What Does China's Interest Rate Rise Mean?

By Derek Thompson

China announced that it is increasing interest rates for the first time in three years, likely out of fear of inflationary pressure, especially in the housing market . The New York Times has some good background on how analysts are interpreting a move which is already "roiling" markets, hurting oil prices and strengthening the dollar.

Some analysts said the rate increase also suggested a deal was in place between China and the United States to strengthen the yuan and put an end to worries about a currency war of competitive devaluations ahead of upcoming Group of 20 meetings.

But others said just the opposite was the case -- with higher rates, Beijing can afford to rely less on currency appreciation to keep the economy on an even keel...

Higher rates make yuan-denominated assets more attractive and could in theory place upward pressure on the Chinese currency. Until a fall on Monday, the closely managed currency had risen 2.5 percent against the dollar since the end of August, its quickest pace of appreciation since a 2005 revaluation.

And Krugman explains why there's a difference between the United States' strategy of expansionary monetary policy (which weakens the dollar slightly) and China's strategy of weakening the RMB (which forces the government to pursue a contractionary monetary policy).

The United States is pursuing an expansionary domestic monetary policy, which increases overall world demand; however, a side consequence of this policy is a weaker dollar. China is pursuing a weak-yuan policy; to counter the inflationary domestic effects of that policy, it's pursuing a contractionary domestic monetary policy, reducing overall world demand.

This article available online at:

http://www.theatlantic.com/business/archive/2010/10/what-does-chinas-interest-rate-rise-mean/64809/