Wednesday, October 20, 2010

Be Careful What You Wish For: China Raises Interest Rates

For the last few weeks, Congress has been quite vocal about its demands that China allow the value of the yuan to appreciate versus the dollar. So yesterday The Bank of China announced a very small increase in internal interest rates, which presumably would have added at least some value to holding yuan versus the dollar.

So what happens?. Well, in the vein of pure Newtonian physics, for every action there is a reaction, and the markets reacted badly across the world. To name a few effects:
  1. Stock markets get slammed across the world, with the U.S. market falling 1.5%;
  2. Oil drops by 4%, or the largest decline in 8 months;
  3. Gold falls by 2.6%;
  4. Brazil announces its second tax on foreign investment in an effort to try to reduce the appreciation of its currency;
  5. Japan and Canada, among other nations, express concerns about the currency markets. The Japanese central bank again publicly worries about the strength of the yen.
I could go on, but you get the idea. Markets are never as simple to manipulate as public leaders would like us to believe. Moreover, as nations across the world compete to see who can depreciate their currencies faster to help spur domestic economic growth, the eventual effects may not be what people want.

One of the most interesting points about yesterday's move in China was the fact that only recently Chinese officials had said that they did not see the need to change interest rate policy. In my opinion, the Chinese continue to want to send the message that they do not have to follow the lead of any other countries in determining domestic economic policies (especially the U.S.).

Here's an excerpt from today's Wall Street Journal:

Investors were split on the impact China's move will have on currency diplomacy. Tensions have been building as a result of the money flooding into emerging markets, driving up the currencies of countries such as Brazil and South Korea against the dollar.

Because China effectively pegs the yuan to the dollar, exporters in those countries have been losing competitiveness against China, their chief rival in the global markets. In response, many governments have been pushing back against the tide of money boosting their currencies.

Those issues were front and center Tuesday.

Brazil raised the tax on foreign investment in Brazilian bonds. And in Seoul, the South Korean finance minister said the government was considering reinstating a withholding tax on foreign investors' holdings in some Korean securities.

China Raises Interest Rates -