China’s central bank increased interest rates by a further 25bps yesterday. This takes the minimum lending rate up to 6.56%. The interest rate on deposits was also increased by 25bps to 3.50%.
The latest rate hike is the third this year and the fifth since October 2010. In total, rates have now risen by 125bps. The reserve requirement has previously been raised by 450 basis points in nine steps during the same period, bringing it to 21.5% for large banks.
China has been trying to engineer a managed slowdown of domestic economic activity, partly in order to combat high inflation, but also to control price developments in the housing market. Inflation was recorded at 5.5% in May 2011, compared with an informal target of 4%, and is expected to increase above 6% in June 2011.
Interestingly, this increase in bank borrowing costs will tend to make very little difference. This is because benchmark lending rates are still low relative to the pace of economic growth (see chart attached), but more importantly, the constraint on credit growth is, instead, the amount that banks can lend rather than the rates they charge. Rather, raising the minimum lending rates allows for an increase in deposit rates, which is vital to the containment of frivolous spending in an environment of high savings and rising inflation.
China’s economic activity has been gradually moderating this year, following the strong performance in 2010 and the ending of government's massive two-year ($586 billion) stimulus program that was adopted in late 2008. Although exports have remained strong this year and rising wages have helped buoy consumption, the booming property market is showing signs of softening and industrial activity has slowed.
It is true that past tightening cycles in China have tended to become too restrictive, so clearly the latest rates hikes are becoming a concern. However, there is already evidence of a slowdown in domestic economic activity and inflation is ultimately expected to remain below the previous peak. This should help to contain the extent of monetary tightening, which (hopefully) results in only an easing of real GDP growth rates in 2011 and 2012.
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