Chinese Interest Rate Hike Complicates Currency War

      October 21, 2010 10:39

      China hiked its key interest rate by a quarter percentage point on Tuesday for the first time in almost three years, prompting analysts to speculate that Beijing is launching a preemptive strike in a currency war with Washington ahead of the G20 Summit in Seoul next month.

      The Wall Street Journal on Wednesday reported China does not usually pursue two different policies at the same time and forecast that Chinese officials will moderate the pace of the yuan's rise now they have raised the key interest rate. The yuan fell against the dollar late Wednesday "after Beijing signaled its intention to fend off speculative capital inflows by guiding its currency sharply lower following a surprise interest rate hike," it said.

      China ostensibly raised the key interest rate to tame a steep rise in real estate prices and control inflation, but the move apparently could have been aimed at easing U.S. pressure to strengthen the yuan. CNBC said the rate hike could have been prompted by "political considerations" ahead of the G20 Summit.

      Some experts say China may have expected fierce pressure from the U.S. and EU to strengthen the yuan during the upcoming meeting of G20 finance ministers and central bank governors in Gyeongju on Friday and Saturday and the G20 Summit in Seoul on Nov. 11-12. Higher interest rates are expected to drive foreign capital to the country in search of profit and cause the yuan to strengthen.

      But others disagree. "The rate hike could be seen as a protest by China against pressure to strengthen its currency by demonstrating that a shrinking Chinese economy would make a global economic recovery impossible," said Prof. Kim Jung-sik of Yonsei University. In other words, China's decision should not be seen as a conciliatory gesture but rather as a warning against the U.S. that a cooling Chinese economy would cause the global economy to enter a slump.

      The widely expected conflict between the U.S. and China during the G20 meetings has been presented with a new variable that could complicate the situation.

      The Korean government, which is hosting the G20 Summit, is preparing an independent compromise. But this task faces tough obstacles. "We are considering a proposal to let individual countries adjust their own exchange rates," said one Korean government official. G20 member countries will apparently be presented with a proposal to allow their own currencies to strengthen or weaken to keep their current account surpluses within 4 percent of GDP.

      There are also hopes that China may announce additional measures ahead of the G20 meetings. One financial industry insider in Beijing said, "Although the situation has calmed down, the U.S. could pressure China one more time ahead of the G20 Summit to strengthen its currency. And in response, China could implement measures to expand the fluctuation band of the yuan."

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