China surprised investors by raising interest rates Tuesday, sparking a world-wide sell-off in stocks, commodities and emerging-markets currencies as investors lowered their expectations for Chinese growth, which has been seen as a key driver of the global economy.
China's central bank announced it would raise key rates by a quarter percentage point, the first move since it cut rates in December 2008. While many investors had been expecting China to raise interest rates in coming months, the timing of the move was unexpected. It is viewed as the first in a series of interest rate increases.
Currency markets, where exchange rates reflect bets by investors scouring the globe for the highest returns, reacted swiftly. On the assumption that China's rate boost will damp its economy, investors removed some bets on the currencies of other surging markets, and money flowed back to the U.S. dollar. Australia, seen as closely linked to Chinese growth, saw its currency fall 2.6% against the dollar. The U.S. dollar rose 1.8% against the Canadian dollar and 0.6% against the Brazilian real.
Investors were split on the impact China's move will have on currency diplomacy. Tensions have been building as a result of the money flooding into emerging markets, driving up the currencies of countries such as Brazil and South Korea against the dollar.
Because China effectively pegs the yuan to the dollar, exporters in those countries have been losing competitiveness against China, their chief rival in the global markets. In response, many governments have been pushing back against the tide of money boosting their currencies.
Those issues were front and center Tuesday.
Brazil raised the tax on foreign investment in Brazilian bonds. And in Seoul, the South Korean finance minister said the government was considering reinstating a withholding tax on foreign investors' holdings in some Korean securities.
The impact of China's rate rise was also felt in the commodity markets, where Chinese demand plays a significant role in setting prices.
Oil prices suffered their biggest decline in eight months, losing more than 4% to $79.49. Gold, which set a record high last week, fell $36.10 per troy ounce, or 2.63% to $1335.10.
Stocks, too, took a hit, although the sell-off in the U.S. was also fueled by renewed concerns about the impact that home loan foreclosure problems will have on banks. The Dow Jones Industrial Average lost 1.5% to close at 10978.62.
Traders say the market swings were likely magnified by the fact that China's move caught many investors off guard. The People's Bank of China said Tuesday that it increased the benchmark one-year interest rates on loans and deposits by a quarter of a percentage point each. The last time it raised interest rates was in 2007.
China's central bank, as usual, didn't elaborate on the reasons for its interest-rate move, which came two days before key economic data for September and the third quarter are due.
"They are starting to see signs that growth is picking up … and now is the time to begin cautious tightening," said Daniel Katzive, a director in the currency strategy research team at Credit Suisse.
Some investors interpreted China's rate move as a sign the country might rein in a steady but gradual appreciation of its currency against the dollar seen recently. That's in part because a rising currency, like higher interest rates, serves as a brake on inflation—thus a rate increase means it wouldn't need to allow the currency to rise as quickly.
Following the rate news Tuesday, pricing on derivatives known as nondeliverable forwards reflected expectations of an increase in the yuan of 3% over the next twelve months. On Monday, investors had been betting on a nearly 4% appreciation.
However, economists believe stubbornly high housing prices were one of the main drivers for Tuesday's move, and that raising interest rates is a more direct way to attack that problem than through the currency markets.
China's interest-rate move marks a shift in strategy by authorities. Until now, they had been relying on administrative controls such as limits on bank lending and changes in required mortgage down-payments to modulate growth. "Today's decision to hike rates suggests that Beijing feels these earlier, more targeted measures are no longer enough to keep the economy on an even keel," said Royal Bank of Canada economist Brian Jackson
Since late August, investors have been adding to their bets on emerging markets, especially Asian developing nations. Fueling that wager: expectations that the Federal Reserve will soon pump at least $500 billion into the U.S. financial system in an effort to boost the struggling American economy. Some of that money is expected to find its way to emerging markets, which offer higher yields and prospects for asset-price growth. That effort was also seen as devaluing the U.S. dollar.
In Japan, where the yen has risen sharply against the dollar in recent months, the country's finance minister Tuesday expressed renewed concerns over its strength, declaring the government's readiness to intervene in the currency market and urging global leaders to work together to stabilize exchange rates. The Japanese government downgraded its view on the economy for the first time in more than a year and a half.
Also Tuesday, Canada's central bank halted a string of interest-rate hikes it started in June, warning that international currency tensions could hamper global recovery and forecasting slower growth than it had projected just a few months ago.
Although the broader reaction in the financial markets suggested a scaling back of expectations about China's growth prospects, another interpretation was that it's actually good news for the global economy.
"Generally we see this as a broadly positive development, that policy makers are more confident of the economic trends," said Manik Narain, emerging markets strategist at UBS in London. "All in all, this is China coming from a position of strength," he said.