Interest Rate Currency Term Paper

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China announced on Oct. 28, 2004 the first interest rate rise in nine years. In this manner, Beijing is showing its willingness to adopt additional market-oriented reforms in order to have a tighter macro-economic control on the already overheated economy. Although the news regarding the evolution of the Chinese interest rate were contradictory, it would appear that North American economists are welcoming this interest rate increase.

The Chinese economy is rapidly becoming one of the most important in the world, with an annual 8% growth-rate, constant expansion in the preceding years and a history of twenty years of economic reforms. The global economy and especially neighboring countries such Taiwan and Hong Kong are feeling the pressure of the Chinese machine. Investors have made public their fears, since April 2004, that the economy will overheat and are now expecting the austerity measures by the Government to slow the growth and provide for a more sustainable pace. Chinese-related share prices have been seriously hit due to the fears provoked by rising oil prices and low interest rates.

According to an article published in April 2004 by the Financial Times, Beijing had been preparing a series of measures in order to cool down the already booming Chinese economy. These measures included a rise in interest rates, according to the senior officials' declarations.

At the time, Wang Mengkui, director of the development research center of the State Council (the Chinese cabinet), said that China is suffering from increasing inflation and an exacerbate investment policy and that it would probably register a trade deficit at the end of the year. He stated "If there is a need, there is a possibility to raise the lending rates, especially those rates on mid- and long-term loans ... The adjustment of interest rates would have a relatively good impact on inflation."

At the same time, Beijing was slightly less opposed to a rising of interest rates, an action that had been last time performed in 1995. As a result, according to the reporter of the Financial Times, "Mr. Wang expected price rises, as measured by the CPI, to reach 5 per cent for the full year, higher than the official prediction of 3 per cent. Inflation was being caused mainly by rising raw material and energy prices but many manufactured goods remained in over- supply, meaning inflation would "not become a big problem."

Wang Mekui also spoke about the situation of raw materials, especially the ones used in infrastructure and construction projects. The inflationary pressure on such materials would be reduced as a result of the increased government efforts to temperate investment.

Concerning the renminbi, the official Chinese currency, the revaluation pressures were abating partially as a result of domestic inflation and partially as a consequence of the Chinese three consecutive months trade deficit. (at the time, April 2004). The currency reserves were also a problem. Wang said "China has got foreign currency reserves of over $400bn [Euro333bn, Stg221bn] and in fact, we can't use that much," he said. "A [trade] deficit is not something to be afraid of. If our reserves fall, it will not be a serious problem."

Falling Chinese reserves have also had an impact on the U.S. economy, but it has not been severe, notwithstanding the fact that Beijing has used its reserves to acquire U.S. Treasuries, which helped maintain the U.S. interest rates low. Another intention of the Chinese government was to avoid taking drastic measures in order to cool down the economy, and to take smaller steps, which were aimed at limiting investment.

Over-invested sectors such as steel, aluminum, cement, automotive and property have also suffered changes, according to the Financial Times article. Authorities decided to intervene and to prevent these already over-solicited areas of the industry to burn out. The article also reports that the Chinese officials have also considered other techniques for achieving their objectives, such as stopping the preferential policies intended to spur the export of some commodities such as coal, or altering the criteria by which the careers of local government officials were judged to lessen the weight put on the economic growth they delivered.

John B. Taylor, under-secretary for International Affairs at the U.S. Department of Treasury, believes that the Chinese interest rate rise is an active approach as it has reduced the risks of exaggerated investment, and that the American economy will be a beneficiary of this effort. Taylor not only approved, but also praised the measure taken by the Chinese government for the control of the inflation and for maintaining a sustainable economic development.

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This is one step closer to a more flexible exchange rate system. The American official expressed his belief that China is more market-oriented and that the renminbi is slowly pushed towards free floating.

As far as the U.S. economy is concerned, Taylor said that the exports of U.S. main commodities to China will increase as a result of these measures." He argued, "Only with the sustainable growth of Chinese economy, there will be export increase for us." It would seem that the United States are working toward a reduction of the trade deficit with China, with exports to the Asian giant up 34% this year. The increase of Chinese imports from the U.S. ranks third, after Canada and Mexico, the other two major U.S. export markets.

According to the chief economist at Morgan Stanley, Stephen Roach, the Chinese interest rate rise will not only slowdown the Chinese economy, but also the global economic growth, which is already advancing at a slower pace. He mentioned that the countries that are heavily dependent on China would be the hardest hit. Among those, Roach pointed to South Korea, Japan and Germany. More than 40% of the export growth from South Korea and Japan comes from China, while a similar thing can be said about Germany (28%)

China still worries about the inflationary pressures, so the recent Beijing interest rate rise was not enough for the Government. Administrative measures were sustained by interventionist moves, such as tightening up the credit and limiting land supplies for real estate developers. The Chinese interest rise is expected to reach 2-3% within a year- year and a half time period.

However, the interest rate increase also has negative effects. Market demand could slow down and that would produce effects difficult to cope with. Funds flowing to banks or for buying debenture shall apply a constant pressure for the renminbi's value increase. The interest rate rise will encourage further speculative money influx, which will in turn raise the pressure on RMB's exchange rate. Should the RMB have a higher value, the export commodities will grow and the export will suffer some damage, a thing that surely is not wanted by Chinese officials. Experts say that the pressure is not so great so as to induce a rise in the renminbi's exchange rate. If consumption goes down, several sectors, such as the automotive industry (Volkswagen, General Motors or Ford are among the players), which were already hurt, will go down even more. Based on the experience of other countries, investment-cooling effects cannot be obtained by modifying the interest rate system, especially under these specific economic conditions.

Another opinion states that the interest rate rise will not affect the raw materials industry in China. The industry of building materials has always proved interesting for investors, so investments are expected to be high in the next period. The consequence will be a sustainable increase in the demand of raw materials. In 2003, China imported about 150 million tons of iron ore, and the number is expected to increase to 200 million tons this year.

The rise of the Chinese interest rate will produce numerous indirect effects on the U.S. economy. The sudden rise of the benchmark rate on the 28th of October had a definite impact on the futures and finance markets. Numerous futures prices and stocks of companies producing raw materials have gone down. The price of crude oil also dropped (about 8%, i.e. U.S.$1.54). Raw materials (steel, coal) prices used in futures contracts decreased to varying degrees.

However, on the 29th of October, the following day, the markets recovered a bit from the blow of the sudden rise of the Chinese interest rate. The Chinese economy will not be affected -- at least as far as the demand for raw materials is concerned, so the greatest effect of this measure will be the acceleration of the Chinese financial reform.

This is the opinion of Sung Won Sohn, chief economist at Wells Fargo, who believes that the interest rate rise will not be that significant for the domestic demand and economic overheating. The world market will be most affected. Sung argued, "I think China's main idea is to conciliate U.S. And other members of Group 7. The Group 7 has asked China to adopt market mechanism to adjust interest rate and currency value. The decision of the central bank shows that the bank is moving forward towards market orientation."

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