China is raising interest rates for the first time since 2007. The decision is both about politics and economics, because China wants growth, but it wants it to be quality growth, not quantity growth. But the prices of nearly everything, from food to labor to houses, are getting out of hand. At the same time, the Chinese are not pleased to see prices so inflated and are expecting their government to do something about it. That said, the government is doing something. It is increasing interest rates to combat inflation that has hit 3.6% in September, achieving the highest and the fastest rate in nearly two years.
The problem is finding the right balance. What Chinese government wants is an economic output of about eight percent, instead of the current 10%, which would be somewhat slower, but surely of a much better quality than the one generating inflation of 3.6% as a byproduct. Classic economic theory requires increasing interest rates in response to out-of-control inflation. However, hitting high inflation with a massive interest rate hike cannot be an answer.
If China raises interest rates too much at once, it could smother prices, kill property values and make a serious dent in the country’s GDP. That is why the government has increased interest rates very timidly, from 5.31% to 5.56%. At the same time, interest rates on savings accounts have decreased from 2.5% to 2.25%. The reason for this policy decision is to give incentive to citizens to start spending, instead of hoarding cash. But saving money and living modestly is how the Chinese have been conditioned over the years, so I am not certain how that is going to change with mere policy.
However, where higher interest rates may have an impact is with banks, which may be a little less prone to lending. This is another problem in China. In September, new loans have reached 596 billion yuan, or about $89.0 billion, which is much higher than the banks’ self-imposed quota of 450 billion yuan. Obviously, whatever China’s government did earlier—and it did a lot, such as implementing higher mandatory down payments on homes and demanding more restrictions on loans—none of it worked.
Why is all this relevant to someone in the U.S.? Well, in case you haven’t noticed, China is a huge player on the international stage, both economically and politically. The “currency war” is raging and it has truly put our greenback through the ringer. At the moment, China is one of the major players holding most of the aces and it has the power to change the dollar’s fortune, both for the better and for the worse. This is why I’m watching policy decisions in China. As of late, they have quite a resonance throughout the world.