China raises interest rates to cool overheating economy

China yesterday increased its interest rates for the first time in 18 months in an effort to rein in booming investment and credit growth that have the potential to destabilise what is now the world's fourth largest economy.

The unexpected increase in the People's Bank of China's one-year lending rate, to 5.85% from 5.58%, signals important changes in Beijing's policy priorities as it aims to support sustainable development of the economy against a background of strong growth, say economists.

The central bank said: "The increase in the lending rate is aimed at further strengthening the fruits of macro controls and keeping solid momentum for the economy to grow in a continuous, rapid, coordinated and healthy manner."

In the first quarter of this year Chinese economic growth accelerated to 10.2% on an annualised basis while fixed-asset investment growth rose to a hefty 27.7%, fuelled by plentiful inflows of money from the country's record trade surplus, which tripled last year to $102bn (£60bn).

With concerns over possible overheating, economists believe the rate rise, although small, could serve as a brake on investment and loans expansion.

Ben Simpfendorfer, a strategist at RBS in Hong Kong, said: "It's a positive step insofar as it should help take some of the steam out of investment demand. It also signals a proactive central bank."

World markets are concerned about the consequences of the rate increase on commodities and energy. Metal prices, which recently reached record highs on the back of surging Chinese demand, fell following the news. Zinc fell more than 6% at $3,150 a tonne. European share prices also weakened as mining stocks lost some of their lustre.

China's investment boom has been sucking in commodities including copper, steel and oil and any slowdown in investment caused by higher borrowing costs will remove one important support from global commodity prices, analysts said.

"This would be good news for commodity consumers in the west, but bad news for commodity producers that have benefited from the price boom," said Julian Jessop at Capital Economics.

But Jason Holland, from F&C asset management, said: "The issue is wider than this and with Japan withdrawing liquidity from the system and rates in major western markets continuing to head higher, volatility in markets will begin to rise."

China's growing trade surplus has been more than matched in recent years by a huge trade deficit in the United States, which has been a big buyer of Chinese imports. While the Chinese authorities have kept the yuan undervalued against the dollar, they have begun to let it appreciate. Economists are worried that the eventual unwinding of these trade imbalances, combined with a sharp fall in the dollar, could destabilise the world economy.

Bank of England governor Mervyn King warned yesterday: "It is very hard to disentangle the underlying trend from what is going on at the moment. But that is not to say that there is not ... a significant risk of a sharp adjustment in exchange rates.

"You can imagine cases where the sharp change in exchange rates could well lead to a fall-off in financial stability and start to lead to a disorderly adjustment which would be very costly and might involve recessions in some countries," he said.