Forex Investment and Currency Trading

Expect no change in policy rates in Q2 so long as inflation eases this month. Instead, there will likely be two 50 bp increases in the reserve ratio in Q2 to control liquidity growth resulting from FX intervention. The PBOC will rely more on administrative-based, rather than market-based, measures to target inflation.

After a busy 07H2, the PBOC is expected to largely sit on the sidelines in Q2 and Q3. True, inflation pressures are rising, but the central bank is limited in its ability to curb food price inflation. The PBOC may also take comfort from a stabilizing trade surplus. The central bank will also worry that US Federal Reserve cuts and a stronger CNY may increase speculative capital inflows as investors try to profit from widening interest rate spreads and currency gains. The PBOC will thus avoid raising interest rates and instead rely on administrative-based, rather than market-based, measures, to target inflation.

More specifically, no interest rate hikes is expected in H2, albeit risks are skewed to a single 27bp increase if inflation remains above 8% in Q2. PBOC Governor Zhou stated March 6 that ‘the room to raise interest rates certainly exists’. However, he noted that other factors, including domestic demand and capital market development, must also be taken into consideration implying that the PBOC is targeting more than inflation.

Still another two 50bp hikes are expected in the required reserve ratio in Q2. However, this is monetary stabilization, not monetary tightening. Moreover, excess liquidity challenges are, at least temporarily, easing. First, the PBOC safely navigated a liquidity bulge in January. Net issuance of central bank bill and repos has since fallen to lower levels. Second, a seasonally smaller trade surplus in H1 is helpful. Lower net issuance and just two hikes in the required reserve ratio in the quarter suggest fears on a sudden rise in hot money inflow are exaggerated.

Speculative money inflows are still a risk. The PBOC faces the challenge of easing as the US Federal Reserve cuts rates aggressively. Another 75bp worth of cuts is forecasted to leave the Fed Fund rates at 1.50% by June 2008. Spreads between Chinese and US 12M interest rates are 70bp versus -240bp twelve months ago. However, the equity market is also in sharp decline, and this may deter speculative investors who were originally looking to profit from equity market gains. The risks of a sudden flood of hot money in the coming months are limited.

Credit growth is a wildcard. January posted a huge 801bn yuan gain, the largest YoY increase on record. The increase is worrying, especially as credit growth had earlier slowed sharply in Q4 after the imposition of credit quotas. However, it is too early to say if credit quotas have failed, especially as credit growth was a smaller 250bn in February. Nonetheless, the PBOC is more likely to rely on administrative-based, rather than market-based measure to tackle credit growth, careful of over tightening even as the currency strengthens and production costs rise.