Shanghai Daily news

My first reaction to the interest rate hike last week was "anyway, it went up."
Many other economists greeted the news with the statement: "At last, the rate increased." Despite the subtle difference between our attitudes, it is understandable that we expected such a rise. The People's Bank of China, the country's central bank, raised the saving and lending rates last Friday, the first rise in nine years.
Major economic indicators had pointed to an interest rate hike. If we looked at the consumer price index in the past few months, a decrease in bank savings due to a negative interest rate, the inflationary pressure brought by growing foreign exchange reserves, and an interest rate hike in the United States, it's obvious it was time for the central bank to adjust interest rates upward.
In this sense, the market was well prepared. But the way the government announced the rate increase was somewhat shocking, like a lightening bolt. People knew there would be a rate increase, but they did not expect it to come so suddenly.
Market reactions last Friday varied. Not all took it so well.
In my view, the slight rate increase this time is a signal. And the government should make a series of policies to buttress the signal, although the market will probably react drastically. The government should increase policy transparency to avert undesirable fluctuations in the economy.
I base my judgment and suggestion on the following considerations.
First, what message does the central bank want to give the market?
In fact, two factors - external and internal - contributed to the interest rate hike.
First of all, demand for the renminbi surged because of an increase in net capital flow under both current and capital accounts. A rapid increase in foreign exchange reserves under a fixed exchange rate regime has made it difficult for the central bank to adjust money supply. It is therefore necessary to tighten domestic credit to prevent growing purchases of foreign currencies, which results in serious inflation.
Let's see whether the market will achieve a consensus on the ramifications of the signal - that the central bank won't easily adjust the exchange rate regime in dealing with growing external pressure.
On the other hand, the market is watching whether the interest rate hike is sustainable. If speculators will make greater profits in interest or currency arbitrages, the central bank may well further tighten monetary policy, which in turn will affect the capital market and the overall economy.
Of course, some people say the central bank may adjust the exchange rate in a similarly sudden way, now that it is clear that the market has taken the interest rate hike with ease. Indeed, a sudden adjustment of the exchange rate may prove an effective way for the central bank to bust speculation.
Secondly, in addition to the external pressure from foreign exchange reserves, an outflow of capital from commercial banks might also have prompted the central bank to take action.
Bank deposits had been declining because of negative real interest rates that eat into people's purchasing power. As a result, a lot of capital has flown into abnormal financing markets. This fact rendered previous credit tightening policies somewhat ineffective.
The interest rate increase demonstrates the central bank's support of commercial banks and their effort to recover the lost field. The rate increase may affect the capital market negatively, but it again proves the dominant position of a financial system centered around banks.
In determining whether the interest rates will continue to rise, one important yardstick would be how the country balances the development of banks and the capital market.
Now my second consideration: the impact of the rate hike on commercial banking reforms.
It is good news for the banking sector. The modified interest rate enlarges the gap between the deposit and lending rates and hence helps banks increase income.
However, market analysts worry the increase in income may provide less incentive for reform. They are especially worried that by 2007, there might be the risk of a run on banks when the country completely opens its banking sector to foreign competition.
By contrast, some other analysts believe the rate increase has laid the foundation for an interest rate regime completely based on market forces. According to these analysts, the commercial banks will accelerate their reform if they realize the rate increase last Friday was the last good chance they got from the central bank.
Finally, what does the interest rate hike mean to the global market?
China's economic prosperity has benefited much of the rest of the world. People in foreign markets naturally wonder whether investment in China will slow down as a result of the rate hike. Slower investment momentum will necessarily affect the amount of energy and raw materials China imports.
If such worries are felt in the international energy market, some speculators may adjust expectations and help reduce global energy prices, which is in fact conducive to the healthy development of the world economy.
If the central bank wants to control inflation associated with foreign exchange reserves, a further increase of 100 basis points can be expected, provided that an easier capital outflow works. If it doesn't work, a sudden change of the exchange rate regime is possible.
If it focuses on an outflow of capital from banks, it will, along with the China Banking Regulatory Commission, accelerate the pace at which commercial banks restructure or go public. Underground financing markets will be further regulated. I believe interest rates are unlikely to continue to rise for this purpose.
The central bank is waiting to see how the market reacts. I hope the central bank will guarantee the continuity of policies in the future.

(The author is professor of economics at the China Center for Economic Studies, Fudan University)