Rumor of another rise in Chinese interest rates

My favorite source for all things geopolitical, Stratfor, is reporting this morning that their sources in China are saying that the government there is going to raise interest rates again in December.  Recall the churning caused in global financial markets when the Chinese announced an interest rate increase October 18 of the year.  Several weeks ago when the rates went up I spent some time discussing the reasons for the increase.  I also said that I thought, net, the Chinese moves would be good for the worldwide economy.

Why would the Chinese want to raise rates even further?

1.  Primarily, the Chinese are trying to switch their economy from a purely export-driven economy to a more consumption-based economy.  Never mind the environmental impact of this, because the ramifications are scary to contemplate, why would the Chinese want to do this?  See below.

2.  The Chinese want to cool off the massive inflationary heat that is developing in their economy.

3.  The Chinese want to create an environment in which they can safely allow their currency to appreciate in value.

Currently, the interest rates in China actually provide a negative return to savers/lenders if you take into account inflation.  That is, real interest rates are negative.  [real interest rate = interest rate paid to lender – inflation rate].  When you save money you agree to have it sit idle and in return you receive interest to induce you to do so.  But if inflation is greater than the rate you make by keeping your money idle then you are actually losing money.  Inflation erodes the value of your money.  Does this make sense?

Rates are held at these crazy low (i.e. negative) levels to induce Chinese industry to borrow to fund massive growth projects.  Effectively, because of the negative quality of real interest rates, the Chinese government is paying businesses to borrow money.  Crazy!  But you see projects take people to complete.  So effectively the negative real interest rate policy of the Chinese government is a full employment act.  The social contract between the Chinese government and its people is that in exchange for promising you a job and income to support yourself and your family, the Chinese communists get to remain the sole, oppressive and suppressive, power in China.

So why would anyone save any money in China?  The answer is that they don’t really.  Instead, citizens are placing their excess income in places like the real estate market.  Needless to say, the Chinese government is starting to get very concerned about a potential real estate and economic bubble being created there.  Does this sound familiar?  Low interest rates induce excess borrowing which leads to inflated real estate prices.  Hmmm.  But the Chinese, unlike western economies and policy makers, is raising interest rates to cool the inflationary fires.

Higher interest rates creates an incentive for citizens to hold on to their money in the form of savings, rather than investing it.  It is hoped those Yuan that are saved are then eventually spent on some form of consumption.  Frankly, this is a long shot.  Consumption takes more than just technical measures to induce, it is much more about creating a culture where people buy stuff they don’t need.  Think Gucci, think Mercedes, think custom golf clubs, think junior high school, think stupid!  But I do acknowledge that many Chinese are doing their best to ape the uglier aspects of Western consumer culture.  My point though, is that it will take a long time to shift the preferences of the more than 1 billion Chinese from communist thinking to capitalist thinking.

Higher interest rates lead to currency appreciation pressures because investors worldwide look at interest rates when they consider investing their deposits.  Those who are inclined to save money look for the highest real interest rates they can find.  But they also look at the strength of the economy that is paying those rates to make sure that risks are acceptable.  That is, the stronger the economy, the more likely it is that borrowers can pay their interest rates obligations.  This creates a demand for the currency of the higher real interest rate economy relative to the prospective lender’s home currency.  So it boils down to supply and demand.  Higher interest rates creates a demand for the currency, and with a fixed supply of the currency, prices rise.  Does that make sense?

All of this is interesting, but the BIG news of the day is that the Chinese are interested in continually raising interest rates throughout the next several months.  I consider this to be a good thing.  It would be nice if the Chinese economic bubble did not burst, but the hot air was let out slowly.  It would also be nice to see the Chinese economy run more for efficiency than full employment.  And, as a citizen of the U.S., it would be nice to see the yuan appreciate in value.

Jason