China Raises Interest Rates to Rein in Overheated

UNCLAS SECTION 01 OF 02 BEIJING 008109

SIPDIS

SENSITIVE
SIPDIS

USDOC FOR DAS LEVINE AND ITA/MAC/AP/MCQUEEN
TREASURY FOR OASIA/ISA KOEPKE AND DOHNER
STATE PASS CEA FOR BLOCK
STATE PASS FEDERAL RESERVE BOARD FOR JOHNSON/SCHINDLER; SAN
FRANCISCO FRB FOR CURRAN; NEW YORK FRB FOR DAGES/CLARK
STATE PASS USTR STRATFORD/WINTER/MCCARTIN

E.O. 12958: N/A
TAGS: EFIN EINV CH
SUBJECT: China Raises Interest Rates to Rein in Overheated
Growth

(U) This report is sensitive but unclassified. Please
handle accordingly.


1. (SBU) Summary: On April 27, the People's Bank of China
(PBOC) announced an increase in loan interest rates, with
rates on the benchmark one-year lending rate rising by 27
basis points to 5.85 percent. Local observers interpret
this move as a response to fears that the economy is
overheating. Statements by government officials indicate
concerns over excessive investment and overcapacity.
Although the increase in lending rates is modest, it sends
a positive signal that the government is using market-based
instruments to rein in lending. If this interest rate hike
fails to have the desired effect, the government could take
further steps, such as more rate hikes or an increase in
reserve requirements. End summary.

Rates Up
--------------


2. (U) The People's Bank of China (PBOC) announced on
Thursday, April 27, that effective Friday, the benchmark
for one-year lending rates will rise to 5.85% from 5.58%,
and deposit rates remain unchanged. According to the
central bank, "The increase in the lending rate is aimed at
further strengthening the fruits of macro controls and
keeping solid momentum for the economy to grow in a
continuous, rapid, coordinated and healthy manner." The
PBOC also increased the six-month lending rate to 5.40%
from 5.22%, and on loans of three to five years to 6.12%
from 5.85%. Interest on loans of more than five years was
raised to 6.39% from 6.12%. The PBOC last raised the
lending rates in October 2004. Furthermore, the central
bank posted a notice on its Web site quoting DeputyQernor Wu Xiaoling telling a meeting of executives of
commercial banQnd policy banks that credit controls are
needed. "We must strictly control loans to sectors that
are overheating. We must ensure control of credit and
prevent sharp swings in credit growth," she stated.

Overheating Fears
--------------


3. (SBU) This policy move is being viewed as a reflection
of growing concern among China's top leaders over
overheating in the economy. In the first quarter of this
year, Chinese economic growth accelerated to 10.2% on an
annualized basis and fixed-asset investment growth rose to
27.7%, fueled by excess liquidity in the financial system.
Referring to this situation, Chinese President Hu Jintao
noted in early April that "We do not want, nor are we
pursuing, excessively rapid economic growth." The National
Development and Reform Commission (NDRC) warned on Tuesday
that annual demand for cement was 1.05 billion tons, while
production capacity had reached 1.3 billion tons. Three-
fifths of the capacity, moreover, was for low-quality
cement that China's increasingly advanced economy no longer
needs. In its notice, the NDRC called for local
governments to limit new projects in a range of industries
facing overcapacity, including cement, aluminum, autos, and
textiles.

A Positive Signal
--------------


4. (SBU) In a research report Stephen Green of Standard
Chartered Bank in Shanghai suggested the PBOC is trying to
send a strong signal that the authorities are serious when
it comes to controlling overheating in the economy and
over-investment. Econoffs' contacts agree that the Chinese
Government is likely to follow up with further cooling
measures to drain liquidity out of the banking system such
as raising reserve requirements. Chris Murck, APCO Asia
CEO and Bank of Shanghai board member, doubted the interest
rate move would have much impact on the exchange rate. He
pointed out that ordinarily high interest rates boost
currencies, but the PBOC did not change bank deposit rates.
By raising lending rates while leaving deposit rates
untouched, the government will allow banks to widen their
profit margins, which will help cover losses on loan
defaults, according to Murck. He noted that low deposit
rates also encourage domestic demand, another government

BEIJING 00008109 002 OF 002


goal.


5. (SBU) Michael Ipson, the banking specialist at IFC's
Beijing office, saw the interest rate hike as a signal that
China is more committed to using market-based tools to
manage the economy, and believes interest rates could
increase further. He noted that banks continue to
underprice loans and this move will help encourage banks to
lend at more appropriate rates. In his view, if the
interest rate hike and PBOC jawboning fail to cool
excessive lending, the central government will take
additional measures, including an increase in reserve
requirements.

Administrative Controls?
--------------


6. (SBU) Professor of Economics Zhao Xijun of Renmin
University suggested the hike is too small to have much
impact on lending decisions. "The move is incremental at
most, and it did not work to slow investment last time when
the central bank raised interest rates back in 2004," Zhao
noted. He expects, however, regulators will shortly pass
instructions to managers of large state-owned banks to lend
less. Ipson of IFC believes the Government will only use
administrative controls as a last resort.

Comment
--------------


7. (SBU) Although the 27 basis point interest rate hike is
modest, it signals that China increasingly is willing to
allow markets play a greater role in shaping the economy,
although directives from the central government may still
play a prominent role. The adjustment also reflects a
greater sophistication of financial policymaking in line
with China?s new status as the world's fourth-largest
economy. In the past, Chinese officials have turned
instinctively to bureaucratic measures to restrain growth,
before utilizing market-oriented instruments such as
interest rates.

Sedney