Beijing Raises Interest Rates Again

JULY 7, 2011   THE WALL STREET JOURNAL

By AARON BACK

BEIJING—China's central bank announced its fifth interest-rate increase in eight months, signaling its concern about accelerating inflation, though a number of analysts said they expect this to be the last rate increase of the year as the world's second-largest economy tries to make sure it doesn't slow growth precipitously.

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Premier Wen Jiabao has said controlling inflation, reflected in pork prices, is Beijing's top priority. Pictured, a butcher carries a slab of pork in Hefei.

The quarter-point increase in benchmark loan and deposit rates, which takes effect on Thursday, comes just over a week before China is due to announce June inflation data, which analysts widely expect to show consumer prices rising by more than 6% from a year earlier, a sharp jump from May's increase and the fastest pace in nearly three years.

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But next week's data are also expected to show that the pace of China's economic growth slowed in second quarter—although it likely remained rapid by comparison with other big economies. Given that the country's leaders fear that either surging inflation or slow growth can stir social unrest, the central bank is reluctant to focus solely on inflation.

"We think this is likely to be the last hike of the year," said Goldman Sachs analyst Yu Song, who expects inflation to moderate over the coming months. "We believe the government is reluctant to use the [interest-rate] tool too often for concerns on potential hot money inflows…and the negative impact on real economic activities."

Across Asia, other central banks also appear to be starting to focus on growth at least as much as inflation—potentially giving a boost to global demand as the U.S. and Europe struggle to regain their footing after the global downturn of 2008 and 2009. Last month, Indonesia, Southeast Asia's largest economy, left its benchmark rate unchanged, saying, "Inflation pressures are decelerating."

In India, the Reserve Bank of India has battled a high inflation rate with 10 rate rises since early 2010, including one in mid-June. The bank's governor, Duvvuri Subbarao, has said the government is getting a handle on the problem and that inflation should be lower by the end of the current fiscal year, in March 2012.

In recent weeks, some prominent commentators in China have raised concerns that the central bank has already tightened policy too far, choking off credit to small and midsize companies, who tend to pay higher interest rates than big government companies. Credit Suisse estimated that there was a 20% chance over the next 12-18 months that China may have a "hard landing"—meaning a sustained period of growth in gross domestic product of less than 7%.

How China balances controlling inflation with keeping up growth is of huge consequence to the global economy. China has emerged as a key driver of global growth as the U.S. and Europe remain mired in tepid recoveries and Japan continues to suffer from the aftermath of the March earthquake and tsunami.

Chinese growth is an especially important swing factor in global demand for commodities, and for countries that produce those commodities like Australia and Brazil. Following the interest rate-increase announcement, copper prices on the London Metal Exchange ended down 0.2%, while crude oil prices declined 0.2% on the New York Mercantile Exchange.

Mark Williams, an economist at research firm Capital Economics, said market fears of a slowdown will likely be inflamed by the rate increase, although he disagrees that China is on the verge of a hard landing. "With inflation over 6% in June, the focus on inflation is understandable," he said.

Despite the central bank's tightening, deposit rates in China remain well below inflation, a situation that encourages people to spend or invest in speculative assets—which ends up fueling inflation—rather than park funds in savings accounts. Lending rates, meanwhile, are barely keeping pace with inflation.

The People's Bank of China's statement on Wednesday said the benchmark one-year lending rate will rise to 6.56% from 6.31%, and the one-year deposit rate will rise to 3.5% from 3.25%. The central bank had already raised interest rates twice this year and twice late last year. In addition, it has repeatedly raised the share of deposits that banks must set aside, rather than lend—a policy that critics say disproportionately affects entrepreneurs and service industries, the most vibrant part of the Chinese economy. State-owned banks prefer to make loans to state-owned companies, whose debts are assumed to be guaranteed by the government.

Central bank allies such as academic adviser Li Daokui have shot back at critics of the bank's tightening, saying other measures such as tax breaks can be used to address concerns of smaller borrowers.

And senior leaders have attempted to reassure the public that they are on top of the issues. Chinese Premier Wen Jiabao reiterated on Tuesday that maintaining price stability is the government top priority, saying that "inflation will be effectively suppressed when government policies take effect."

And many private-sector economists now widely expect that inflation will soon peak and start to moderate in the second half of the year, while growth remains healthy.

Still, many of the same forecasters and officials have underestimated the extent of inflation pressures over the past year. Late last month, Mr. Wen said inflation is unlikely to be contained within the official government target of 4% this year, and that a more realistic target is below 5% for the full year.

Moreover, the expected moderation in inflation is at least partly due to a statistical effect whereby higher inflation late last year makes this year's seem milder by comparison.

The central bank's spate of rate increases are a particularly strong sign of its concern over inflation in light of China's historical aversion to raising interest rates to control prices or to prick inflating property bubbles. The country's leaders prefer to run the economy through administrative measures and whispered orders to big state-owned firms, rather than relying more heavily on broad policy moves that give a bigger role to markets to determine outcomes.

In addition, increasing interest rates raises the cost to the central bank of its so-called sterilization operations, in which the bank issues debt to soak up funds from exports and foreign capital inflows.

Moreover, an increase in interest rates also raises the burden on provinces and municipalities to repay debt. China's National Audit Office last week said local governments owe debt equal to more than a fourth of the country's economic output—a figure some analysts have said is too low.

—Eliot Gao in Beijing and Bob Davis in Washington contributed to this article.

Write to Aaron Back at aaron.back@dowjones.com