China Plays the Role of Grinch

On Christmas Day, as investors in Whoville were away from their Bloomberg terminals celebrating with family and friends, China did their best Grinch impression and surprised markets by raising interest rates a quarter point in response to surging inflation. They raised their 1-year lending to 5.81%, while the 1-year deposit rate was increased to 2.75%. They’ve also been hiking reserve requirements for banks in an effort to cool their red-hot economy.

The interest rate action knocked Chinese stocks down by -2% today. There’s been a notable divergence developing between Chinese and U.S. equities over the past several weeks, with the FXI China ETF off -1.3% so far this month while the S&P 500 is up 6.6%.

With inflation rising above 5% in November, odds are that China will feel the need to continue to tighten going into 2011. The possibility of them overdoing it is certainly one of the bigger risks facing the global economy, since China has been considered the main engine of growth in the current environment. Achieving the proverbial “soft landing” has proven to be a difficult feat over the years. We'll be watching closely to see if they can pull it off.

Chart: China 1-year deposit rate