International Herald Tribune
SHANGHAI (Reuters) — Signaling a growing divergence between the U.S. and Chinese economies, a key dollar interest rate has dropped below its Chinese counterpart for the first time since the yuan's peg to the dollar was abolished in July 2005.
The vanishing of the longstanding spread between U.S. and Chinese interest rates shows how monetary policies in the two countries are headed in opposite directions, and complicates China's effort to curb a huge inflow of speculative money, analysts said.
Some predicted Chinese rates would rise a percentage point or more above U.S. rates in coming months, as the U.S. Federal Reserve eased monetary policy further because of the subprime mortgage crisis and China tightened policy to fight inflation.
"Only a year ago, the markets could not imagine today's situation. But the disappearance of the spread became inevitable. China is heating up and the U.S. may be entering a downturn," said Shi Lei at Bank of China.
The one-year U.S. dollar London Interbank Offered Rate , a benchmark used by many firms, tumbled to 4.04188 percent late on Thursday from 4.18750 percent a day earlier.
That brought it below the one-year Chinese central bank bill yield, which was flat at 4.0950 percent bid, near a multi-year high of 4.11 percent hit in November.
The gap is closely watched by financial markets since China has traditionally kept its rates well below U.S. rates, to limit pressure for appreciation of the yuan and deter inflows of "hot" foreign money that could destabilize its asset markets.
The U.S. one-year rate stayed roughly three percentage points above the Chinese rate long after the currency peg was scrapped, and was at two percentage points as recently as July last year.
Shi at Bank of China estimated that following Thursday's cross-over, the one-year Chinese yield could stand 1.5 percentage points over the U.S. rate in the middle of this year.
Analysts said the disappearance of the dollar's interest rate premium would not cause a sudden flow of fresh funds into China, since flows also depended on factors such as Chinese capital controls and the health of the stock and real estate markets, which have cooled somewhat in the past two months.
But the Chinese central bank's willingness to allow the rate spread to vanish indicates how radically its priorities have changed over the past few months, the analysts said.
In the first two years after the currency peg was abolished, Chinese monetary policy revolved around U.S. interest rates as the central bank sought to keep appreciation of the yuan against the dollar at a slow, even pace.
But as Chinese consumer price inflation soared in the second half of last year, hitting an 11-year high of 6.9 percent in November, the central bank largely abandoned the attempt to keep yuan interest rates below dollar rates.
Instead, it made fighting inflation the priority, tightening monetary policy faster and accelerating appreciation of the yuan, which is up 2.6 percent against the dollar over the past two months after a 4.6 percent rise in the previous 10 months.
"The central bank considered the psychological impact that losing the spread with the U.S. would have on the market. But it concluded it had no choice," said Xu Jian, an analyst at China International Capital.
This week's rise of global oil prices to a record $100 a barrel may have been the final nail in the coffin of the dollar's interest rate premium. The Chinese central bank has said it is determined to prevent higher oil prices from transforming China's food-based inflation into broader inflation.
Poor data means calculating the exact size of hot money flows into China is impossible, but some analysts estimate such flows totaled about $100 billion last year, a rise from 2006.
The widening spread of Chinese interest rates over U.S. rates could worsen the problem, not only by making it more attractive to keep foreign money in China, but also by making it even less attractive for Chinese to put money overseas.
But that may be offset to some extent by slower growth in China's trade surplus this year if the U.S. economy slows.
The authorities may also cope with the changed U.S.-China interest rate outlook by further tightening enforcement of capital controls such as curbs on foreign currency borrowing and conversion of export earnings, and by draining funds more aggressively from the money market, traders said.
______