Investors wonder if their cash will go to the wall as China blows hot and cold

Simon Hildrey asks if the rate rise signals stability or slowdown for the economy

It's not just in the UK where interest rates are a hot topic of conversation: China raised its cost of borrowing on 28 October for the first time in nine years, in an attempt to cool the economy.

It's not just in the UK where interest rates are a hot topic of conversation: China raised its cost of borrowing on 28 October for the first time in nine years, in an attempt to cool the economy.

As investors wonder what will happen to their money, fund managers and economists are split on whether the rise in lending rates by 0.27 per cent to 5.53 per cent, and deposit rates by the same amount to 2.25 per cent, will prevent overheating or whether it is too late to avoid a hard landing.

Hugh Young, manager of the Aberdeen Far East Emerging Economies fund, welcomes the increase. "This is a sign of the further maturing of China and the move by the government towards more sophisticated methods of controlling the economy," he says. "In the long run, it is a positive development, although it may cause some pain in the short term."

Mr Young is confident that China can achieve a soft landing, particularly as recent data suggests the economy is already slowing. But he adds that there is a risk of a sharp slowdown as growth was 9.1 per cent in the third quarter, compared with 9.8 per cent in the first and 9.6 per cent in the second. Annual price inflation also eased to 5.2 per cent in September.

Having predicted Chinese economic growth of between 7.5 and 8 per cent in the second half of this year, the International Monetary Fund has also forecast that growth will slow to 7.5 per cent in 2005, compared with 9.1 per cent in 2003. When a hard landing is discussed, it is usually meant as economic growth of below 6 per cent.

Some fund managers say the slowdown can be at least partly attributed to previous attempts by the government to prevent overheating, through strategies such as limiting state investment and lending by banks.

Shifeng Ke, co-manager of the Martin Currie China hedge fund, also believes the country's economy will achieve a soft landing, although he admits the timing of the interest rate rise is strange. "The GDP and inflation figures for the third quarter suggest the economy is slowing already," he says. "We believe the rate rise was part of an effort by the government to normalise monetary policy."

Another plank of this policy, he adds, was the abandonment of the ceiling on lending rates by banks on 28 October. While the private sector in China now comprises a third of the economy, privately owned companies, especially small and medium-sized firms, struggled to gain access to capital under the lending restrictions imposed by the government on banks.

Fund managers argue that the large state-owned enterprises could still borrow money as banks continue to lend to the government. But higher rates will affect them and therefore may be more successful in cooling economic growth. Meanwhile, there will be a levelling of the playing field with other businesses that can now get their hands on fresh capital. "The ending of the ceiling on rates is seen as the government trying to support the private sector," says Mr Ke.

But others do not share this optimism. Diana Choyleva, senior economist at Lombard Street Research, believes the rise in rates strengthens the argument that China is heading for a sharp slowdown. Indeed, she says, there are already indications of a downturn as there have been "falling imports over the past three months, exports have levelled off and credit growth has slowed sharply".

Ms Choyleva argues that a hard landing for the Chinese economy will be partly caused by the yuan being pegged to the US dollar. "The pain from maintaining the peg has been over-investment, coupled with over- heating and rising inflation."

Over the past three years, she says, strong output growth in China has been driven by investment and exports. She believes external demand will slow next year, with the effect compounded by administrative tightening to slow investment - and that the shortfall will not be made good by consumer spending.

It is not just in China where there are fears of a downturn. Peter Hensman, global strategist at investment house Newton, says there is a risk of both China and the US suffering from slower economic growth in 2005. This is of great concern because these countries are the main drivers for global growth.

Mark Dampier, head of research at independent financial adviser Hargreaves Lansdown, believes China and Asia generally offer an attractive investment story over the long term but that investors have to be prepared for volatility along the way. "There will be events like this where the stock market will be hit temporarily," he says. "Investors should consider drip-feeding money into a fund to smooth the effects of the volatility in the market. Or you can try to buy into China during one of the dips in the market."

He recommends investors use Asian or Greater China funds rather than one focused purely on the country itself. "[These] provide diversification while being able to benefit from growth in China. Many of the companies in Taiwan and Hong Kong do business there. We like the First State Greater China Growth fund.

"Investors should also not forget about India, which has at least as much, if not more, potential than China."