China roils markets with rate hike

China's central bank is raising interest rates in its strongest effort yet to temper the ill effects of a massive monetary stimulus package, a surprise move that has sent shock waves through global commodity and currency markets.

The unexpected 25-basis-point rate hike marks the first time China has tightened lending rates in almost three years and suggests Beijing remains deeply concerned about inflation and a runaway property market but is also confident enough in the country's economic recovery to impose a measure that will cool growth.

Commodity prices and resource-related currencies swooned on fears that China, whose strong rebound from the financial crisis paced growth for the global economy, will begin to curb its demand for materials. Prices for oil, copper and other commodities fell and gold recorded its largest one-day loss since early July. Equity markets dropped and the commodity-driven currencies of Australia and Canada retreated sharply against the U.S. dollar.

"The rationale behind this is that very easy Chinese monetary conditions have been one of the primary drivers for global asset demand (including commodities) and that this start to the rate-hiking cycle will tighten monetary conditions, thus reducing demand from China at the margin," said Nick Chamie, global head of emerging markets research at RBC Dominion Securities Inc.

In response to the global financial crisis, China cut interest rates in 2008 and also initiated a $586-billion (U.S.) stimulus package that spurred economic growth through infrastructure building, which in turn created rising demand for commodities. But the enormous monetary stimulus also inspired record lending and a red-hot property market which the government has repeatedly tried to curb - through quantitative instruments such as mortgage controls and bank lending restrictions - with little success.

China's banks offered 596 billion yuan ($92-billion Canadian) worth of new loans in September, far more than consensus estimates of 500 billion yuan. Although sales have slowed, property prices in China are 9.1 per cent higher than they were a year ago. China's annual inflation rate hit 3.5 per cent in August, the fastest pace in almost two years.

"I think this shows that the central bank is serious about controlling both inflation expectations and asset appreciation. It should be noted that People's Bank of China (PBOC) just temporarily hiked reserve ratios for six Chinese banks. The current monetary situation in China is that liquidity is very ample - maybe a bit too much," said Na Liu, founder of CNC Asset Management, which focuses on China's equity markets and the global raw materials sector.

"Generally, I like what the PBOC did. It is very necessary under the current monetary environment. In fact, it is overdue," Mr. Liu added.

China's unexpected rate hike, which takes effect Wednesday, will increase one-year lending rates by 25 basis points to 5.56 per cent. One-year deposit rates will rise to 2.5 per cent - an increase that could help China towards its long-term goal of creating a more domestic-driven economy that is less reliant on exports.

"By raising the income of savers (and thus most households), it is a small step that could promote economic rebalancing while also, at the margin, reducing the incentive for those with savings to shift them into equities or property markets," said Mark Williams, senior China economist at Capital Economics in London.

The rate increase comes amid mounting pressure on China to allow further appreciation of its undervalued currency, the yuan, against the U.S. dollar. U.S. lawmakers have accused China of implementing monetary policy conditions that keep the currency artificially low to help Chinese exporters.

Just a week ahead of the Toronto Group of 20 Summit in June, China vowed to permit further flexibility of the yuan against other currencies. However, the yuan has only appreciated 2.6 per cent against the greenback since then, inflaming tensions between the U.S. and China.

Manik Narain, emerging currency strategist at UBS, told Reuters the rate rise could be interpreted as a sign China is reluctant to use a stronger yuan to tighten liquidity.

"This might not be positive for the markets if it represents a possible rise in trade frictions between the U.S. and China," he said.