China's threat to our recovery

A surprise interest-rate rise in China sends shockwaves around the world and could harm the UK's recovery...

Now that the global financial crisis has eased since the dark days of 2008, a series of ‘currency wars’ is threatening to break out across the world.

A race to the bottom?

Last month, the Japanese central bank intervened in the currency markets for the first time in six years. The Bank of Japan sold trillions of yen in an attempt to buy dollars in an effort to stop the Yen from a seeming unstoppable rise. Recently, the currency of the world’s third-largest economy has hit a series of 15-year highs against the US dollar.

Earlier this month, the finance ministers of the powerful G7 group of nations met to discuss ways to improve international co-operation and prevent a string of damaging currency devaluations. At the same time, the head of the International Monetary Fund, Dominique Strauss-Kahn, warned that currency clashes could ‘prove a real threat’ to the global economic recovery.

The US v China

As other countries try ‘competitive devaluation’ of their currencies in order to improve exports, China has the opposite problem. Whereas Japan is having a problem with the strength of its currency undermining its exports, the US has a big beef with the weakness of China’s currency, the Yuan (or renminbi).

China’s was one of the few major economies not to go into recession in the global slowdown of 2008/09. Its booming economy (which grew by 10.3% in the second quarter of this year) relies heavily on competitively priced exports. Hence, a weak Yuan gives Chinese exporters a huge competitive advantage, enabling them to flood with world with low-priced consumer goods.

However, the US authorities are unhappy with the low Yuan/dollar rate, claiming that it is holding back the US recovery. (European leaders have expressed similar concerns.) Hence, the U.S. House of Representatives last month passed a China Tariff Bill, which threatens to impose punishing duties on Chinese imports.

Rates up; Yuan down

Although this Bill isn’t likely to pass into law, it shows that the US is prepared to act to defend its recovering manufacturing sector. However, in this currency face-off, China has blinked first.

With effect from Wednesday, 20 October, the People’s Bank of China announced a 0.25% increase to its deposit and lending rates. China’s one-year deposit rate rose from 2.25% to 2.5% a year; its one-year lending rate crept up from 5.31% to 5.56%.

This surprise move -- the first Chinese rate rise since December 2007 -- sent a shockwave around the world, driving major stock markets down as much as 2% overnight.

Clearly, China’s rate hike shows that it is more worried about inflation (rising prices) getting out of hand than it is about the country’s vibrant economic recovery. As expected, this rate rise weakened the Yuan and strengthened the dollar, helping to appease China’s critics in the US.

What does this mean for the UK?

One piece of good news is that China’s rate rise caused commodity prices to fall, bringing down the cost of crude oil (which fell over 4% on this news), base and precious metals, and other key resources. Lower commodity prices lessen the threat of future inflation, which would help the Bank of England to keep its base rate low for longer.

As always, this is a flipside to this seemingly good news. By raising interest rates, China is trying to curb economic growth and prevent runaway inflation and rampant property speculation. Chinese inflation rose to 3.5% in August, 0.5% above the target level of 3% a year.

However, ‘Yuan’ rise is usually not enough, so others are likely follow as the rates cycle starts moving upwards again. Alas, a series of steep or steady rises in interest rates could choke off Chinese growth, causing a global slowdown. (One forecast is for up to three further rate hikes from China in 2011.)

In this scenario, falling growth within the world’s second-largest economy is sure to have a negative impact on our recovery here in the UK. If China applies the brakes hard, then the UK could head for if not a crash, then for a slowdown. Worst-hit could be importers facing higher prices for materials from China, especially manufacturers specialising in big-ticket items.

In addition, if China continues to raise rates in order to slow its economy, then risky assets -- such as shares and commodities -- could take a beating. In contrast, any ‘rush from risk’ would lead to even higher prices for perceived ‘safe havens’ such as UK, German and US government bonds.

In summary, China’s move to reduce its reliance on foreign exports could spell bad news for the UK, but only if it unsettles the fragile global recovery, leading to a ‘hard landing’ and lower world growth. However, if China’s currency is allowed to appreciate gradually, then this could benefit British exporters.

Who can say what the ultimate outcome will be? Watch this space...

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