China Raises Interest Rates for First Time in a Decade

October 29, 2004

The People's Bank of China (PBOC), China's central bank, as reported in the Washington Post, yesterday announced that it would raise two key interest rates today for the first time in almost ten years. The move, intended to curb inflation and prevent overheating in the economy, is the latest of several efforts by the Chinese government this year to reduce the rate of growth, but is the first use of interest rates, the most fundamental monetary policy tool at a central bank's disposal. Previous efforts had included raising banks' reserve requirement and declaring by administrative fiat that lending in construction-related sectors should slow.

The subtext behind this rate hike may indicate that its value as a harbinger of changes to come may outweigh its effect as a simple shift in monetary policy. First, the PBOC not only raised two of its interest rates--the one-year lending rate from 5.31% to 5.58% and the one-year deposit rate from 1.98% to 2.25%, both increases of 0.27%--it also, as reported by the, eliminated the cap on the rate that all banks could charge on loans. That cap, 1.7 times the PBOC's lending rate, had created a significant capital black market where rates could reach as high as 20%. The cap's elimination will bring down the rates on the black market as banks compete to lend to riskier projects at rates that would previously have been above the cap. Eliminating the cap leavens China's financial sector with another measure of market competition. Of course, the AP reports that the PBOC did not eliminate the mandatory minimum (10% less than the official rate) that banks may charge for loans--a device to make sure competition isn't too robust--indicating that market forces have not entirely insinuated themselves into China's monetary policy.

Careful observers will also scrutinize this rate hike for any indication that it predicts a change in the exchange rate value of China's currency. While raising interest rates has no direct effect on the exchange rate between China's yuan and the U.S. dollar, a rate that has been pegged at 8.28 yuan to the dollar for over 10 years, it is possible that the hike will put more upward pressure on the yuan. As the PBOC must know this, the rate hike may signal some form of revaluation upward in the coming months. Although previous interest rate reductions have not resulted in any change in the exchange rate, the speculation in Chinese yuan is sure to continue.

This move also demonstrated that the PBOC lacks the independence of a true central bank. As made clear at the PBOC's press conference to discuss the rate hike (in Chinese), the spokesman explained that the PBOC agreed with the analysis of the State Council, China's cabinet, which suggested this move. The PBOC is independent enough to actually make the final decision on interest rates, but the political leadership of the State Council initiated the process.