China's growth has been expected to moderate in response to government measures aimed at putting the brakes on investment spending. However, the jury is out as to how much the economy is slowing. The pace ofretail sales and exports has remained robust. Although investment spending and industrial production were soft in July, this followed several months of strong gains. In particular, the pace ofbank lending, which should be a barometer ofinvestment spending, accelerated in July. In addition, the headline CPI surged 5.6%oya in July, up from 4.4% in June. This was the fastest monthly headline inflation rate since February 1997. However, after stripping out the food component, nonfood CPI inflation edged lower t0 0.9%oya in July, compared to June's 1.0%, highlighting that the spike in headline CPI was still driven by food prices. With largely stable nonfood prices, we look for gradual moderation in the headline rate toward year end, though this is taking longer than we expected earlier, partly because of the recent floods. We have revised full-year 2007 CPI forecast t0 3.8%y/y (originally 3.3%).Policymakers probably were not satisfied with signs of economic moderation in the July activity data. At the same time, officials likely were concerned that the soaring stock market will be fueled by a further inflow from bank deposits now that real deposit rates have fallen into negative territory. Consequently, China's central bank bucked the trend toward easier global monetary policy last month, raising its key lending and deposit rates for the fourth time this year, While policymakers are closely watching global financial markets, China enjoys a degree ofinsulation from recent developments that no other major economy can claim. Its financial markets are relatively closed, limiting the po ssibility of contagion. And China is a large external creditor with a large pool of domestic saving to support spending. The main concern officials have is that the downturn in global markets will undermine external demand growth and deal a blow to China's booming export sector. For now, Chinese policymakers appear cautiously confident about the global growth outlook. This means that they will continue to focus on the domestic excess liquidity situation, the asset bubble, and the overheating risk
in the real economy. The PBoC will continue to manage liquidity in the financial system through sterilization and open-market operations. We expect another 27bp policy rate hike in the next six months. The government also will employ administrative controls on credit and land supply to prevent overheating.On the exchange rate, we continue to look for more significant CNY appreciation as an essential tool to tighten overall monetary conditions and to contain the further widening ofthe trade surplus, with the CNY/USD exchange rate expected to reach 7.0 by the end of2007. While the authorities are trying to rechannel the excess liquidity from current account surplus into outflows from capital and financial account, the last two weeks also showed CNY appreciation has re-gained momentum, with the CNY spot rate against USD hitting new post-revaluation highs.This suggests that China's policy makers are resuming the CNY appreciation program and could resort to turning the taps on capital equity flows to manage the pace of CNY appreciation, in addition to using the tried and tested method of direct intervention and sterilization headaches that it indirectly brings.