The Hindu Business Line : China's rate hike is just the beginning

JUST on the eve of the US Presidential elections, China managed to steal the thunder away from the US with its rate hike. Its one-year lending rate has gone up from 5.31 per cent now to 5.58 per cent. The deposit rate is being raised too from 1.98 per cent to 2.25 per cent. Too much is being read into this. That is, analysts are debating whether it signals some flexibility on the currency down the road. The author submits that only a central banker who has not done Economics 101 would simultaneously begin to raise interest rates and revalue the currency.

Much ink has been spent writing on Chinese yuan revaluation. Let us briefly recap. If China floats the currency now and if it appreciates, it might result in excessive tightening and, if it sinks, rates have to go a lot higher. I am not sure China would like either of this to happen right now. So, let us not get overexcited. This move does not presage any move on the currency. Not as yet.

The rate hike move is an acknowledgement of the basic economic fact that, as long as real interest rates are low (or even negative), administrative measures would only go thus far in cooling a white-hot economy. The fact that the official growth rate in the second quarter was still above 9 per cent means that the real growth rate was in double-digit.

So, the truth is that there is far more work to be done by China to bring the growth rate down to a level that they are comfortable sharing with the world.

That would inevitably raise the risk of a much harder landing in China in 2005 or in 2006. `Soft landing' is seen only in sell-side economists' reports. Very few economies in the world have achieved that.

Even the United States that appeared to execute a soft landing in 1995 flirted briefly with recession that year and it required three 25-basis point rate reductions plus a super-weak dollar to avoid that.

Bullish for bonds

If anything this move should raise the risk of a global economic slowdown/recession/mini-depression. Readers are free to pick a scenario that is consistent with their mental disposition.

If China succeeds in cooling its economy and succeeds well, its excess capacity would add to the global capacity glut in manufactured goods. Other things being equal, this would only add to the disinflation or deflation scenario for the coming years. Therefore, if anything, the move is bullish for bonds globally and, therefore, bearish for the US dollar, eventually.

Commodity currencies should hold up

Any knee-jerk reaction in commodity currencies such as the Australia, New Zealand and Canadian dollars to sell off should be used as opportunities to accumulate them. In the case of the former two, their rate differential with the US, Europe, Japan and Singapore would keep them on a firming trend. For the third one, its fundamentals are solid and the central bank is embarked on a mission to raise rates and prevent inflation from rising.

Hence, this move on the China's part presents me with no compelling case to revise my views on these currencies. I remain optimistic on their prospects versus the US dollar.

No change in East Asian exchange rate outlook

East Asian currencies are not going to be able to appreciate (nor are their central banks losing sleep over it) on the back of this rate hike by China. If any, it increases the risk of a hard landing in China and globally. That should reduce their own economic growth rates in the coming quarters and that calls for easier and not tighter monetary policy. That means cheaper currencies and low interest rates.

Therefore, externally dependent and internally challenged East Asian governments and central bankers are not going to be in any hurry to let their currencies appreciate until China really moves on the currency. We have argued earlier that the rate hike does not signal any such intention on the part of China. QED.

So, to sum up, there has been a lot of excitement and flutter. Hats off to China for stealing the limelight from the US. Other countries can learn some media management from PRC. But it certainly did not make the world a safer and better place for the future. It only raised (choose your own magnitudes!) the risk of a global hard landing. Consequently, it strengthened the case for bonds and for a weaker dollar.

(The author is founder-director of Libran Asset Management Pte Ltd., Singapore. The views are personal. Please address feedback to van@libranfund.com)

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