China caught investors by surprise last week, when it raised its benchmark interest rate for the first time in years, to 5.85%. Foreign banks applauded the move as emblematic of China’s broader effort to allow market forces to play a larger role in the economy. China must tread carefully, however, as the Yuan-USD peg severely constrains its ability to conduct monetary policy. If China’s Central Bank wishes to raise rates further (to rein in growth and inflation), it may have to allow the Yuan to appreciate at a faster pace, so as not to invite an influx of speculative capital. Reuters reports:

U.S. officials will consider all of the steps China has taken to retool its economy when assessing the nation in a semiannual report on whether U.S. trading partners manipulate exchange rates to gain unfair trade advantage.

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