China lifts rates — now what about the yuan?

October 20, 2010

China’s first rate hike since 2007 sounds more momentous than it is. But the modesty of the 0.25 percentage point move means there’s scope for more substantial action on China’s too-cheap currency.

There are two good reasons for China to tighten, namely to remedy negative real interest rates and to curb runaway property prices. The new higher deposit and lending rates — 2.5 percent and 5.56 percent respectively — won’t really do either. Consider the negative real rates. The central bank’s action will at best take the edge off stirring inflation, but the maximum allowable reward for holding deposits is still below the targeted inflation rate of 3 percent. Depositors’ own inflation expectations are likely to be much higher. China’s savings are still being bled away.

Dwindling savings have driven depositors back to real-estate speculation, but the rate hikes won’t be enough to call them back. Urban property prices increased 9.1 percent year on year in September, and total transactions by value were up more than 50 percent from August. Raising interest rates might threaten a property crash if buyers were highly mortgaged, but they are not. Moreover, the expectation of property gains is now so engrained that a tiny rise in rates is unlikely to dampen the mania.

Still, just because the rate hikes are a baby step, that doesn’t render them pointless. GDP and inflation data due on Oct. 21 are likely to show that demand remains strong, and price pressures are rising. Money growth in August was up a worrying 19 percent year on year. And for a country whose GDP is likely to grow at 10 percent this year, China’s rates are still low in absolute terms.

There is room for more tightening, and of the kind that both China’s consumers and trade partners really need. Beijing can help control inflation by allowing the currency to appreciate, putting a dampener on commodity and other input prices. That would make Chinese exporters less competitive, but not deter the budding consumers the country hopes to promote.

A stronger yuan is what almost all of China’s trade partners crave, especially given the currency’s recent falls against almost all of its major counterparties. By raising rates just a little, Beijing may have left itself room for a welcome sequel.

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The thought that there exists in China a “consumer collective” with a voice, as if their demand can play out as a factor in their government’s decision on rates, either forex or lending, is a Westerner’s hubris.

In this decision making process at the highest levels of a central authority, there is real-estate, yes. There is export of the manufacturing output, yes. But that is it!

There is an obvious wait-and-see approach to see how angry the governments of China’s main trading partners will eventually become with their manipulations of the Yuan. China knows that the lobbying multinationals are helping it continuously and through their influence the retaliations will most likely never amount to much. So there is plenty of time to contemplate the matter while the Chinese economy continues to grow faster than any other economy of size.

But would you ever see internal social pressure that would lead to a stronger Yuan? Never! The government has a full array of other tools to control the inflation problem with, which for the non-consuming Chinese is the mildest of problems right now in any circumstance. Gasoline is heavily subsidized and that takes care of the main thing which somehow has escaped the government’s control, doesn’ it.

No. It is entirely between governments, and if there is any bystander with a voice, that would be the multinationals, and unfortunately this bystander isn’t helpful at all if you happen to be a thinker wishing for a higher Yuan as a matter of good principle.

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