Manas Chakravarty: Thank you, Governor Zhou Xiaochuan

The hike in China's lending rate is likely to be positive for the Indian economy

The central banks of two of the world's fastest-growing economies raised interest rates last week. While the Reserve Bank of India raised its repo rate by 25 basis points to 4.75 per cent, the first hike in four years, the People's Bank of China raised its one-year lending rate by 27 basis points to 5.58 per cent, the first tightening in nine years.

The People's Bank of China also removed the upper limit on the range in which commercial banks can adjust lending rates to price credit risk.

Previously, banks in China could only adjust the benchmark rate upward by 70 per cent, and removing the limit would mean that interest costs for second-rung companies could rise sharply.

The reaction to the Chinese central bank's move was instantaneous. Nymex crude oil futures, already under pressure from higher than expected US inventories, slipped almost $5 a barrel.

The reason "" the Chinese economy has overtaken Japan as the second-largest consumer of oil in the world, just behind the US.

The International Energy Agency estimates Chinese and Indian demand to grow 9,70,000 barrels a day (bpd) this year "" nearly 40 per cent of total world growth, China accounting for the lion's share with 8,40,000 bpd of incremental demand.

Commodity prices also slipped, on fears that China's voracious appetite for commodities would be affected.

On the other side of the world, growth in the US economy has, in the words of Alan Greenspan, entered a "soft patch". The data indicate that US growth is slowing, as the effect of the huge US fiscal and monetary stimuli wears off, and as the oil price spike begins to bite.

The latest figures show a higher than expected jump in initial weekly jobless claims. The upshot has been a downward revision of the US growth figures, with the most recent downgrades being done by investment banks J P Morgan and Morgan Stanley, who have cut their forecasts for world growth to reflect the stubbornly high price of oil.

Even oil exporters are worried, and the Organisation of Petroleum Exporting Countries (OPEC) has warned that high oil prices will slow world growth next year.

Growth slowdown?

With the Chinese authorities showing that they are determined to cool their economy and with the US economy decelerating, will we confront the nightmare of a synchronised slowdown in the two main global growth engines?

That's unlikely. If Chinese growth slows, that will have a dampening effect on oil prices, as well as on commodity prices. While that will hit commodity producers, it will impact consumers favourably as the price of fuel declines, inflation falls, and real incomes rise.

That could result in an improvement in US consumer confidence, and a resumption by the heroic American consumer of his traditional role as consumer of last resort.

At the same time, manufacturers will heave a sigh of relief, as lower raw material prices ease the pressure on their margins.

In other words, the Chinese central bank's determination to cool its economy is a blessing for the fuel-importing countries, although those economies with strong export links to China could lose.

Medicine for Governor Reddy

Back home, RBI Governor Y V Reddy should forthwith award a medal to his Chinese counterpart, People's Bank of China Governor Zhao Xiaochuan. Reddy's 25 basis point hike in the repo rate was unlikely to have much of an effect of inflation, since almost all of the rise in domestic prices was due to "imported" inflation.

As the RBI's mid-term monetary policy review points out so eloquently, the rise in inflation in recent months has been almost entirely due to four commodities "" crude oil, iron ore, steel, and coal.

Stripped of the effect of these four commodity groups, India's inflation would be a manageable 4.2 per cent, according to the RBI, a rise of a mere 40 basis points compared to inflation a year ago.

What's interesting is that it is precisely these four commodity groups that owe much of their price rise to exploding demand from China. If the Chinese economy cools, so will inflation in these commodities, which will pull down inflation across the board.

And although the initial lending rate hike may not do much, it is widely expected that this is the first of several such increases.

In short, it is Zhao's medicine that will cure Reddy's headache. Ironically, the Chinese central bank's monetary policy stance may be more effective in curbing Indian inflation than any measures that the Indian central bank can dream up.

No wonder the local bond market perked up initially on the news, betting that the RBI will not have to go in for any further rate increases.

The Chinese move is also good for the growth of the Indian economy. Finance Minister P Chidambaram had pointed out last Thursday that high oil prices would affect growth and lead to higher inflation, and that a rise in oil prices by every $5 a barrel cuts Indian GDP growth by 1.5 per cent.

That could lead to stagflation. If China is able to successfully engineer a managed slowdown, on the other hand, not only will Indian growth increase, but inflation too will be lower.

Good for corporate India

For corporate India, the Chinese central bank's actions should be very welcome. That's because the key defining feature of the second quarter results has been the twin hits from higher interest costs on the one hand and higher raw material costs on the other. Both these trends have eaten into corporate margins.

Moreover, although banks have been quick to state that lending rates will not go up, the fact of the matter is that interest costs for corporations have already gone up, as seen from the rates at which they have been raising money from the bond and money markets.

For instance, in mid-September, a corporate with the "highest safety" rating could raise money through a 90-day commercial paper at 4.90 per cent. By the end of September, that rate had gone up to 5.14 per cent. By mid-October, 90-day commercial paper for top-rated corporates could be offered at around 5.3 per cent.

On October 28, GE Capital placed three-month paper at 5.50 per cent. In short, within the space of a month and a half, the rate for three-month paper for top-rated companies had increased by around 60 basis points.

And although prime lending rates have not been increased, sub-PLR rates have risen in tandem with yields in the bond markets.

A rise in interest rates is all the more unwelcome for corporate India because of the expansion plans lined up. The capex cycle has turned, and high levels of capacity utilisation have resulted in companies firming up plans for expanding capacity.

That will mean more borrowing and higher interest costs. Corporate India, therefore, has a lot to gain if the pressure on both inflation and interest rates eases.

To be sure, the downside of a Chinese slowdown is that commodity producers will get hurt, ranging from crude oil producers such as ONGC to all those companies that export to China.

Steel and iron ore companies, for instance, will be hit. And it's not just exporters who will be hurt "" lower global commodity prices will also mean lower prices for all domestic commodity producers.

The International Monetary Fund (IMF) estimated that a 10-percentage point decline in the growth of China's imports triggered by a slowdown in investment would slow Asia's growth by 0.4 percentage points.

But for the Indian economy as a whole, which unlike some other Asian countries, is not so dependent on exports to China, lower commodity and oil prices will be unambiguously positive.

Moreover, even for commodity producers, the fact remains that the Chinese authorities are equally concerned that while growth should slow, there should be no hard landing.

Of course, the caveat is that China should be able to successfully manage that. The last time the benchmark lending rate was raised in July 1995, growth halved to 7.1 percent in 1999, from 12.8 percent in 1994.

A Chinese slowdown will also be good for the rupee, as lower oil prices boost the balance of payments. Moreover, it's probable that higher interest rates in China are a prelude to an eventual revaluation of the yuan.

That will remove the pressure on other Asian central banks to defend their currencies, allowing their currencies, too, to move up. That in turn, will bring down prices of imports even further, thus reducing costs.

Putting it simply, a Chinese slowdown, provided it doesn't get out of hand, will be positive for the Indian economy, which is not dependent to a great extent on exports to China, but is on the cusp of investment-led growth.