China's domestic interest rates will probably continue to rise in the near future as the central bank is sparing no effort to curb speculative purchases in the real estate sector and preempt the outflow of deposits from commercial banks.

"The central bank's interest rate rise is moderate, but it signals a significant change in interest rate policy," said Yi Xianrong, head of the Financial Development Division of the Chinese Academy of Social Sciences.

The People's Bank of China, the central bank, surprised the market on October 28 by increasing the benchmark one-year lending rate from 5.31 percent to 5.58 percent and lifting the one-year rate on bank deposits from 1.98 percent to 2.25 percent.

Although the latest interest rate rise will have only a minor impact on both borrowing and lending, according to analysts, the central bank's move indicates that the country's interest rates are now at a turning point, after nine years of falling, and are set to continuously rise over the next few years.

"Despite signs that China's economy is slowing down and domestic inflation has been effectively curbed, the central bank's decision to raise interest rates at this point of time was made for good reasons," said Yi.

The economy has slowed, growing 9.1 percent year-on-year in the third quarter, compared with 9.6 percent in the previous quarter. Inflation has also stabilized, edging downwards from 5.3 percent in August to 5.2 percent in September.

But when calculating the consumer price index (CPI), the central bank does not take into account the price rise of home purchases. The statistics are therefore biased towards showing an inflation figure less than actual inflation, especially when considering significant rises in house prices this year, said Yi.

House prices on the Chinese mainland rose 13 percent in the year's first nine months, fuelled by "speculative demands that will likely drive property prices to new highs in a short period of time," he added.

Yi said if the property bubble can not be deflated as soon as possible, price rises in the real estate sector will eventually spark higher prices in other related industries, including cement and steel.

But the interest rate rise will increase house buyers' costs, squeeze out speculative demands and cause house prices to fall in the long term.

"Although the potential demand in China's real estate sector remains high, considering the large population, the recent sharp increase in house prices is creating bubbles in the sector. Any bubbles will eventually either burst or be deflated," Yi said.

The central bank's interest rate rise will at least increase land developers' costs and rein in over-investment in this sector, according to Pan Shiyi, president of Soho China, one of the country's largest land development companies.

"But land developers with a low liability-to-asset ratio will still feel little impact from the interest rate rise," he added.

Interest rate increase, even if much higher in the near future, are unlikely to affect land developers' decisions to erect more buildings because the comparatively high returns in this sector will surely have little difficulty in attracting funds, according to Yi.

"But higher mortgage rates will work on the demand side," he said.

The central bank's move to raise interest rates was also a reflection of its worries that the actual deposit rate has declined below zero. Negative deposit rates, if they last for a long time, will cause outflows of bank deposits, said Li Huiyong, an analyst with Shenyin and Wanguo Securities Co.

Because of the virtually negative deposit rates, more that 200 billion yuan (US$24 billion) of funds have over the past nine months been channeled into other high-return investments, according to a recent speech by Wu Jinglian, a renowned Chinese economist.

If China's domestic inflation rate stabilizes at 3 percent, the central bank will probably raise deposit rates to 3.6 percent within a few years, Li predicted.

But most observers do not expect a total increase of more than 0.5 percent.

According to the central bank and analysts' reports, inflation has already leveled off and should fall to more sustainable levels by next year.

The central government is wary about raising rates too high over fears that large speculative inflows will increase pressure for a revaluation of the renminbi and there are strong voices within the leadership that feel tightening measures have already been too strong.

(China Business Weekly November 9, 2004)