Why Interest Rates Need to Rise in China

China’s central bank raised interest rates for the second time in a month and the third time since October in an effort to fight surging inflation and speculative real estate buying. The speculation is that the central bank will increase interest rates two additional times by the mid-year. While it may not be what you want to hear due to its potential impact on Chinese growth, the higher rates are necessary and make sense. As was widely expected, China’s central bank raised interest rates for the second time in a month and the third time since October in an effort to fight surging inflation and speculative real estate buying. The speculation is that the central bank will increase interest rates two additional times by the mid-year. While it may not be what you want to hear due to its potential impact on Chinese growth, the higher rates are necessary and make sense.

The reality is that China continues to report impressive GDP growth and, yes, higher rates could slice off some of the growth, but longer-term it will only help create stability and growth.

The Organization for Economic Cooperation and Development (OECD) predicts that China will grow its economy by 9.7% in 2011 and 2012. While lower than the previous rates, this is still well above the global averages of 4.2% and 4.6% in 2011 and 2012, respectively.

I view the growth of China over the past decade as akin to the Industrial Revolution that started in the United Kingdom in the 18th century and spread across Europe, to the U.S., and around the world.

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But, with all the growth come rising prices, or inflation. Inflation is estimated by economists to rise to an annualized 5.3% in January. China has not seen inflation at these levels in over 25 years. The target inflation rate was raised to four percent from the previous three percent.

Prices across the board have been rising in the country. Food prices are surging across the country due to the higher commodity prices. The government has come in to help subsidize the rapidly rising prices, but this is only a temporary measure for a deeper problem.

When a country is growing at the rate China has been, it is not unreasonable to see inflation. The country is placing a cap on essential foods such as cooking oils to try to help the many poor people.

Real estate values, while rising at a lower rate, continue to move higher despite the government’s efforts to tighten the flow of money via higher bank reserve ratios. China increased the bank’s reserve ratio to 18.5%, representing the fifth increase in 2010 and the third in over a month. The reality is that this does not appear to be working and the government may need to further increase interest rates to dampen the lending demand.

China estimates that it has targeted about US$1.05 trillion in bank lending in 2011, which still appears to be relatively high, but lower than the expected $1.35 trillion in 2010. Some economists feel that the lending should be US$975 billion to US$1.0 trillion for 2011.

In my view, China’s central bank finally appears serious about tackling the inflation by increasing interest rates. And my gut feeling is that higher interest rates are around the corner in China.