Accessibility links

Expectations High on China Interest Rate, Yuan Increases

Economists and financial analysts around the world say pressure is mounting on China to raise interest rates and appreciate the yuan - after data show higher inflation.

At the National People's Congress meeting that ended last week, Chinese banking officials tried to soothe concerns over rising prices, saying February's inflation figure is in line with their expectations. Inflation rose 2.7 percent in February, just a touch below Prime Minister Wen Jiabao's announced 3 percent annual target.

But financial markets over the past week heard considerable talk that with inflation kicking in, China is running out of options on ways to limit the amount of cash in the financial system and stabilize the economic rebound.

Economists and analysts say that China is likely to soon raise interest rates for the first time since 2008 and let its currency appreciate. The yuan has been pegged at about 6.8 to the dollar for nearly two years.

Jing Ulrich is the chairwoman of China equities and commodities at investment bank JP Morgan. She says so far Chinese banking authorities have been imposing higher requirements on the amount of money banks have to keep with the central bank to mop up excess cash in the system.

The central bank has raised the bank reserve requirement twice this year. But Ulrich says authorities will have to take more aggressive measures.

"The next step will be an interest hike. Sometime in the second quarter of 2010 we could be getting the first interest rate hike in two years," she said.

Like many countries, China cut interest rates and implemented massive spending programs to lessen the damage from the global financial crisis, which began two years ago. The efforts worked, and China's economy is growing rapidly, but authorities now are trying to clamp down on new lending after Chinese banks lent a record $1.4 trillion last year.

Qu Hongbin, chief China economist at HSBC in Hong Kong, says China needs to start tightening its policy because recent economic data raise concerns of overheating and a potential inflation risk from last year's accelerated lending.

Ulrich says some of those loans have moved into the stock and property markets. As a result, property prices in major Chinese cities have skyrocketed.

"Because lending was so strong, credit was so easily available, as a result the money actually did not all go the real economy. It actually went to speculation and this is precisely what the central government is trying to prevent," she said.

Pressure also is mounting on China to do something about the yuan, which many international market analysts and economists say is undervalued. A weak currency makes Chinese goods cheaper overseas; in February exports jumped 46 percent from a year ago.

Some economists say letting the yuan, also called the renminbi, appreciate would reduce inflation - by cutting the price of the raw materials China imports.

Nobel-Prize winning economist Paul Krugman is among them.

"It actually is true that from China's own point of view, from the point of view of their national welfare, an appreciation of the renminbi is actually the right thing to do …. With China facing inflationary pressure and talking about the need to slam the brakes on domestic expansion of credit … what it says is that this is a clear indication that they have an undervalued currency and what they want to be doing is to appreciate it," he said.

In the latest attempt at sanctioning China for its foreign exchange policy, there are threats of legislation in the U.S. that would penalize Chinese imports. U.S. lawmakers have long argued that cheap products from China have led to U.S. factory closures and unemployment.

Krugman says the U.S. must press for a yuan adjustment to benefit the still weak global economy.

"Never been has there been intervention on this scale to keep the currency undervalued," he says. "We are experiencing depression-like economic conditions with zero interest rates, shortage of demand, loss of traction by monetary policy are at the core of our problems. This is a world in which these issues that have been theoretically batted around for generations now become acute real world concerns …. We are at the stage where we have to be talking about treating this … as if the Chinese were subsidizing their exports to the tune of 25, 30 percent."

China's leaders are resisting calls for an appreciation. Prime Minister Wen said Sunday that the yuan is not undervalued and in fact, it has appreciated when factoring in inflation.

He says China will continue to implement a "managed, market-based and floating-exchange rate regime", and keep the exchange rate "basically stable at an appropriate level."

In the United States, President Obama has until April 15 to decide whether to officially designate China as a currency manipulator in the Treasury Department's semi-annual report.

President Obama said last week that a Chinese move toward a market-oriented exchange rate would be an "essential contribution" to the global effort to reduce trade and fiscal imbalances after the financial crisis.