Forex Investment and Currency Trading

USD/CNY

Current Spot Rate - 6.85

• 3Q2008 - 6.70
• 4Q2008- 6.45
• 1Q2009 - 6.27
• 2Q2009 - 6.14
• 3Q2009 - 6.05
• 4Q2009 - 6.00

Macroeconomic Trends and Prospects

China economy is expected to slow down moderately in 2Q 2008 (market consensus 10.4% yoy vs. 10.6% in 1Q 2008) “in an expected direction of macroeconomic control” (Premier Wen). The authorities have shifted rhetoric from preventing overheating to ensuring stable economic growth. In fact, there are additional signs of continued moderation of economic activities. June PMI reached a two-year low at 52, following the decline in May to 53.3. The 2Q 2008 entrepreneur confidence index dropped to 134.8 from 140.6 in 1Q 2008. Exports growth is set to slow further in 2H 2008 with the prospects of weakening demand from EU and US markets, the top exports destinations.

Despite the internal and external downside risks, the economy is expected to be underpinned by robust
consumption and investment growth. Social retail sales have registered 14% yoy growth in real terms (deflated by retail price index) in April-May, well above 13.2% and 13.4% in 1Q 2008. Fixed asset investment has slowed to 25.6% yoy in the first five months on tight credit control. However, it is expected to maintain a relatively high level driven by the local officials’ strong incentives and a likely boost from the after-quake reconstruction need.

June CPI has reportedly eased to 7.1%, following the moderation of 7.7% in May, mainly on account of slower
food prices hikes and high base effect. However, the likely moderating trend doesn’t imply an alleviation of
inflationary pressures. Food prices, albeit with a slower yoy growth, will likely remain at a high level, as the
agriculture input costs have risen in line with the surging oil prices. The authorities are also likely to use high food prices to encourage food supply and increase farmers’ income, as long as sufficient subsidies could be extended to the poor to offset the negative impacts. The Ministry of Commerce’s production costs index rose for the tenth consecutive week, which reinforces the trend higher in PPI. In addition, if oil prices surge further, the authorities will likely initiate another fuel price hike, following the nearly 20% fuel price hike in June.

The stock market has recently touched a 16-months low, with the Shanghai stock exchange composite index declining by as much as 56% from its peak in last October. The decline, coincident with the domestic growth moderation and the global subprime crises, is more about corrections of overvaluation and investors’ weakening confidence in response to the authorities’ disappointing supervision or (and) policy arrangements. Encouraged by the good preview of listed companies’ semi-annual reports, the Shanghai composite index has showed some signs of bottoming since last week. The market is likely to be stabilized or slightly improved ahead of the Olympic Games.

Monetary Policy and the Exchange Rate

In market’s view, the central bank may enter a new phase of monetary management with further slip in USD/CNY likely providing an increasingly palatable and productive solution to taming inflation. In
addition, a stronger CNY, as a disinflationary tool, could be more accepted by Chinese exporters, as a recent Central Bank survey suggested that 1121 surveyed export and import firms are increasingly accustomed to the two-way exchange rate fluctuations and increasingly seeking risk hedging tools from financial institutions.

The authorities are making efforts to deter speculative money inflows by intensified monitoring and checking of the goods trade transitions (and this could be extended to services trade). These measures, if effectively implemented, should play a significant role to discourage hot money inflows via trade channels and are likely to enhance the authorities’ efforts to allow gradual CNY appreciation as a disinflation tool. Market expects USD/CNY will likely reach 6.70 by the end of 3Q and 6.45 by the end of 2008.