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China will raise its benchmark one-year lending and deposit rates by 25 basis points effective Wednesday, the People’s Bank of China has said. The move takes the one-year deposit rate to 2.5 per cent, and the one-year lending rate to 5.56 per cent.

Raising rates will dampen domestic demand for credit, which has remained high despite efforts to restrict bank lending. A different tightening measure was reported last week, when China’s central bank temporarily raised the reserve requirement by 50bp for six major banks. This also removes money from the system and restricts credit availability.

The recent weakening of the dollar will have added to existing inflationary pressures in China. The renminbi closely tracks the dollar; if it were free-floating, the Chinese currency would have strengthened as the dollar fell. Annual inflation was reported as 3.5 per cent in August. September’s data is due out on Thursday, and expectations are for a slight rise.

In a slight twist to a straightforward tale of monetary policy, one Reuters interviewee has suggested we are witnessing the result of a Sino-American agreement. 

The IMF has tried to rally the troops at a meeting in China, urging central bankers to maintain the international co-operation forged during the financial crisis, and looking to Asia to lead the way.

At an IMF-sponsored meeting of central bankers and regulatory luminaries in Shanghai, an “important consensus” was reached, according to PBoC deputy governor Yi Gang, on the need for international co-operation in ensuring strong macro-prudential policies, because systemic risks “are very likely to spread over borders.” In practice, this means central banks and national regulators taking on more international roles.

Central banks also need to take a broader view domestically, said IMF managing director Dominique Strauss Kahn, seeming to suggest that financial stability would be part of central banks’ remits going forward. “Clearly, conventional macroeconomic policies and macro-prudential tools are intrinsically linked, just as price stability and financial stability are intrinsically linked,” Strauss-Kahn said. “We need a holistic approach, which means a changing role for central banks in the years ahead.” 

China has temporarily increased the reserve ratio required from six large commercial banks banks. For two months, the banks will need to keep 17.5 per cent of depositors’ balances on hand, instead of 17 per cent. With banks hoarding more cash, money supply and credit availability will fall in China. In two months’ time, the reserve ratio is expected to return to 17 per cent.

The surprise move, reported by Reuters from four unnamed sources, may be a response to rising capital flows, rather than a prelude to monetary tightening. It could also be intended as a warning to banks rumoured to have stepped up their lending in September, above government targets. 

Another day, another hint from Chinese regulators about the future opening up of the country’s capital account. The latest statement from Safe today said that it was considering introducing new foreign exchange instruments, as well as containing a pledge to push forward with selective capital account reforms.

There was no information about what these new products might be – market participants say that FX options are likely to be the next new development.

The hints about new openings in the foreign exchange market are partly directed at an overseas audience where there are already grumblings about the slow pace of change in the exchange rate since the initial fanfare (see chart). As Mark Williams at Capital Economics pointed out today in a note entitled ‘Return of the Peg’, the renminbi barely moved at all against the US dollar during July. Indeed, “the renminbi has actually weakened in trade-weighted terms since the reform was announced”. 

Is the People’s Bank of China planning to further liberate the yuan? The central bank has cut the commitment to “keep the yuan’s exchange rate basically stable” from its latest currency communique. The rest of the message repeated the existing policy, i.e. to improve the currency’s exchange rate mechanism, and adjust its value with reference to a basket of foreign currencies.

Although the currency’s peg was loosened on June 19, the daily midpoint set by Safe has barely strayed out of the tolerance levels of the original peg; the currency need only have been 0.3 per cent weaker to meet the original, pegged criteria. Against the US claims of the yuan’s ‘true value’, the currency’s ‘strengthening’ is barely discernible.

Having strengthened yesterday, the renminbi has opened sharply down against the dollar – indeed by the largest weakening since December 2008.

Market talk suggests Chinese state-owned banks bought dollars to save the central bank from having to intervene. If the currency is seen as a one-way bet, ‘hot money’ will likely flow into China – potentially interrupting monetary policy transmission and causing inflation. 

China’s central bank has spoken of measuring the yuan “with reference to a currency basket”. One of the bank’s academic advisers, Xia Bin, said the change in language suggests a change to the dollar peg, reports Business Week. An economist at Morgan Stanley interpreted the shift in the wording of the report as significant, and yuan forward prices have been rising for the past two days on speculation of a rise in the currency.

China is carrying out stress tests on labor-intensive industries to gauge the effect a stronger yuan would have on earnings, reports Bloomberg (itself reporting local paper the 21st Century Business Herald). Consequent speculation on the yuan has pushed forward prices up.

The yuan’s value has been kept at about 6.83 per dollar since July 2008, following a 21 per cent advance over three years, as policymakers intervened to help exporters weather a global recession.