beyondbrics

By Qu Hongbin of HSBC

China’s decision to raise interest rates for the first time since 2007 surprised us given that GDP growth has been slowing and producer price inflation has shown signs of peaking.

It shows that policymakers have been encouraged by some better-than-expected economic data in the last two months. They are no longer worried about a sharp slowdown in growth, giving them scope to respond to public concerns about negative real deposit rates.

China’s move means one-year benchmark deposit and lending rates will rise by 25 basis points to 2.50 per cent and 5.56 per cent, respectively, from Wednesday. However, we don’t think this modest rate increase is likely to harm the real economy, given its solid fundamentals. Investment will continue to be underpinned by 100,000 ongoing infrastructure projects and an accelerated public housing construction programme. Meanwhile, consumer spending should be boosted by higher deposit rates.

Renminbi appreciation is likely to continue not least because of a likely weakening in the US dollar. The rate hike might widen the differential between China and global market rates and hence attract more capital inflows. But China’s capital controls and the absence of full renminbi convertability are likely to limit the impact.

If anything, we expected the People’s Bank of China (PBoC) to raise interest rates in the first half of the year when there were signs that the economy was overheating and inflation was rising. But it seems that policymakers held back at that point because of fears that growth might slow too sharply.

In fact, there have been clear signs of stabilization in recent months. After dropping below 50 at the end of the second quarter, HSBC’s purchasing managers index has picked up in the last two months. Meanwhile, investment growth and retail sales numbers have proved resilient. And although there has been a gradual slowdown in exports, imports growth has surprised on the upside thanks to strong domestic demand.

The result is that GDP growth will be slow, but it will still be better than policymakers’ initial expectations. We expect third quarter GDP growth to slow to around 9.5 per cent year on year from 10.3 per cent in the second quarter. We believe the pace of growth is likely to continue to moderate in the fourth quarter, but still expect 10 per cent growth this year and around 9 per cent in 2011.

It may be no coincidence that China is raising rates just ahead of the publication of third quarter GDP and inflation figures. Although producer price inflation has probably peaked, we believe that consumer price inflation will creep up further in September, after hitting a 22-month high of 3.5 per cent in August. China has had negative interest rates for seven months and they are likely to remain negative for the foreseeable future. This has led to growing public concerns about the impact of negative interest rates on household income, alongside worries about higher inflation and inflating asset prices.

The interest rate hike addresses all these issues. It will also help cool the property market, which remains frothy. The additional property control measures announced in late September showed Beijing’s renewed determination to rein in property prices after a significant rebound in transaction volumes. Besides these measures, raising interest rates is the most powerful tool that policymakers have to curb property speculation and restrain excessive housing demand.

Qu Hongbin – Co-head of Asian Economic Research and Chief China Economist, HSBC