Forex Investment and Currency Trading

CPI inflation jumped to 8.7% yoy in February, the highest level since May 1996. The spike in CPI prices was driven by higher food prices, which rose by 23.3% yoy, while non-food prices rose by 1.6% and core inflation excluding food and energy remained at 1%. The pick-up in food price inflation was mainly due to the snow storm which drove up prices of fresh vegetables and pork. Nevertheless, persistently elevated CPI inflation is beginning to entrench expectations. Moreover, the general environment of excess liquidity and low interest rates could lead to an excess-demand led generalized inflation. In addition, import prices of energy, industrial material and agricultural products continued to rise and the pass through will gradually take place. Therefore, we see inflation to decline only gradually in the second half of 2008, with the annual average reaching 6% in 2008.

The latest economic data may reflect some negative impact from the slowing global economy. Export growth decelerated sharply to 6.5% yoy in February from 26% in 2007 and 27% in January, and the growth of industrial production also dropped from 17.4% in December to 15.4% in the first two months. We think that the drop in both export and industrial production growth mainly reflected the temporary disruption of production and transportation caused by the winter storms, but cannot exclude the possible negative impact from slowing US demand.

Looking forward, uncertainty has risen regarding the magnitude of slowdown in global demand and the impact on China’s exports and related investment. Rising  inflation and declining production complicate economic policy decision making, especially as global economic uncertainty is rising with the deepening financial market turmoil. The Chinese government expressed serious concerns over the state of global economy and the US monetary policy, for it sees the paramount need to control inflation but is weary that tightening measures may be overdone at a time of a possible global meltdown. Moreover, the global uncertainty and market gyration has not led to less, but probably more, foreign exchange inflows into China. The latest data show that FX asset increases in 2007 was much larger than the official reserves show, and January 2008 saw another $61.6 billion increase.

Apart from the persistent large trade surplus and rapidly increasing interest income on China’s expanding stock of FX assets, unexplained capital flows have been sizable and may have accelerated in recent months. The global financial market turmoil and declining US interest rate could lead to more capital inflows to China, especially as the expectations of a steady and significant CNY appreciation get entrenched.

Senior officials reaffirmed during the recent National People’s Congress that curbing inflation remained the top priority in China and a tighter monetary policy would be followed. The PBOC announced a 50bps hike in required reserve ratio on March 18 to help absorb excess liquidity in the banking system. We expect the government to continue to use reserve requirements and OMOs to withdraw liquidity, rely on credit controls to manage bank lending, and front load the exchange rate appreciation to help with inflation control. An interest rate hike has been widely expected but the latest developments in the US financial market and expected additional aggressive cuts in US interest rate have led to increased caution. A one-off revaluation could deliver instant relief on import prices while helping stem the speculative inflows, but is highly unlikely given the increasing global uncertainty.

Looking forward, China GDP growth in 2008 is being well supported by strong domestic demand, especially investment. In the case of a larger-than-expected decline in external related activity, the government could and is prepared to ease credit control and other tightening policies to stimulate domestic economy. Therefore, even as a sharp slowdown in export growth is projected, market still see GDP growth to reach 9-10% in 2008.