China moves in right direction

LAST week's decision by the People's Bank of China to raise interest rates for the first time in nine years shook the world's financial markets, sending energy and metal prices and even US bonds into a tailspin.

It is proof, if any is needed, of the massive economic power that China now exerts over the rest of us.

When did the deliberations of our own Monetary Policy Committee ever have such a dramatic impact on the world stage?

On the face of it, there should not have been too much to be frightened about. Economists had been expecting a rate rise for some time in an attempt to curb China's relatively strong inflation which has been running at more than 5%.

And the PBOC hardly turned the screw too viciously. The rate rose just over one-quarter of a percentage point to 5.58%. Britain seems to cope with a quarter-point here or there without too much of a wobble.

Even so, the world shivered since China has been the economic engine pulling us all along for some time. The main worries are that this rate rise is the first of a series.

Many of China's businesses have been borrowing heavily to finance expansion. Higher lending rates depress profits and may force firms to cut back future investment.

That was why oil and metal prices took such a dive on the back of it.

China has become a huge and growing importer of raw materials in the past decade as it has developed into the workshop of the world.

A rise in rates that could temper the growth of its manufacturers would also stifle demand for those raw materials.

The financial markets are also worried that the rate rise will be followed by a revaluation of the yuan, the Chinese currency.

This would mean in turn that the PBOC would not need to buy so many US government bonds, which could push US interest rates higher. Since the US is such a heavy borrower at present it needs all the takers possible for its Treasury debt. A revaluation in the short term is unlikely, however. But, as this moves shows, the PBOC is master of its own timing.

Putting these concerns to one side, it can be argued that the Chinese government is moving in the right direction.

The PBOC is adopting market policies to manage its economy - which has to be a good thing.

If interest rates had not risen, borrowing and inflation in China could have risen to worrying levels.

In the China of old, the authorities would have simply clamped down on credit by stopping firms borrowing.

Increasing the price of borrowing is a far more market-friendly way of managing an economy.

Just as important as the rise in base rates was the PBOC's decision to lift the ceiling on the interest rates that China's commercial banks can charge on loans.

This gives them far more freedom to set sensible rates on loans and to discourage binge borrowing that could prove ruinous.

This will encourage China's fast-growing companies to be more efficient and to invest more wisely than if they knew they had endless access to cheap cash. So the world's financial markets should probably have taken this move rather more calmly than they did.

In many ways it is good news and shows that the Chinese are managing their economy in a way that should help to avoid boom and bust.

This rate rise looks set to be followed by a few more discrete hikes with the overall impact muted once financial markets come to appreciate the reasons behind them.

Investors interested in entering the dragon should look to companies with strong cash flow and low debt levels, working with profitability in mind, so as to not be caught out again by the PBOC's timing decisions.

Hugh Young is managing director of Aberdeen Asset Management Asia.