China sent financial markets into turmoil after it increased its benchmark interest rate by 25 basis points with effect from tomorrow.

The move to raise rates by a quarter percentage point was flagged by the Chinese authorities as an internal signal to property developers that rampant house price inflation was intolerable and would be controlled by the Beijing government.

However, the rise was seen more widely as appeasing US policymakers, who have called for China to increase the value of its currency.

The IMF warned earlier this month that the world economy was threatened by attempts to artificially depress currency values. China has long been accused by the US administration of maintaining low interest rates to keep the value of its currency low and exports cheap.

The pound reacted by falling more than two cents against the dollar in mid-afternoon trading, while the euro was 1% lower on the day at $1.3805

Stock markets reacted badly to the news with Germany's Dax down 41.10 points, or 0.6%, at 6475.53, while the CAC-40 in France was 20.99 points, or 0.6%, lower at 3813.51. The FTSE-100 index of leading British shares was down at 5,711, a drop of more than 30 points.

In the US, the Dow Jones industrial average was down 146.18 points at 10,997.51.

Hitendra Dave, head of global markets at HSBC India, said internal pressures led to the rise. "China hasn't raised so far and [they] have only been raising the reserve requirements. With all the asset price speculation, they had to raise rates to normalise policy. It is the local factors that led them to take this decision."

Chris Turner, head of foreign exchange at the Dutch bank ING, said: "This is part of the moderate tightening cycle that we are seeing from Chinese authorities to balance their economy. It is part of the normalisation of interest rates in an economy which is growing at a modestly fast clip.

"The market is reacting like there is an increased risk of hard landing with the commodity currencies like the Aussie being sold off, but I don't think that is the case," he said.

Simon Derrick, of Bank of New York Mellon, said the move was fuelling speculation that Beijing was involved in backdoor deals with the US administration to nudge its currency upwards.

"The move follows a clear need by the Chinese authorities to take out some of the heat from the economy. Whether this will lead to a broader move on its currency is open to debate. It certainly leads to speculation that the US and China are in some sort of a deal which will perhaps see the US taking a more gradualist approach to quantitative easing. The dollar has already moved higher after this news," he said.