Oxstones Investment Club™From WSJ, by Mark Gongloff
China’s interest-rate increase has less to do with the controversy over the value of its currency than with a straightforward effort to fight inflation— but it risks intensifying the currency battle nonetheless.
Many observers say China’s move Tuesday to raise key rates is a textbook response to the country’s strong growth, rising inflation and the risk of a dangerous property bubble. More increases are likely, they say, as China tries to slow the frenzied borrowing that helped it through the recent recession.
But the rate move—which comes just days before finance ministers and central bankers from the Group of 20 industrial and developing nations meet in South Korea—has implications for China’s currency, too. In most economies, higher interest rates attract foreign investors looking for better returns. The cash flooding into the economy boosts the local currency. But China’s economy is mostly closed, limiting—though not eliminating—the impact of higher rates on the yuan.
The increase in interest rates could actually complicate matters for China on the currency front, said Nicholas Lardy, a specialist in China at the Peterson Institute for International Economics, a Washington think tank. Given that Chinese interest rates were already above what developed countries are paying on one-year deposits, and that the market is betting that the yuan will rise over time, the rate increase could serve only to attract more investor money.
As a result, “they’re going to have to work harder to keep the yuan from rising,” he said.
The yuan retreated Wednesday from its recent high against the dollar, opening at 6.6625 against the dollar, versus Tuesday’s close of 6.6447.
Allowing the yuan to rise could slow the economy’s heated growth just as effectively as raising interest rates. But China appears to have little interest in a quick yuan appreciation, despite loud complaints from the U.S. and elsewhere that its currency is too cheap, giving it an unfair trade advantage.
Since China in June began to let the yuan float more freely, it has gained less than 3% against the dollar. In contrast, the dollar has fallen roughly 13% against a basket of other major global currencies during that time in response to Federal Reserve plans to pump more money into the economy, a move that could devalue the dollar.
By raising interest rates, China solidified the view among some observers it is in no hurry to let its currency appreciate.
“At worst [the rate move] signals China’s reluctance to share more of the brunt of the dollar’s devaluation,” Lena Komileva, head of Group of Seven market economics at London brokerage firm Tullett Prebon, wrote in a note, adding that the “undervalued exchange rate remains deeply reflationary.”
If China decides to temper the yuan’s gains, then the factors driving the currency feud will remain unchanged.
Beijing will need to continue to buy large quantities of U.S. Treasury debt in order to keep the dollar strong and the yuan in check. That could weaken U.S. exports, potentially countering Federal Reserve efforts to kick-start the U.S. economy.
It is always possible that China could let the yuan rise at the same time it raises interest rates. It did that as recently as 2007, Bank of America Merrill Lynch analysts noted, when the yuan rose 6.5% against the dollar while policy makers raised domestic interest rates.
The question is whether the yuan will rise quickly enough to quiet critics.
Tags: China, FDI, FX Rate, growth, inflation, interest rates