China hike could help risk assets elsewhere

December 30, 2010

James Saft is a Reuters columnist. The opinions expressed are his own.

China’s Christmas day interest rate hike may prove to be bad for global growth but good, at least for a time, for risky assets.

From that perspective, the Chinese policy change could end up being a much-needed helping hand to Federal Reserve chief Ben Bernanke, who has engineered a policy partly aimed to boost economic growth through the false miracle of asset price inflation.

The Chinese rate hike, taking the benchmark interest rate up by a quarter of a percentage point, signals an increased willingness by Chinese authorities to do what they must to dampen the party domestically. The move increased the one-year lending rate to 5.81 percent and one-year deposit rate to 2.75 percent.

It is aimed at cooling inflation, which is running at 5.1 percent annually on the consumer level, not to mention making itself felt through a booming property market and gold-rush-like appreciation in things like herbal remedies and rare delicacies.

Of course, higher interest rates, while they may cool speculation domestically, will only make China more attractive to international capital, which is already slavering at the prospect of an eventual appreciation of the yuan.

This is well understood within the People’s Bank of China: “Many domestic academics are worried that interest rate rises may accelerate global speculative inflows into China,” Sheng Songcheng, the head of statistics at the PBOC, wrote in a piece published on the bank’s website, warning that these flows were exacerbating inflation.

That implies that China may be steeling itself to more effectively block international capital flows.

But these flows, so-called hot money, don’t just exist because people think China is going to be a good investment over the next few years.

Those flows are, at least in part, a function of the extremely easy monetary policy in the United States and Europe, policy that is aimed at forcing money from the sidelines into risk asset markets. For a time, the easy implication of that easy policy appeared to be a grand carry trade, in which  investors partook of the generous liquidity and terms available in Frankfurt and New York and plonked it down in emerging markets, notably China.

MONEY NEEDS A HOME

China appears to be becoming less hospitable to that money, but it will not cease to exist. It will find a way into other markets, perhaps other emerging markets or places like Australia that are a play on emerging markets. It will also drive the developed markets of Europe and the United States.

This is not because growth prospects have improved in the West — given that Chinese growth may be capped by the rate rise, they haven’t — it is because it is cheap money that is seeking some sort of a home.

Federal Reserve officials have been relatively upfront that the second round of quantitative easing was aimed in part at fomenting a rally in asset prices and with it an increase in consumption and demand. Thanks to the latest PBOC hike, they may find that more of that wealth effect is concentrated in the United States.

This is not to say that a U.S. monetary policy aimed at boosting consumption by inflating asset markets is a good thing; it worked out badly the last 10 years and very likely will work out badly this time as well.

For the time being at least, that will not be in the front of investors’ minds. They will see that markets are going up, and if they are fund managers whose performance is tied to a benchmark, that will compel them to take on risk. This in turn will make a lot of economists inclined to see the glass as half full and the talk will be of how the recovery is becoming something worthy of the name.

One crucial hurdle will be the behavior of companies, which have been sitting on billions in cash and have been reluctant to add jobs even if they have been forced to add hours. Will they see a sustainable increase in demand and put money back to work? Or will it be simply another round of speculative frenzy, profitable for some but disruptive for the economy as a whole?

Ultimately China will likely have to raise rates repeatedly and take other strong steps to brook bank-fueled speculation, none of which will do anything good for global demand.

Even so, unless the market gets a shock, most likely from a troubled euro zone, it is fair to expect risky assets to continue to rally, seemingly without reference to the underlying fundamentals.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

10 comments

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This article gets it completely wrong. As interest rates rise in China and upward pressure on the Yuan increases both as a result of these rate rises and continuing political pressure from the US and Europe, fewer Yuan will be recycled back into Dollar assets like government bonds resulting in higher long-term interest rates in the US and an eventual decline in the value of risky assets.

Posted by StevenFeldman | Report as abusive

This article gets it completely wrong. As interest rates rise in China and upward pressure on the Yuan increases both as a result of these rate rises and continuing political pressure from the US and Europe, fewer Yuan will be recycled back into Dollar assets like government bonds resulting in higher long-term interest rates in the US and an eventual decline in the value of risky assets.

Posted by StevenFeldman | Report as abusive

This article gets it completely wrong. As interest rates rise in China and upward pressure on the Yuan increases both as a result of these rate rises and continuing political pressure from the US and Europe, fewer Yuan will be recycled back into Dollar assets like government bonds resulting in higher long-term interest rates in the US and an eventual decline in the value of risky assets.

Posted by StevenFeldman | Report as abusive

Sorry Guys you’re al WRONG! WHAT IS IMPORTANT is the financial well-being of our OWN nation, but with the few postings that we’ve seen out here is that the only thing anybody is concerned about is “Financial Security” aka “GREED”!!! Look! Until all we Humans take a introspective view of ourselves in the “Global scheme” of things and work out our selfish differences and come to some form of “CONSENSUS” we’re ALL SCREWED!

Posted by Middleclassman | Report as abusive

Reader StevenFeldman considers only a small, relatively minor side-effect, and gives it a vastly disproportionate weight. He expects the tail to wag the dog.

Saft’s article looks at the whole picture, and gets it all right — compellingly and powerfully.

Great article. Excellent food for thought.

Posted by AdamSmith | Report as abusive

Higher interest rates and tighter monetary policy in China will result in imported deflation for the US, the heretofore biggest beneficiary of China’s immense trade surplus via recycled capital flows. This is central and intrinsic to the scenaio Saft has laid out, not a “relatively minor side-effect” as the presumptuously-named “AdamSmith” suggests.

However, Mr. Saft thanks you for gushing over his article with empty praise.

Posted by StevenFeldman | Report as abusive

Higher interest rate or tight monetary policy in china will result reduce credit off take or decrease supply of money in the system that ultimately results appreciation of Yuan against the $ (depreciation of $ against Yuan) & boosts US export to China & reduces US deficit balance of payment.

However QE-2 will make opposite impact. QE-2 will result investments of $ in china and increases supply of $ in Chinese market that ultimately offset the appreciation gain of Yuan against $ and it further appreciates value of $ against Yuan and reduces US export and increases import.

So, QE-2 will out favor US at least against China.

Posted by Deepak2010 | Report as abusive

I’ve been gone for a while, but now I remember why I used to love this site. Thank you, I will try and check back more often. How often do you update your web site?

Awsome article and straight to the point. I am not sure if this is in fact the best place to ask but do you guys have any ideea where to employ some professional writers? Thanks in advance

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