the same capital inflows that the increase in interest rates may encourage.

If investors come to regard the renminbi as a "one-way bet" - only moving upward - then the flow of money into the country will only increase, the company's analysts concluded.

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