China's rate rise surprises markets

China's central bank threw global financial markets into a frenzy yesterday with a decision to raise interest rates for the first time in nine years writes Alexandra Harney in Beijing.

The move by the People's Bank of China (PBOC) to lift its benchmark one-year lending rate from 5.31 per cent to 5.58 per cent hit commodity prices, stock markets and exchange rates around the world. The deposit rate rose from 1.98 per cent to 2.25 per cent. It was the first rise in the lending rate since July 1995 and in the deposit rate since July 1993.

The move suggested a shift by Beijing toward using market-oriented measures to control the economy - a change long urged by economists.

China has been relying on administrative measures to tamp down what it sees as excessive investment in certain sectors such as steel, property and aluminium. The central bank has also been trying to limit liquidity in the system and tighten credit to commercial banks.

Investors' immediate reaction to the decision highlighted the pivotal role that China has recently assumed in the world economy. Its rapid economic growth has turned it into an important source of demand for many raw materials.

Metal prices were the hardest hit and oil prices also fell. Bond markets reacted nervously as short-dated Treasury prices fell and yields jumped by more than 0.15 percentage points.

China's consumer price inflation hit 5.2 per cent in September, well above the deposit rate. But economists said the move would demonstrate to depositors that it would step in and raise rates if inflation remained high.

The PBOC further loosened controls on loans by lifting the ceiling on the range in which commercial banks can adjust lending rates. "This is the beginning of a long process of normalisation of interest rates," said Mr Dong Tao, chief regional economist for Credit Suisse First Boston.

Although yesterday's timing came as a surprise, economists had been expecting an interest rate rise at some point. Many believed more would follow.

"It's very likely they will have another 25 basis point [ rise] in the next six months," said Mr Qu Hongbin, senior economist for China at HSBC.

However, Mr Jonathan Anderson, chief economist for Asia at UBS, said the move should not be seen as an attempt at credit tightening. "This is just the PBOC being careful," he said.

Central bank officials have become increasingly concerned about potential leakage of deposits out of the official banking system as inflation has risen, pushing real deposit rates into negative territory, Mr Anderson said. If individuals began to take deposits out, it would threaten the health of the banking sector.

The US Treasury department said the rate rise was consistent with a move towards flexible exchange rates. The bank's decision, effective from today, was announced on its website.