As China raises interest rates, don’t forget the yuan


Reuters

China was Grinch-like in raising interest rates on Christmas Day, but in fact investors have good reasons to be grateful.

The government provided much-needed reassurance that it was determined to rein in price pressures — and a salutary reminder that more yuan appreciation than the market expects could be in the offing.

The key take-away from the rate increase, China’s second in just over two months, is that Beijing is softly, softly pulling every tightening lever within its reach.

“The central bank will only raise rates in small and steady increments in the coming months,” said E Yongjian, an analyst at Bank of Communications in Shanghai. “The yuan will also steadily climb next year, serving as one tool to alleviate the inflationary pressure,” he said.

Ba Shusong, an economist with the Development Research Center, a think-tank under the cabinet, provided a neat summary of the government’s strategy for taming consumer prices, which rose 5.1 percent in the year to November, a 28-month high.

“The rhythm of policies will become regular, something we call the simultaneous implementation of the three rates: banks’ required reserve ratios, interest rates and the exchange rate,” he said in comments published in the Economic Information Daily, a Chinese-language newspaper, on Monday.

Even though a move on Christmas Day was a surprise, the 25-basis point increase in benchmark one-year interest rates announced on Saturday was in line with a majority view in a Reuters poll earlier this month. Most economists had predicted that China would raise rates by the end of this year and the consensus was for two more increases in the first half of 2011.

Normally apprehensive of tightening, investors had begun to worry about the opposite in China — that the government was delaying the inevitable for too long and that the ultimate reckoning with inflation would be more painful as a result.

“As long as tightening is not too much lagged behind the curve, market sentiment should improve gradually in the first half of 2011,” Shen Minggao, an economist with Citigroup, said in a research note. Shen echoed Ba in saying that faster yuan appreciation would play a bigger role in the campaign against inflation.

That view has been notable by its absence in financial markets of late. Investors are pricing in just a 2.4 percent rise in the yuan versus the dollar over the next year, according to offshore forwards. In 2007-08, when China was last battling inflation, the government let the currency climb more than 7 percent in six months.

Although price pressures are less serious now, it would not be surprising to see a mini-burst of yuan appreciation in the coming months.