On Oct. 28, the People's Bank of China announced it would raise the one-year interest rate by 0.27 percent to 5.58 percent from 5.31 percent -- the first rate hike in over nine years. Why did China raise its interest rate? Will it continue to raise the rate? Will this affect the yuan's exchange rate?
Basically, there are three reasons behind the rate hike. First, the speedy growth in "investment in fixed assets" that has overheated China's economy has not been completely reined in, showing that Beijing's macroeconomic control measures have not yet cooled down the overheated economic growth. Total investment in fixed assets grew by 26.7 percent last year, and by 43.5 percent to its highest peak in March, causing much concern about the economy. After Beijing officially launched its new control measures in April, investment still grew by 30.3 percent in the first eight months.
Second, inflation pressure is still high. China's inflation rate jumped 4.2 percent points within a year -- hitting 5.3 percent in July and August, from only 1.1 percent last September. Although the Chinese government claims that higher food prices, which trigger inflation, will decline after the abundant autumn harvest, no major price drop has yet been seen. On the contrary, growth in prices for non-food items gradually increased to 1 percent in August from 0.1 percent in January, as China's overall price levels remain high.
Moreover, as international oil prices move above US$50 a barrel, this has caused prices of Chinese commodities to climb. Viewing the latest figure in August, Chinese commodity prices grew were up 6.8 to 12.9 percent from the same period last year.
Third, people's savings have continuously dropped, decreasing banks' liquid funds and increasing financial risk. Due to inflation, seen since last October, the actual one-year deposit rate has become negative, sinking to minus 3.72 percent in August. As a result of the negative figure, growth in deposits has slipped month by month, and savings grew by a mere 15.3 percent in August, which was 4.7 percent lower than the rate in August of last year, marking seven months of consecutive decline.
Between June and September, the US raised its interest rate three times, or a total of 0.75 percent, providing a good external environment for China's rate hike. Still, the 0.27-percent hike may not resolve the cause of the overheated economy: massive foreign exchange that is flooding into China's market due to its low exchange rate.
Since last year, the People's Bank of China has been forced to absorb more than US$10 billion of foreign exchange every month to maintain the fixed exchange rate. The amount in July was still as high as US$12.4 billion. This phenomenon has seriously interfered with the autonomy of China's currency policy.
Additionally, China's "unidentified" foreign exchange reached US$50.3 billion in late August, which was US$17.6 billion, or 53.8 percent, higher than that of the same period last year. Rampant "hot money" in China may become even worse this year.
The 0.27-percent hike was indeed insignificant. It does little to relieve inflation pressure, not to mention that investors may expect more rate hikes in the future. Such expectations will bring more money into China's market, and will increase appreciation pressure on the yuan.