When China Moves, Countries Tremble

The Peoples Bank Of China has finally given up on reserve ratios as their preferred monetary tool, and have raised interest rates by 25bp:

Asian Stocks Fall to Two-Week Low After China’s Rate Increase

Oct. 20 (Bloomberg) -- Asian stocks dropped, dragging the MSCI Asia Pacific Index to a two-week low, after China unexpectedly raised lending and deposit rates to curb inflation in the world’s fastest-growing major economy...

..."The perceived problem with China raising rates is it limits economic growth from one of the higher growth economies," said Tim Schroeders, who helps manage about $1 billion at Pengana Capital Ltd. in Melbourne. "Markets in Asia have adopted a very cautious approach to today’s trading in light of this news."

The MSCI Asia Pacific Index declined 0.8 percent to 128.79 as of 12:23 p.m. in Tokyo, heading for its lowest close since Oct. 12. The measure completed its seventh weekly advance last week, the longest winning streak since 2006, on speculation growth in corporate profits will weather Europe’s debt crisis, Chinese steps to curb property-price inflation and concern about the pace of the U.S. economic rebound...

...Asian equities fell today after China’s central bank raised one-year lending and deposit rates by 25 basis points, boosting borrowing costs for the first time since 2007. Policy makers are trying to curb lending and prevent an asset-price bubble in a country that surpassed Japan this year as the world’s second- largest economy even as growth in the U.S. and Europe slowed...

What gives? China had – virtually on its own – pulled the rest of Asia out of recession last year. Even with recovery well entrenched, it’s a toss-up whether the impetus from China’s growth will be less needed, especially with the slowdown in the US.

(Incidentally, this rate move illustrates one of the key principles in economics – expectations matter. In the ordinary course of things, a 25bp (1/4%) increase in interest rates shouldn’t have a big effect. But the rate increase says a lot about the future path of monetary policy – investors are now expecting interest rates to continue to climb over the near term.)

China’s influence over Malaysia’s economy is pretty strong, and getting stronger. They’re a bigger direct trade partner with Malaysia (15% of total trade) than the US is (12%), and about on par with Singapore (also about 15%).

The structural shift in Malaysian export pattern – more commodities, less manufactures – has primarily been driven by China’s import demand, and so are global commodity prices. The IMF calculated a few years back that a 10% drop in China’s import demand would lower growth in South East Asia by 0.5%. I suspect the effect would be even stronger now.

Downside risks to growth have just risen.