China hikes rates for the third time in three months

Economists expect more hikes to come, but argue that the moves will be moderate as the PBoC has to strike a difficult balance between fighting inflation and fending off speculative liquidity inflows.

China sent its disappointed savers a new year gift last night when the People's Bank of China (PBoC) hiked interest rates for the third time in just three months in an effort to dampen runaway inflation. Economists expect more rate hikes in the coming months as real deposit rates are still negative.

The PBoC announced late yesterday that the one-year deposit rate and the one-year lending rate will rise by 25 basis points to 3% and 6.06%, respectively. The increases will take effect today when the mainland stock markets re-open after the Chinese New Year break.

This is China's third rate hike in the current cycle, following the first surprise hike in October and a second hike on Christmas Day. However, even after the frequent hikes, China's real deposit rate remains negative when adjusted for 4.6% consumer price inflation in December last year and 5.1% in November. Both months were well above the official 2010 inflation target of 3%.

Worse still, it is widely expected that the headline consumer price index (CPI) will rebound to 5% to 6% soon, due to the shopping spree during Chinese New Year, the nation's most celebrated holiday. Snowy weather in many areas of the country is also expected to send prices of agricultural products higher, pushing real interest rates further into negative territory.

However, Qu Hongbin, co-head of Asian economics research at HSBC, argues that yesterday's hike “should at least provide additional interest income for Chinese households, most of whose wealth is parked in saving deposits, and help stabilise public expectations regarding future price growth”.

“We expect PBoC's interest rate hikes to remain modest, as policy rate hikes are seen as more of a signalling than a quantitative tightening tool. They will unlikely be too aggressive. The bank has to strike a difficult balance between fighting inflation via rate hikes and fending off speculative flows into the mainland,” he said.

“The PBoC is behind the curve [with regard to] interest rate hikes, but once the negative rate becomes too big, the central bank will have to take action,” said Dong Tao, a regional economist at Credit Suisse.

In a country like China where most people spend a big portion of their income on food, inflation, which reached a 28-month high in November last year, has become a political issue that policymakers can't afford to ignore.

The central government has made the battle against inflation a priority and ordered a shift from easy credit to a “prudent monetary policy” in 2011. Some economists believe the use of the word "prudent" rather than “tight” is a careful choice and means the government might keep a mildly accommodative monetary policy.

The big risk is still the excessive liquidity in the market, economists warn. New lending in China is reported to have topped Rmb1 trillion ($151 billion) last month, despite Beijing's efforts to slow down credit growth after the lending target was missed last year. Chinese banks issued Rmb7.95 trillion of new loans in 2010, compared to the government's target of Rmb7.5 trillion. New lending this year is estimated to be around Rmb7 trillion to Rmb7.5 trillion, although the central bank may not set a new target after the previous one failed.

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