The Central Bank's Interest Rate Hike Bombshell

By Sun Jianfang
Published: 2010-10-21

EO Online
Translated by Leslie Walczak
Original article

"It's too sudden. In the afternoon, during an exchange with a fund company, we said interest rates would not rise within the year, however, that night the central bank raised interest rates." Cathay Pacific Head Macroeconomic Analyst An Wanghu told reporters.

The interest rate hike was announced at 7pm on October 19 via the central bank's website; on October 20, banking institutions began increasing benchmark bank deposit interest rates.

The decision to raise interest rates came right after the conclusion of the 5th plenary session of the 17th CPC Central Committee and before the release of third quarter economic data.

"We suspect that the reasons behind the rate increase may be related to economic statistics that will be announced on the evening of October 21. China's third quarter economic data will be announced on the 21st, perhaps showing that some portions of the economy are overheating." An Wanghu said.

The interest rate hikes have surprised economists. Beforehand, as a result of the central bank's October 11 decision to raise the reserve ratio requirements of six banks, the market's general opinion was that because the RMB faces pressure to appreciate, the central bank would put more emphasis on using quantitative methods to regulate the market. This quarter, CITIC Securities, Cathay Pacific, Goldman Sachs, and other domestic and international investment banks all issued forecast reports stating that during the current year, the central bank would most likely not raise interest rates!

But this time, the central bank's actions defied everyone's expectations. Within an hour of the central bank raising interest rates, economists' cell phones were ringing off the hook, as everyone sought explanation for the bank's unexpected announcement.

Anticipation of increasing inflation may be the central bank's reason for raising interest rates. If this is the case, then one can indeed uncover some hidden signals. In mid-September, at this summer's annual World Economic Forum in Davos, Li Daokui, the director of the Center for China in the World Economy, Tsinghua University, expressed his personal opinion that the central bank should consider small increases to bank deposit interest rates. Do not forget that Li Daokui's other position is as a member of the central bank's monetary policy committee.

At that time, Li Daokui believed that the most recent rise in commodity prices was due to greater labor costs, greater costs of agricultural production, and international price increases of a large number of commodities. Within the next few years, moderate increases in these three fields will become a normal occurrence and appropriate increases in bank deposit interest rates are beneficial to the economy's stability.

But to return to the third quarter data, what may worry the market is that the consumer price index (CPI) might exceed current estimates. Presently, most economists estimate CPI to be about 3.6 percent, however, the central bank's interest rate hikes are causing some to question if the third quarter CPI will be higher than expected.

CITIC Securities (CITICS) found another reason behind the interest rate hike: concern over the stability of bank deposits. Recently, although the amount of bank deposits has increased, savings deposits are still few. The amount of CITICS's clients' reserves in other funds increased substantially in September. CITICS's latest report indicates that as expectations for an increase in real estate prices are lowered, the possibility of bank withdrawals is comparatively high; the new policy may be a response to stabilize the trend.

However, some economists have suggested that in addition to stabilizing bank deposits, the central bank should also take into account the profits of enterprises and adopt asymmetric interest rates. Because the domestic economy is still recovering from the effects of the economic crisis, it is relatively weak. China State Information Center Economic Forecasting Department Director Fan Jianping recently stated that the speed of the economy will slow down at the end of the year.

The policy adopted by the central bank increases interest rates proportionally. Financial institutions annual benchmark interest rates increased 0.25 percent, increasing rates from 2.25 percent to 2.50 percent; annual loan benchmark interest rates also increased 0.25 percent, increasing rates from 5.31 percent to 5.56 percent; the benchmark interest rates of other types of deposits are adjusted accordingly.

This indicates that the government currently believes that the economy will not face any risk.

The negative consequences of the interest rate hikes are: the RMB already faces pressure to appreciate and higher interest rates will lead to an even greater influx of "hot money" in China.

As to the interest rate hike's influence on economic entities, CITICS believes it will not be very large. They believe that in response to the interest rate hike, the increase to the industry sector's yearly interest costs will be about 45 billion yuan (this year its interest costs are approximately 10 billion yuan). Considering that the entire industry sector's profits are 25 trillion yuan, this will not have a significant impact on industry sector investments. However, the interest rate increases may have a greater influence on the real estate market.

Are interest rate increases the beginning of a new round of interest rate hikes?

There are some differences of opinion in the market. Cathay Pacific's An Wanghu believes that currency appreciation and interest rate increases will strike a relatively large blow to exports. This new interest rate hike, he believes, is not the beginning of a round of interest rate increases--he feels it is unlikely that there will be another increase by this year's end.

Yet, CITIC Securities reported that if the speed of the economy increases, inflation will rise and interest rates may be increased. If within the year commodity prices continue to exceed expectations, then it cannot be ruled out that the central bank may adopt additional interest rate increases.

However, what can be confirmed is that the central bank's future regulatory actions will be more flexible. The bank may raise interest rates, they may increase the flow of future foreign investment, or they may lower interest rates when it is clear that the funds outstanding for foreign exchange reserve are increasing.

However, the market is not entirely suited for the central bank's quick and flexible strategy. Some people are beginning to rebuke the central bank, asking, was it not a few days ago that Zhou Xiaochuan stated it seemed that interest rates would not be raised? Others are sarcastically saying, Zhou Xiaochuan, you are badass.  

Image: People's Daily

This article was edited by Rose Scobie