China's bank raised interest rates -- Expect slower growth

March 24, 2007

Partly in response to the global stock market meltdown on February 27th, the China's central bank (People’s Bank of China) raised bank interest rates .279 percentage points on March 17. Since banks are regulated by the government, this means that all one-year deposits will receive 2.79% and all one year loans will cost 6.39%. The central bank raised interest rates in China in August of 2006. It also increased commercial banks’ deposit reserve ratio by .5 percentage points twice this year.

The central bank is trying to reduce the number of loans that Chinese banks are making as a way to cool down the economy, which grew at 10.7% last year, the fourth year in a row of double-digit growth. As a result, inflation is already at 2.7% in February, which means it may exceed the goverrnment’s target rate of 3%.

What China’s interest rate increase means:
Chinese banks have traditionally been owned by the government, and so are not subject to the usual market disciplines. Their loans are often made more for political reasons than financial ones, and as a result they have an unknown quantity of bad loans. (See " China’s banking system")

To defuse this potential land mine, China agreed to open up its banking market to foreign ownership. In addition, U.S. Treasury Secretary Paulson has been meeting with President Hu to put in place other financial disciplines needed to strengthen China’s financial markets. (See "Paulson meets Hu in China") All of this is needed before China can safely allow its currency, the yuan, to rise which will then allow U.S. exports to increase. And THAT is needed to reduce the U.S. current account deficit, which is being financed by China’s excess profits from its export trade with the U.S.

This all needs to occur slowly and carefully to prevent a run on the dollar, causing a dollar crash, and to prevent another panic and stock market crash. That is why you can expect slow but steady increases in China’s interest rates, slow but steady decreases in the U.S. dollar value, and hopefully slow but steady winding down of China’s overheated economy and stock exchange.

However, don’t be surprised if, in addition to slow and steady, there are a few more volatile bumps along the way. And no one can say what the impact will be if there are supply side shocks, such as a bump in oil prices, or a huge scandal or failure in some large Chinese bank loan.

Action steps:
Make sure that emerging markets funds, which stand to benefit the most from China’s growth, are a part of the part of your retirement plan. But think about selling any emerging market funds if you need the cash to live on within the next ten years. If you can’t afford to let it sit, should there be a market melt-down, then talk to your financial advisor about safer alternatives.

Source: China People’s Daily Online, “China raises benchmark interest rates by .27 percentage points”, March 18, 2007.

See the World Money Watch Special Report "How to Profit from China's Growth."

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