China raised its interest rates for the first time in three years this Tuesday. A lot of articles and views are doing the rounds regarding this. So what is all the fuss about?
First of all, some basic facts on the situation in China; China as we all know runs a large trade surplus unlike the U.S – which essentially means they export much more than they import. As we all know, India is a service hub and China is a manufacturing hub – cheap labor and a communist government that opened up its economy in 1979 (India did in 1991) helped the Chinese evolve into manufacturing giants, and the world’s largest exporter of goods.
China has the largest savings rate in the world – “China's gross national savings soared from 39.2 per cent of output in 1990 to 53.2 per cent in 2008, far higher than the United States, which saved just 12.2 per cent in 2008. Even compared to other Asian giants -- Japan with 27 per cent in 2007 and India with 33.6 per cent in 2008 -- China's share of savings as a percentage of gross domestic product (GDP) is significantly larger”, to quote from a website.
Chinese investment flows are especially heavy into these sectors: infrastructure, aluminum, steel, autos, cement and real estate. “A penny saved may be a penny earned, but in China a penny saved is usually invested in an infrastructure project or an increase in manufacturing capacity”.
Ok.. end of all rosy stuff.. Now where is the problem?
In late 2008 - Just like the U.S and other countries, China infused a huge stimulus (pumping money into the system) that helped quickly rebound from the global crisis. It has had a stunning recovery, growing at close to 10 % for more than a year now. But while the Indian markets have been gaining considerably during the past one year, the Chinese capital markets have been subdued. The benchmark Shanghai Composite though, has risen 13% since October on robust foreign inflows.
Lately, China has realized that relying heavily on exports (read “demand from other countries”) is not sustainable and is subject to global economic conditions. Rather, they want to promote internal demand, make consumers spend more. Also, there is concern that the property prices in China are way too high. The Chinese consider real estate as a main investment class. Last year, Beijing put a tab on lending credit to buy property and asked banks to lock up more cash. But these efforts did not cool the real estate sector as the Chinese continue to believe real estate is a better form of investing than bank deposits.
Of late, consumer prices have been rising faster than China’s 3% annual target. This would mean that the real interest rate (nominal interest rate minus inflation rate – simply put, the returns we get adjusting inflation) that people make out of investments will reduce substantially. The government is under pressure to keep inflation subdued.
Some believe that Beijing has kicked off a cycle of interest rate increases. Just like the way the RBI has increased rates five times this year to clamp down inflation (higher interest rates in a country mean, that investments will give more returns, prompting investors to take liquid money and invest it – this means lesser money in the system, people have lesser money to spend and demand for goods slows down, eventually reducing inflation).
China has now increased rates by 0.25 % (or 25 basis points) - so what does that mean for their currency the Yuan and the economy?
Take the case of a county like India where the monetary body (RBI) does not interfere too much in maintaining the currency at a fixed level. An increase in interest rates will translate into more investments and more demand for the currency, pushing up the value of the currency. But China has been keeping the Yuan undervalued vis-à-vis the U.S dollar so as to not hurt exports. After repeated calls from the U.S and Europe that an under-valued Yuan artificially raises demand for Chinese goods, China agreed a few months back to allow “a calibrated appreciation of the Yuan”. In the past two months, the Yuan has appreciated 3% against the dollar. In a bid to stop currency appreciation due to the rate hike, the central bank intervened and lowered the exchange rate on Wednesday, a day after the rate hike. So we can pretty much expect China to maintain the Yuan at these levels (1 U.S. dollar = 6.65 Chinese Yuan). China still faces heavy pressure from the US, Europe and others to allow a stronger yuan, so the currency could gradually appreciate 3-5% from these levels in a year.
Another implication or a rate hike is that of foreign fund flows increasing to capitalize on higher interest rates. Due to the money flooding emerging markets, currencies of countries such as India, Brazil and South Korea have turned higher against the dollar. As China pegs the Yuan to the dollar, exporters in these countries feel they are losing out in the competition to China, their biggest rival. Developing countries are facing a deluge of foreign funds from developed countries. So much that Thailand and Brazil have raised taxes on foreign money to restrict too heavy capital flows that might cause instability. But China feels that its inflows are based on the rising prices of assets than the interest rate differentials.
Let us see how other markets reacted to this rate hike – these are just knee jerk reactions though. Assuming that China’s rate boost will slow down its economy, global investors removed some bets on the currencies of other emerging markets, and money flowed back to the U.S. dollar. Australia is linked very closely to Chinese growth (Australia earns the most from mining metals and sells them to China for manufacturing). The Aussie dollar fell 2.6% against the dollar. Till now, China had been depending on controls on banks and mortgage to clamp down lending and formation of asset bubbles. Now, they have taken up monetary control too.
References:
http://www.econstrat.org/index.php?option=com_content&task=view&id=169&Itemid=1
http://epaper.financialexpress.com
http://online.wsj.com/article/SB10001424052702304510704575561780406217028.html
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