China Begins Stimulus Exit

Chinese policy makers will likely raise interest rates and allow the yuan to appreciate this year

China January 8, 2010, 8:50AM EST

(Bloomberg) — China's move to raise the cost of three-month bills will probably lead to the nation's first interest-rate increase in almost three years by September, a survey of economists showed.

The People's Bank of China will lift the benchmark one-year lending rate to 5.85 percent by year-end from 5.31 percent now, according to the median estimate of 15 economists surveyed by Bloomberg News today. The survey was after the central bank yesterday sold the bills at a higher interest rate for the first time in 19 weeks.

Premier Wen Jiabao's government may keep the increase in borrowing costs this year to less than 1 percentage point because it wants to ensure a sustained economic rebound. Policy makers need to support "relatively fast" growth while managing inflation expectations, the central bank said in a statement this week after an annual work meeting.


"There's still a lot of uncertainty over the strength of the recovery," said Ken Peng, an economist with Citigroup Inc. in Beijing. "Policy makers are concerned about inflation but they will see how that plays out before moving on rates in the second half of the year."

Stocks stabilized after tumbling yesterday in the aftermath of the PBOC's move. The MSCI Asia Pacific Index added 0.5 percent to 123.93 as of 3:10 p.m. in Hong Kong after a 0.6 percent drop. The Shanghai Composite Index closed up 0.1 percent after a 1.9 percent slide that was led by Bank of China Ltd. and Industrial & Commercial Bank of China Ltd.

Reserve Ratio

Along with higher rates and an increase in banks' reserve ratio, officials are projected to allow the yuan to appreciate this year after preventing gains since July 2008.

The proportion of deposits that big banks are required to hold as reserves may increase by 50 basis points to 16 percent as early as the second quarter, according to the median estimate of 11 economists. China's currency may rise almost 3 percent to 6.63 per dollar by year-end, while banks are expected to extend 7.5 trillion in new yuan loans, the median forecasts show.

In the first 11 months of 2009 officials allowed a record 9.21 trillion yuan ($1.4 trillion) of new bank loans, a credit surge that fueled construction spending and business investment. Domestic demand helped counter what economists estimate was the first annual decline in exports in a quarter century.

Timing of Moves

Policy makers may raise the benchmark rate to 5.58 percent in the third quarter, with a further 27 basis point move in the final three months of the year, according to today's survey. They have kept the one-year lending rate at a five-year low since five reductions in the last four months of 2008.

In yesterday's step, the PBOC offered 60 billion yuan of three-month bills at a yield of 1.3684 percent, 4 basis points higher than at last week's sale, it said in a statement yesterday.

Daiwa Institute of Research and Royal Bank of Scotland said that accelerating inflation may prompt the central bank to tighten monetary policy more quickly. Daiwa forecasts a 27 basis point rate increase and a 50 basis point move in the reserve ratio as early as next month.

"Policy makers are quietly implementing an exit strategy and paving the way for interest-rate hikes," said Kevin Lai, an economist with Daiwa in Hong Kong. "This is reasonable because inflation is likely to shoot up in the next few months."

Inflation Outlook

Consumer prices probably rose 1.6 percent in December after a 0.6 percent gain in November, Qing Wang, Morgan Stanley's chief Asia economist, said in a research note this week. Inflation expectations in China are likely to advance this year in the face of "very loose" monetary policy, Wang said.

"Yesterday's rise in yields was only the beginning," said Ben Simpfendorfer, an economist with Royal Bank of Scotland in Hong Kong. He forecasts that the reserve ratio may be changed this quarter and rates in the following three months.

Because commercial banks allocate their lending at the start of the year, yesterday's bill sale is a signal to them "not to overindulge," said Alaistair Chan, an economist with Moody's Economy.com in Sydney. "They're going to tighten in various ways," including using the benchmark rate and required capital reserve ratio for banks, he said.

The central bank may this month start issuing guidance to banks on how much credit they can extend, Bank of China Ltd. said today. New credit may fall to less than 2.6 trillion yuan in the first quarter from 4.58 trillion yuan in the same period a year earlier, Bank of China analyst Shi Lei wrote in a note.

Central bank Governor Zhou Xiaochuan this week reiterated government warnings that investment in industries with excess capacity and in redundant infrastructure projects could threaten banks' loan quality.

The PBOC will guide credit, seeking to avoid volatility in lending, Zhou said in an interview on the Web site of China Finance, a central bank publication. Investment in duplicated projects or industries with overcapacity could "pose a risk to the quality of banks' loans," Zhou said.

—Kevin Hamlin, Paul Panckhurst, Jay Wang and Li Yanping. Editors: Chris Anstey, Paul Panckhurst.