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Craig Stephen's This Week in China
Oct. 24, 2010, 8:23 p.m. EDT
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By Craig Stephen
HONG KONG (MarketWatch) "” This week, we can expect the market to continue to digest China's unexpected interest-rate increase. Ten months after China signaled tightening by raising bank reserve ratios and cutting bank lending, last week we finally had a rate hike "” the first since 2007.
The quarter-point increase caught most economists off guard, and they are now scrambling to interpret the move: Why now? Is this the beginning of a painful cycle of rate increases or more of a sign that things are back to normal?
Rescue workers in Taiwan and China search for survivors of Typhoon Megi. Video courtesy of Reuters.
One view is the rate hike is a tacit admission that previous tightening measures have not worked and Beijing is ready to act over asset bubbles and inflation. We should be prepared for a cycle of interest rates moving higher. Deutsche Bank forecasts two more 25-basis-point increases in the next 12 months, taking deposit rates to 3%.
The more benign interpretation is that policy makers believe the economy is now stable enough to withstand orthodox interest-rate medicine. We can expect a soft landing and relatively minor adjustments in interest rates.
Still, predicting how much more tightening lies ahead is more art than science, with policy making in China very much a political haggling process carried out behind closed doors. For example, only on Oct. 4 did Zhou Xiaochuan, the head of the People's Bank of China (China's central bank), say: "The Chinese government has no plan to raise interest rates. It will remain steady."
If Zhou doesn't know what's going on, who exactly should we be listening to?
And if we go back to the summer, there was actually talk of policy loosening in China. Then, fears over a double-dip recession were keeping policy makers up at night, and Deutsche Bank's economists were preparing us for a "turning point" in mainland Chinese macro policies, forecasting Beijing would actually be loosening "” rather than tightening "” in the fourth quarter.
Arguably there has been a "?turning point" since then, but it's an upturn in certain key areas in the mainland economy.
Firstly, property transactions and, now, prices have rebounded. Data out last Friday showed property prices in 70 mainland cities rose half a percent in September from August "” the first increase since May. The rebound in sales value and volume was more pronounced, rising more than 50%.
We have also seen an improving trend in various purchasing-managers-index numbers in recent months.
And could policy makers have been influenced by the resurgent Chinese stock market?
Back in the summer China was home to the world's second-worst-performing equity market. A rate hike might have added to downward pressure. Since July, the Shanghai A-share Index has broken comfortably above the key 3,000-point resistance and has risen by a quarter.
Externally, another factor that has been adding an expansionary bias has been the depreciation of the yuan, alongside the drop in the dollar. The yuan has lost 14% against the euro since June this year.
Meanwhile, with the U.S. ready to commit to further quantitative easing, China "” like many Asian economies "” will have to watch for the spillover of plentiful global liquidity. This all suggests monetary conditions have been loose.
In an update from Deutsche Bank, its economists' highlight that a policy consensus has been reached to tolerate lower gross-domestic-product growth and to use interest-rate policy to contain speculative property demand.
The move is not without risk however, as "” given China's loose peg to the U.S. dollar "” more hot-money flows may flood into the mainland, seeking the higher deposit rates.
But even if rates are going up in China, and with that, borrowing costs for corporates, it is not necessarily bad for equities, argue some brokers.
Nomura, in a new strategy note, says interest rates only go up when economies are doing well or returning to trend. Another positive in China's case, they say, is that using formal monetary tools reduces the uncertainty over some of the arbitrary verbal and regulatory intervention used in the past. Of course, you could argue the uncertainty now is just transplanted to rate policy, going by the central bank chief's conflicting messages.
Merrill Lynch is also sounding relatively upbeat, arguing Asia is headed for a liquidity boom in 2011, and investor risk appetite is returning in anticipation of QE2. Fundamentals are sound, and now concerns have switched from fears of a double-dip to worries about asset-price bubbles and rising interest rates short-circuiting domestic demand.
Still, this is a cautionary warning for China, where property prices remain high and affordability severely stretched. The worry has always been that Beijing has been storing up trouble by delaying increasing the price of money until asset prices have already reached bubble proportions. As interest rates now rise, that worry has certainly not gone away.
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