China's interest rate hike last week is a reflection of mounting inflationary pressure. Figures to be released later this week are expected to show that consumer prices on the mainland in March rose by more than 5 percent compared with last year as measured by the benchmark Consumer Price Index.

The People's Bank of China (PBoC) announced last week an increase of 25 basis points (bps) in both the 1-year lending and deposit rates, taking them up to 6.31 percent and 3.25 percent respectively. It was the second interest rate rise since early February.

The PBoC also raised the rates for all other deposits and loans. It is noteworthy that the demand deposit rate was raised by 0.1 percent while the one to three-year lending rate was raised by 0.3 percent, indicating that the latest policy move should have a limited impact on banks' interest margins.

However, I expect the CPI to have rebounded to more than 5 percent in March due to a relatively higher comparison base and consecutive month-on-month price increases in the first two months of the year.

Besides, the long-term lending rate was also raised by another 20 bps after being raised three times in recent months, indicating further tightening of the property market by the authorities. The cumulative effect of tightening policies as well as the signal that it sends should have a marked negative impact on the property market. The lending rate hike underscores the government's commitment to rein in soaring property prices in some cities. The central government will likely maintain a tight policy stance over property market until at least the end of the year.

The ongoing rise in base interest rates and reserve requirements ratio (RRR) illustrates the relative tightening of monetary policy, at least for the first nine months of 2011 when the inflation figure is expected to remain higher than the official target.

As the CPI might hit a new high around July, the PBoC may raise its base rates again before the end of the third quarter, with the one-year lending and deposit rate reaching about 6.81 percent and 3.75 percent, respectively, by end-2011. Meanwhile, the banking system will probably still face huge liquidity pressure in April due to the incremental foreign exchange reserve and mature central bank bills.

Thus I cannot rule out the possibility of further RRR hikes in the next few months. The rising rate hike trend also indicates the government's firm determination to push forward the transition of the economic development model, as the hikes will exert more pressure on the country to become more flexible in terms of the yuan exchange rate going forward.

In terms of its effects on the property sector, although the hike for five-year mortgage loans was smaller than that for the benchmark rates, the cancellation of the preferential lending rate and the pressure caused by the cumulative effect of the hikes will gradually become more noticeable. Taking the 1.1x lending rate as an example, the current round of rate hikes has caused a cumulative increase of 7.6 percent in the average monthly payment amount. The discount for the rate on second homes was raised from 0.85x to 1.1x, translating to an actual increase of 21.4 percent.

For property developers, given the role of interest capitalization, the effect of the benchmark rate adjustments is not a major issue. Its effect on whether they can secure loans is, however, much more significant. The liquidity squeeze has raised capital costs at the social level, and the interest rates of trusts and other social funds are on a clear uptrend. This will put pressure on developers' margins and affect their ability to expand.

On the other hand, I believe the effect of the latest rate hike will be mildly positive for the banking sector compared to the three previous hikes due to three major reasons. First of all, the interest rate for demand deposits was hiked by 10bps, while among the previous three hikes, only the one in February entailed a demand deposit rate hike of 4bps.

Secondly, all term loan rate hikes amounted to roughly 25bps and long-term loan rates were not adjusted excessively. Thirdly, the upward adjustment of time deposit (more than one-year) rates was milder than in the three previous hikes and mirrored the benchmark rate movements, but this was insufficient to fully offset the negative impact of the demand deposit rate hike due to the smaller proportion of these types of deposits.

The author is executive director of BOCI Research Limited (www.bocigroup.com). The opinions expressed here are entirely his own and do not represent BOCI or any other affiliated companies within the group. Nothing in this article constitutes an investment recommendation.

(HK Edition 04/14/2011 page2)