China took global markets by surprise on Thursday by raising interest rates for the first time in 18 months to slow a boom in credit and investment that risks destabilizing the world's fastest-growing major economy.

The central bank said on its Web Site (www.pbc.gov.cn) that it was raising its benchmark one-year lending rate to 5.85 percent from 5.58 percent but would keep its deposit rate unchanged at 2.25 percent.

The increase came as a surprise to most economists, who had expected the central bank to require banks to lock up more cash in reserve as the first step toward curbing credit growth.

This is very unexpected. The market was anticipating a hike in reserve deposit ratios, said Ben Simpfendorfer, a strategist with Royal Bank of Scotland in Hong Kong.

But he added: It's a positive step in so far as it should help take some of the steam out of investment demand. It also signals a proactive central bank.

The case for tighter policy was sealed after first-quarter figures showed annual gross domestic product growth accelerated to 10.2 percent from 9.9 percent in the fourth quarter of 2005.

Annual fixed-asset investment growth picked up to 27.7 percent from 25.7 percent in all of 2005, while banks extended 1.26 trillion yuan in new loans in the first quarter -- more than half the central bank's target for the whole year.

Still, Tim Condon with ING Financial Markets in Singapore said he was surprised at the central bank's choice of tightening tool because the last increase in lending rates, in October 2004, had scant impact in cooling the economy.

So I am kind of sceptical this one will either, but it does show the authorities' determination to rein in some of that liquidity, Condon said.

MORE TIGHTENING TO COME

Like others, Condon expects the authorities to weigh in with other steps before long.

The government and central bank are determined to tighten and if they don't see the target being met, there could be more measures coming, said Jun Ma, a Deutsche Bank economist in Hong Kong.

Zhu Jianfang, chief economist at China Securities in Beijing, added: I'm quite sure that there must be more measures to be rolled out in coming weeks to drain extra cash from the banking system because, with the lending rate increasing while the deposit rate remain unchanged, the wider gap will encourage banks to lend more.

Investment is booming because China is awash with cheap money from its record trade surplus, which tripled last year to $102 billion; from foreign direct investment exceeding $1 billion a week; and from speculative inflows betting on a stronger yuan.

The Group of Seven industrial nations urged China last weekend to redress this imbalance by letting the yuan rise faster. So far the central bank has let it edge up just 1.2 percent since revaluing it by 2.1 percent last July and unshackling it from a decade-old dollar peg.

But Beijing has conspicuously held the yuan down this week, despite the G7 statement, and Wang Chuanglian, an economist with Great Wall Fund Management in Shenzhen, said it was no accident that the central bank had not raised deposit rates, which could have attracted more unwanted capital inflows.

The central bank is reluctant to raise deposit rates because of its concerns over the yuan, he said.

Yet many economists believe a stronger yuan will have to be part of the solution to restoring balance to the economy.

Partly because Beijing has been reluctant to let the currency rise, fearing job losses in export industries, it has had to keep the cost of money far too low for such a fast-growing economy.

The yuan's exchange rate imposes interest rates which are too low, considering the strength of Chinese economy, Lorenzo Bini Smaghi, a member of the European Central Bank's executive board, said in Florence before Thursday's rate rise.

(Additional reporting by Kevin Yao and Tamora Vidaillet in Beijing and Umesh Desai and Edwin Chan in Hong Kong)

China Royal Bank of Scotland