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China May Need More Rate Increases to Contain Economy


Economists say China may need to raise interest rates again in the coming months as it struggles to cool its economy and move toward free-market banking reforms. Many analysts say new lending rules may have as much of an effect on China's economy as higher rates.

China's central bank unexpectedly raised the official cost of borrowing money by a bit more than a quarter of a percentage point, pushing the one-year lending rate to 5.58 percent. The increase takes effect Friday.

The bank hopes its first rate increase in nine years will help slow China's explosive economic growth and keep inflation under control.

Tao Dong, an economist with the bank Credit Suisse First Boston in Hong Kong, says the rate increase will likely be followed by more later this year. "One rate hike will not do all the job but this is the beginning of a second round of tightening measures," he said. "It's likely that we're going to see a series of interest rate hikes."

China's economy has been growing by more than nine percent a year for the past few years. There are concerns that overexpansion could lead to high inflation and endanger the country's weak banks.

Beijing also announced Thursday that it has removed limits on what banks can charge for loans. In many ways, analysts say, this is a more significant change than the new interest rate.

Under the old regulations, interest rates were kept low by the central government. As a result, banks avoided riskier loans, especially to individual entrepreneurs. Instead, lending went to inefficient state enterprises, and did little to help the economy grow.

Mr. Dong says the new policy means smaller and privately run businesses will be able to get loans if they agree to pay higher interest rates. "The government does want the banks to lend according to credit worthiness and the commercial risks it perceives," he said.

In effect, Mr. Dong says, the new regulations apply simple supply and demand principals to China's banking system.

It is one of the first times the communist government has allowed banks to use free-market considerations in lending. As such, it could help stabilize China's banking system, which is burdened with vast unpaid loans issued to failing state businesses.

"This is the beginning of an adjustment in the way that financial products are priced," said John Wadle, a bank analyst for UBS in Hong Kong. "And that's a positive step forward. Without that you would not have a functioning movement of capital in the economy."

However, the central bank has not addressed international concerns over its fixed currency rate. The United States says China's yuan is undervalued, giving its exporters an unfair advantage on the global market.
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