China's 2004 Interest Rate Rise and US Economic Impact

Introduction: China's First Rate Hike in Nine Years

China announced on October 28, 2004 its first interest rate rise in nine years. In doing so, Beijing signaled its willingness to adopt additional market-oriented reforms in order to achieve tighter macroeconomic control over an already overheating economy. Although reports on the evolution of Chinese interest rate policy were at times contradictory, North American economists broadly welcomed the increase.

The Chinese economy was rapidly becoming one of the most important in the world, with an annual growth rate of approximately 8 percent, sustained expansion over the preceding years, and a twenty-year history of economic reforms. The global economy — and especially neighboring economies such as Taiwan and Hong Kong — was feeling the pressure of China's economic momentum. Since April 2004, investors had publicly expressed fears that the economy would overheat, and they were now expecting government austerity measures to slow growth and provide a more sustainable pace. Chinese-related share prices had been seriously affected by fears provoked by rising oil prices and persistently low interest rates.

Early Warnings of an Overheating Economy

According to an article published in April 2004 by the Financial Times, Beijing had been preparing a series of measures to cool its booming economy. These measures included a rise in interest rates, as confirmed by declarations from senior officials.

At the time, Wang Mengkui, Director of the Development Research Center of the State Council (the Chinese cabinet), stated that China was suffering from increasing inflation and an exacerbated investment policy, and that it would probably register a trade deficit by the end of the year. He said: "If there is a need, there is a possibility to raise the lending rates, especially those rates on mid- and long-term loans. The adjustment of interest rates would have a relatively good impact on inflation."

Beijing was also becoming slightly less opposed to raising interest rates — an action that had last been taken in 1995. According to the Financial Times reporter, "Mr. Wang expected price rises, as measured by the CPI, to reach 5 per cent for the full year, higher than the official prediction of 3 per cent. Inflation was being caused mainly by rising raw material and energy prices, but many manufactured goods remained in oversupply, meaning inflation would 'not become a big problem.'"^[1]

Wang Mengkui also addressed the situation of raw materials, particularly those used in infrastructure and construction projects. He suggested that inflationary pressure on such materials would be reduced as a result of increased government efforts to moderate investment.

Regarding the renminbi — China's official currency — revaluation pressures were abating, partly as a result of domestic inflation and partly as a consequence of China's three consecutive months of trade deficits (as of April 2004). Currency reserves were also a concern. Wang said: "China has got foreign currency reserves of over $400bn and, in fact, we can't use that much. A [trade] deficit is not something to be afraid of. If our reserves fall, it will not be a serious problem."

Falling Chinese reserves had some impact on the US economy, though not a severe one — notwithstanding the fact that Beijing had used its reserves to acquire US Treasury securities, which helped keep US interest rates low. The Chinese government's broader intention was to avoid drastic measures to cool the economy, and instead to take smaller, targeted steps aimed at limiting investment in overheated sectors.

US and Global Reactions to the Rate Increase

Over-invested sectors such as steel, aluminum, cement, automotive, and property had already experienced significant changes. Authorities decided to intervene and prevent these over-solicited areas of industry from burning out. Chinese officials also considered other techniques, such as ending preferential policies intended to spur exports of commodities like coal, or altering the criteria by which local government officials' careers were evaluated, so as to reduce the weight given to economic growth figures.

John B. Taylor, Under-Secretary for International Affairs at the US Department of the Treasury, viewed the Chinese interest rate rise as a proactive step that reduced the risks of excessive investment and would benefit the American economy. Taylor not only approved of but actively praised the measure taken by the Chinese government for its role in controlling inflation and maintaining sustainable economic development. He described it as one step closer to a more flexible exchange rate system and expressed his belief that China was becoming more market-oriented and that the renminbi was being gradually pushed toward free floating.

Regarding the US economy specifically, Taylor argued that American exports of key commodities to China would increase as a result of these measures, stating: "Only with the sustainable growth of the Chinese economy will there be an export increase for us." Indeed, the United States appeared to be working toward reducing its trade deficit with China, with exports to the Asian country up 34 percent that year. The increase in Chinese imports from the United States ranked third among US export markets, behind only Canada and Mexico.

Stephen Roach, Chief Economist at Morgan Stanley, offered a more cautious view, arguing that the Chinese interest rate rise would slow not only the Chinese economy but also global economic growth, which was already advancing at a reduced pace. He noted that countries heavily dependent on China would be the hardest hit, pointing specifically to South Korea, Japan, and Germany. More than 40 percent of export growth from South Korea and Japan came from China, and Germany derived approximately 28 percent of its export growth from the same source.

Despite ongoing concerns about inflationary pressures, the Beijing interest rate rise was seen by the government as insufficient on its own. Administrative measures were therefore sustained by interventionist steps, such as tightening credit and limiting land supplies available to real estate developers. The Chinese interest rate was expected to rise by a further 2 to 3 percentage points within a year to a year and a half.

Conclusion

At least in the short term, maintaining the fixed exchange rate proved beneficial to the Chinese economy, as the dollar's depreciation helped boost China's export activity. However, in the long term, this artificially maintained exchange rate carried the risk of systemic breakdown — a prospect that would be genuinely difficult to manage, especially as China continued to establish itself as one of the most powerful economies in the world.