The interest rate cycle in China is an important instrument for investors as it points to where the world's second-largest economy is heading.

With the country's consumer price index hitting 5.1 percent in November - the highest level since August 2008 - many market participants are predicting that monetary tightening measures are looming, which may suggest lower growth in the year to come. But will aggressive rate hikes appear soon? We doubt it.

The benchmark policy rate is expected to move up but at a more gradual pace since inflationary pressure is not as severe as the headline price index indicates, and there are still some concerns about growth sustainability that policy makers must heed.

The surge in inflation is mainly attributable to a 11.7 percent sharp rise in food prices. In sharp contrast, inflation for non-food items averaged only 1.9 percent, which is relatively tame under the emerging market standard. Moreover, monetary policy - ie raising interest rates - is not an effective way of easing inflationary pressure, as the current inflationary pressure is caused by supply shortage and speculative activity, rather than by overheating demand.

It is a repeat of 2008 when we saw headline inflation hitting nearly 9 percent, driven by unabated food price rises. At that time, officials might have mistakenly thought that raising interest rates could curb inflation. But the reality was that raising borrowing costs would not help ease the problems caused by a temporary decline in food production and bottlenecks in the supply chain. And the situation could only worsen after the outbreak of the global financial crisis. Therefore, after that painful lesson, I believe further administrative price caps are more likely to be adopted to control food prices than monetary tightening moves. Together with direct controls on credit through bank lending quotas, interest rates should be the measure used to manage any bubbles in property as well as other real assets.

An aggressive rate hike may only hinder China from sustaining its growth engine as the outlook of developed countries remains uncertain. As domestic manufacturers are still facing headwinds, accommodative policies remain important for them to weather storms. Moreover, under aggressive monetary easing policies in developed countries, rising interest rates may widen the interest rate spread and induce more capital inflows, stirring up the fears of potential bubbles in real assets and magnifying the pressure on yuan appreciation. Therefore, the existence of QE2 and other liquidity injection programs in developed countries would limit the room for manoeuvre by policy makers at the People's Bank of China.

Finally, money supply (M2) has returned to its 10-year range - ie 15-20 percent - from 29.6 percent in November 2009, reflecting the fact that administrative measures on bank lending controls have started to have an effect. With the bank lending quota for 2011 being lowered to 7 trillion yuan from 7.5 trillion this year, aggressive rate hikes are unnecessary.

The implication is that, with a moderate rate-hike cycle, robust growth and ample liquidity will help maintain an investor-friendly environment next year. Meanwhile, any correction on fears of restrictive policies should be the time to buy in.

The author is a research manager at Alroy Financial Services Ltd, an independent financial services provider. The opinions expressed here are entirely his own.

(HK Edition 12/22/2010 page2)