Will we see the simultaneous rising of two rates?

 Cheming Yang

The People’s Bank of China has decided to raise RMB benchmark deposit and loan rates of financial institutions as of Dec. 26, 2010. The one-year benchmark deposit and loan rates are raised by 0.25 percentage points respectively.

Will we see the rise of the exchange rates for RMB and the rise of interest rates simultaneously in the near future? RMB has under constant pressure to appreciate in these two years. The appreciation of RMB is good for reducing the consumer prices but bad for export. The whole world including the Chinese community has been facing the pressure of inflation since the economic downturn a few years back. RMB appreciation appears to be a good move from this perspective. However, potential decrease in export will slow down the economic growth of China, which is likely to widen the income gap in China.

On the other hand, the rise of interest rates will curb inflation as well, especially in decreasing the bubbling of housing market in China. Nonetheless, the increase in interest rates will also deter the motivation to invest and in turn hurts the job market, which is caused by the slow down of economic growth. Clearly, these two measures have synergistic effects. Both can stabilize inflation but stamp growth.

The more horrible consequences of the two rises are the inflow of hot money. Hot money comes in anticipation of the appreciation of RMB. With the hike of interest rates at the same time, the exchange rate speculators find a perfect berth for their money. They are able to benefit both from the rises of exchange rates and interest rates. So what should the government do? In theory, if there is a perfect market, government will have no role in the rise and fall of these rates. However, the financial market is never a real free market. Even in the United States, the Federal Reserve will intervene. Therefore, how to build up a market that will reward investors but punish speculators is an important task for the government in policy making and in liberating the capital market.

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