October 19, 2010 / 12:06 PM / 9 years ago

WRAPUP 3-China surprises with first rate rise since 2007

* China’s rate rise is first since Dec. 2007

* Global investor sentiment dented by surprise move

* Analysts says rate rise could be start of tightening cycle

* Speculation move is part of pre-G20 deal with U.S.

By Aileen Wang and Tom Miles

BEIJING, Oct 19 (Reuters) - China’s central bank surprised on Tuesday with its first increase of interest rates in nearly three years, a move that reflects concern about resurgent asset prices and could mark the start of a more aggressive phase of monetary tightening in the world’s fastest-growing major economy.

The People’s Bank of China said it was raising benchmark rates by 25 basis points, taking one-year deposit rates to 2.5 percent and one-year lending rates to 5.56 percent.

If there was ever any doubt about China’s role in driving the stuttering global economic recovery, the impact was felt by markets across the board. Oil and gold prices tumbled, stocks turned negative in Europe and the dollar jumped. [ID:nN19125123] [ID:nLDE69I1CS]

“The interest rate rise is entirely outside of market expectations,” said Zhu Jiangfang, chief economist at CITIC Securities in Beijing.

“The recent rise in headline inflation has put the real rate into negative territory. And I think that’s why the central bank needs to raise interest rates in such a hasty way,” he said.

Some analysts said the rate increase also suggested a deal was in place between China and the United States to strengthen the yuan and put an end to worries about a currency war of competitive devaluations ahead of upcoming Group of 20 meetings.

But others said just the opposite was the case — with higher rates, Beijing can afford to rely less on currency appreciation to keep the economy on an even keel.

Finance ministers of the G20 major economies will aim to tackle the currency strains in a meeting in South Korea starting on Friday. The country also hosts a G20 leaders’ summit in November. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

Graphic on China lending rate r.reuters.com/fyj29p

Rate rise to hit stocks, yuan rise may slow [ID:nTOE69I09D]

Preview of China data due this week [ID:nTOE69D042]

Related stories on China rate rise [ID:nLDE69308R]

China raises big banks’ required reserves [ID:nTOE69A03Y] ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

Although announced by the People’s Bank of China, the decision to increase rates would have received approval from the highest echelons of Chinese power, with Premier Wen Jiabao likely signing off on it.

Once a consensus has been forged in Beijing to raise or cut rates, past experience shows that moves often come in bunches.

In the view of some, it is about time for China to embark on a more aggressive tightening cycle. To date, it has relied on lending restrictions and banks’ reserve requirements to keep growth from boiling over.

“Fundamentally, policy rates are just too low for an economy that’s growing around 10 percent. To avoid bigger distortions, China needs to start moving rates to more appropriate levels,” said Rob Subbaraman, an economist with Nomura in Hong Kong.

“China’s economy looks as though it’s decoupling from other major economies, and its policies should as well,” he said.

DEBATED BUT UNEXPECTED

A number of leading economists, including some advisers to the central bank, have urged an increase in deposit rates to keep savers’ returns in positive territory.

China reported consumer inflation of 3.5 percent in the year to August and economists expect that the pace climbed to 3.6 percent in September.

Still, the increase in rates is surprising given that several top leaders have recently expressed confidence that inflation is under control, and have said that higher rates would potentially suck in speculative capital from abroad.

“They did it now likely because Thursday’s GDP and CPI data is too strong for them,” said Dariusz Kowalczyk, senior economist at Credit Agricole CIB in Hong Kong.

China is due to report third-quarter GDP and a suite of economic data for September on Thursday. The consensus forecast is that economic growth slowed to 9.5 percent year-on-year last quarter, down from 10.3 percent in the second quarter.

Economists polled by Reuters last month had expected an extended period of interest rate stability in China, with no increase until the second quarter of 2011.

COLD WATER ON MARKET?

Propelled in part by these expectations of low rates, Chinese asset prices have shown signs of taking off.

The Shanghai stock index .SSEC, a laggard for much of this year, has jumped nearly 16 percent in the past nine trading days. And despite a months-long campaign to clamp down on the real estate market, housing inflation has started to perk up again.

“This is a bucket of cold water for the market,” said Zhang Yuheng, an analyst with Capital Securities in Shanghai. “The hike itself is not a big one, but the psychological impact is big as the expectations for more rate hikes will appear.”

Higher rates make yuan-denominated assets more attractive and could in theory place upward pressure on the Chinese currency. Until a fall on Monday, the closely managed currency had risen 2.5 percent against the dollar since the end of August, its quickest pace of appreciation since a 2005 revaluation.

“It certainly leads to speculation that the U.S. and China are in some sort of a deal which will perhaps see the U.S. taking a more gradualist approach to QE (quantitative easing),” said Simon Derrick, head of forex research at Bank of New York Mellon.

The speculation was also fuelled by recent events. U.S. Treasury Secretary Timothy Geithner said he had delayed a report due last Friday into whether Beijing manipulates the yuan’s value to win time to drum up support within the G20 for “improvements” in the currency policies of China and other emerging economies.

On Monday, he said the United States would not devalue the dollar to gain an export advantage. [ID:nN18291636]

Beijing, and other emerging markets, complain that loose money in the United States is generating an influx of speculative capital and weakening the dollar, while Washington and others say a deliberately undervalued yuan gives China an unfair trade advantage.

But Ting Lu, an economist with Bank of America-Merrill Lynch in Hong Kong, said the exchange rate’s rise would be capped.

“The People’s Bank of China will firmly control the pace of yuan appreciation once pressure from U.S. politicians is alleviated,” he said. (Additional reporting by Reuters bureaux around the world; Writing by Simon Rabinovitch: Editing by Neil Fullick)

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