The dramatic rate cut of 0.75 points in the US also brings with it problems. Massive Chinese trading losses on exchange rage movements will also anger the Chinese people.
The loss the Chinese will realise on US paper has been inevitable for years. This policy of buying US paper to keep exchange rates low to boost exports was never sustainable. These losses are in many respect a travesty.
This excellent article outlines the technicalities. It also illustrates very clearly that macroeconomics can get complicated very quickly.
US action adds to pressure on China [FT]
The sharp cut in US interest rates has increased the conflicting pressures on Beijing's management of its economy and its simult-aneous efforts to stem potential losses of billions of dollarsin its foreign exchange holdings.
To keep the currency stable, the People's Bank of China buys almost all incoming foreign currency, and then attempts to "sterilise" the monetary impact by issuing renminbi bills to take the funds out of circulation.
The US cut means China's central bank will pay almost 200 basis points more on the bills it issues at home to manage its currency than it will get on purchases of US Treasuries.
The PBoC pays about 4 per cent on its so-called "sterilisation" bills, while one-year US Treasuries now carry an interest rate of 2.07 per cent.
Both countries are likely to maintain their policy biases in coming months, the US cutting rates, and China lifting them, a trend that will intensify the pressure on Beijing's currency policies.
"Things just got a lot more complicated for the managers of China's economy," said Stephen Green, of Standard Chartered bank, in Shanghai, yesterday.
China does not release the exact makeup of its foreign exchange holdings, nor how they are invested, making it difficult to get a precise reading on their profitability.
But Hong Liang, Goldman Sachs China economist, calculates the PBoC is losing about $4bn a month on its bills because of the turnround in the interest rate differential over the past 18 months.
"The trend is clearly accelerating as the reserves continue to grow faster than GDP," she said.
China has lifted rates eight times since early 2006, to cool an economy that grew by more than 11 per cent last year and, more recently, to combat inflation, which hit an 11-year high in November.
But further use of interest rates is constrained by Beijing's tight management of the renminbi, a policy aimed at preventing it appreciating too rapidly.
The government fears more rate rises could attract speculative capital inflows, adding to already swollen foreign reserves, which stood at $1,530bn at the end of 2007.
Despite this objection, the government's commitment to fighting inflation means further rate rises are inevitable, China economists say.
The PBoC, in expectation of losses on its sterilisation bills, has used other tools in the past year to drain the funds, mainly by requiring commercial banks to leave more money with it on deposit. Chinese banks are required to place 15 per cent of their deposits with the PBoC, at a much lower interest rate than the 4 per cent offered by the sterilisation bills.
The heavy use of this measure has allowed the PBoC to limit losses on its foreign exchange holdings.
Some economists argue the reserve losses are only on paper, but "at some point, that paper loss may result in a fiscal loss", said Brad Setser, of the Council on Foreign Relations. "It certainly represents a fall in domestic purchasing power of China's external foreign assets. Money held in dollars will end up buying fewer Chinese goods in five years than it does now," he said.