Earthquake in China

In a much awaited move, the Chinese authorities managed to surprise the markets by raising their interbank rate 27 basis points to cool their overheated 10.2 % y/y growth in 06Q1. The usual centralized broadcast of orders to banks to curtail specific loans was expected, maybe an increase in loan requirements or even furthering land restrictions for real estate development; but not the free market economic reign-in liquidity tool of raising rates.

Richard McGregor from the FT describes the situation like this:

China moved to tackle a surge in new bank loans and investment on Thursday by lifting the benchmark one-year lending rate by 0.27 per cent, sparking a sell-off by investors worried that the rise signalled a slowdown in the Chinese economy.

The rate rise, the first by the People’s Bank of China since October 2004, surprised the markets, which had expected Beijing to use a combination of administrative measures and higher reserve requirements for banks to rein in credit growth.

The key benchmark one-year lending rate will rise from 5.58 per cent to 5.85 per cent, effective from Friday), just days before a week’s national holidays for May Day.

China’s economy grew by 10.2 per cent in the first quarter and new lending by local banks reached Rmb1,260bn in the first three months of the year, over half the government’s target for all of 2006.

“We believe the central bank is trying to send a strong signal that the authorities mean business when it comes to controlling overheating in the economy and over-investment,” said Stephen Green, of Standard Chartered Bank, in Shanghai.

An interesting fact about the Chinese announcement is that it coincided with Ben Bernanke's meeting with the Joint Economic Committee; where he hinted a pause in the Fed rate hike in the near future.

So, the markets got a double whammy, both events hurting the USD, which took a tumble. But the ripples extended themselves to engulf commodities as well, oil (Bush's remarks helped here) and metals came down significantly.

And, although metals behaved as they should, like currencies, taking a hit because of the CNY rate increase; shortly after, they seem to be in a path to recover their previous USD prices.

Analysts point out that this measure will lower Chinese demand, therefore affecting mainly commodities prices.

I doubt it.

First, there's already a glut of liquidity in China, loans have almost doubled their target for the quarter; and I don't see how a flimsy .27% rate hike is going to stand in the way of this growth train.

In fact, the Chinese have limited intentions to lower their growth to a strong 7.5%. In the past, they've always stopped midways; worries of a hard landing have deterred their intentions.

And let's not forget that their main customer, the US consumer, had a significant GDP growth of 4.8% for this quarter --the US economy is not slowing down, driving the growth of China with it. In other words, US growth drives Chinese growth, not the other way around.

Finally, there is a very important political issue, there are still an estimated 800 million Chinese which do not participate in the new and buoying economy. Hu Jintao, an inner province native from the poorer regions of China, has the chairman's position because the leadership in China acknowledges the importance of keeping under control the political turmoil which is surely festering within the sideliners.

In conclusion, an earthquake in China, turns into an adjustment in the tectonic plates of the world economic landscape with limited effects. The major significance to this measure would be that it furthers the case of a declining and weakening USD.

This chart says it all:

For further and improved comments take a look at what JD Hamilton , Mark Thoma and Brad Setser have to say about this subject.