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China surprises the market by raising interest rates to battle inflation

October 19, 2010 Business, Featured News No Comments

People's Bank of China in Beijing

To tame the overheated economy, China raised its interest rate by .25% for the first time in almost 3 years. This move has surprised the market. The official position was to keep the current interest rate unchanged. The deposit rate was raised to 2.5% and the lending rate increases to 5.56%.

China’s central bank announcement creates shock waves through out the world markets. Money, flocked to U.S. Dollars, increases its value worldwide against other currencies. It also sends stock markets lower on exchanges.

China’s move is an indication that it cannot itself tame the country’s sharp rise in inflation and its soaring house prices. China has excess money liquidity in the economy, and the rest of the world is overflowing money into China for investment. China’s mandate is to keep inflation under control and maintain tight control of its currency fluctuation.

Another reason for the move is that China has experienced sharp increases in bank lending during both August and September. This is an indication that the country’s overheated economy.

“This move is symbolically huge, as it is the first rate hike for this cycle,” Dong Tao, a Hong Kong based economist at Credit Suisse claimed. “Yet it may only have limited impact on the real economy because overall rates are still at excessively low level. This move probably will dampen sentiment in the property sector and equity market in the short run. However, we think excess liquidity will still prevail, if this is just a one-off rate hike.”

Some view this as a vicious cycle. With higher interest rates, more money will be attracted to China for speculative investments. In hopes that China will continue to increase interest rates and will let its currency appreciate, more money inflow means more inflation problems and even higher property prices.

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