China Hikes Interest Rates, and the World Stumbles

China shocked the international commodity and stock markets Tuesday by raising interest rates for the first time in three years. The move was primarily taken for domestic reasons, but it's likely to increase "hot money" inflows from speculators, particularly hedge funds in the U.S. The People's Bank of China said it will raise the one-year interest rate ceiling on deposit accounts from 2.25% to 2.5%, and the floor on lending rates from 5.31% to 5.56%.

The action caused a sell-off in world stock and commodity markets given the implication that it would cause the Chinese economy, one of the primary drivers of world growth, to slow down. The Australian dollar fell 1% because the country is a major commodity exporter.

A Boost for Chinese Savers

Nicholas R. Lardy, a senior fellow at the nonpartisan Peterson Institute for International Economics in Washington, D.C., says the move was primarily aimed at helping the China's beleaguered savers, who have $4.5 trillion in bank accounts, and at slowing down the growth rate of Chinese investments.

"Savers have been getting a negative real rate of return as a result of the higher inflation that's been experienced in recent months, and they want to rectify that," Lardy says. "They're also trying to slow down the growth of credit. I don't think they're primarily worried about inflation."

The last Chinese inflation report was for August, when the government said prices had risen about 3.5% compared with the previous year. But August's inflation rate was closer to 4.5% compared with July. That means with a 2.25% interest rate, savers were losing more than 2% of the value of their savings every year.

Unlikely to Dampen Speculative Fervor

"I don't think savers will be swayed by this small adjustment to put their money in the bank rather than buy more apartments," says Pieter Bottelier, senior adjunct professor of China studies at the School of Advance International Studies at Johns Hopkins University. "The surplus liquidity in China is finding an outlet in speculative investments where they hope to get a higher return, and the main objective of that is residential apartments in big cities. I don't think that will change in any fundamental way."

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One of the reasons the Chinese have been reluctant to raise interest rates to reduce investment is that, while relatively low, those rates are still much higher than in other nations. The U.S. Fed funds rate, by comparison, is now just 0.25%. Although China has capital controls aimed at limiting the inward flow of foreign money, canny investors are borrowing in the U.S. and investing the proceeds in China at the higher rates. Those investors now have another quarter-point's worth of incentive to do so.

It remains unclear whether the Chinese action will have any impact on exchange rates. The U.S. in particular has been calling on China to let its currency, the yuan, appreciate against the dollar. China announced that it would do so in June, but so far, the increase has only been about 2%. That's because China's current account surplus -- trade plus financial flows -- has been shrinking, down from 11% of GDP in 2007 to about 5% last year. Exports have been a little lower this year.

"The export interests in China are arguing 'Why are we appreciating so much against the dollar when our trade surplus is getting smaller?'" Lardy says. "If the trade surplus tends to rise, then I think we'll see a continuation of the appreciation. But if it tails off, I think we'll see a slowdown in the appreciation."