UPDATE 3-China raises rates, shrugs off slowing growth

Wed Jul 6, 2011 9:13am EDT

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(Edits)

* China raises interest rates by 25 basis points

* Third rate rise this year

* Intention may be to pre-empt rise in inflation data

* Analysts reckon inflation fight is nearing end

By Kevin Yao and Aileen Wang

BEIJING, July 6 (Reuters) - China raised interest rates for the third time this year on Wednesday, making clear that taming inflation remains a top priority even as the growth pace of its vast economy gently eases.

The 25-basis-point increase in lending and deposit rates underscored China's quiet confidence that the world's second-biggest economy is resilient enough to endure tighter monetary policy and is not threatened by the hard landing that some investors fear.

Analysts suggested China was close to, or even at the end, of a cycle of rate rises and the latest move was a pre-emptive strike before another big jump in inflation in data next week heightens depositors' worries about low yields.

"Today's rate hike suggests that China's June inflation could be higher than expected and the second-quarter GDP remains solid, consistent with our expectation," said Ligang Liu, head of Greater China economics at ANZ in Hong Kong.

"The rate hike will help the PBOC to fine-tune its monetary policy by alleviating the worsening negative real interest rate problem so as to prevent an outflow of deposits from the banking system."

The latest move increases China's benchmark one-year lending rate to 6.56 percent, and its benchmark one-year deposit rate to 3.5 percent, the central bank said.

The increases will take effect from Thursday, the central bank said in a short statement on its website.

Risky assets, particularly those with direct links to China's growth such as the Aussie dollar , sold off after the announcement, reacting to concerns this latest monetary tightening will choke an already sluggish global economy.

China-watchers couldn't agree on whether there will be more rate rises in the second half of the year. The People's Bank of China (PBOC) has raised banks' reserve requirements nine times in addition to these rate rises in its nine-month cycle of tightening monetary conditions.

"China's inflation battle is almost at an end. Already, there are signs that price pressures are coming off," said Frederic Neumann, an economist at HSBC in Hong Kong. "Today's rate hike may therefore have been the last in the cycle,"

GROWTH VERSUS INFLATION

Hopes that the PBOC may be near a pause in tightening was seen as a positive for stocks and could halt the rise in yuan onshore swap rates. Such expectations have helped the Shanghai Composite index bounce from nine-month lows hit in June.

The world's second-biggest economy expanded more than 10 percent last year but has cooled in 2011. First-quarter growth was 9.7 percent and data next week is expected to show the pace eased to 9.4 percent in the second quarter.

Evidence is growing that China's vast manufacturing sector is losing momentum, due both to tighter policy at home and slowing demand overseas.

A survey of purchasing managers showed the factory sector expanded at its weakest pace in 28 months in June, mainly owing to a drop in new orders. Many analysts reckon the pace is in keeping with an economy expanding on average at around 9 percent and industrial growth of around 13 percent.

Moreover, a double-digit increase in wages is expected to feed into already strong domestic demand.

With U.S. interest rates near zero, Beijing worries it might attract more speculative funds into China if it raises rates too far. That would exacerbate the problem of excess liquidity and further fuel inflation.

Equally, it has to placate depositors struggling with a negative real rate of return on their cash in banks.

China's inflation quickened to a 34-month high of 5.5 percent in May as elevated food prices and a red-hot property market kept price pressures alive.

A Reuters poll forecast data due on July 15 will show that inflation in June rose to 6.3 percent -- its highest reading since mid-2008. Many economists estimate inflation will peak in June or July.

Beijing is especially sensitive to rising prices that might stir social unrest and threaten its leadership.

Wang Jun, an economist at CCIEE, a government think tank, said Beijing may feel compelled to raise rates again if inflation, proves more stubborn than expected.

"If inflation comes down, there will be no need to raise rates. But if prices rebound, there could be further rate rises," he said. (Writing by Koh Gui Qing and Vidya Ranganathan; Editing by Ruth Pitchford and Neil Fullick)

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