• Mainland China's consumer price inflation soared to nearly a 12-year high of 8.7% in February 2008 as food prices continued to surge.
• To alleviate the inflationary pressure, the government raised the required reserve ratio for the second time this year to the record high of 15.5%, and accelerated the appreciation of the domestic currency (the CNY) against the US dollar.
• A stronger CNY and a slowing global economy will hit the Mainland's exports eventually, the growth of which is trending downward in recent months. The government's tight monetary policy will also keep the growth of bank lending and investment subdued.
• Overall, Mainland China's economy is heading towards a slower growth path this year. Inflation, however, will remain high for a longer period given that it is driven more by supply shocks than demand factors.

Inflation soaring

Mainland China's inflation rate, as measured by the consumer price index (CPI), soared further to 8.7% in February, the highest in almost 12 years (Exhibit 1). In the first two months of 2008, CPI averaged 7.9% after an increase of 4.8% for the whole of last year. Surging food prices continued to be the major factor behind the soaring CPI. In February, food prices rose 23.3% (year-on-year) after an increase of 18.2% in January, and was responsible for nearly 90% of the increase in CPI.

In his latest Government Work Report, Premier Wen Jiaobao set an inflation target of 4.8% for this year. But even the Premier admitted that meeting the target would be a challenge. To contain inflation, the People's Bank of China (PBOC), China's central bank, not only maintains a tight grip on monetary growth, but also accelerates the appreciation of the CNY against the US dollar.

Required reserve ratio up further

Soaring inflation and rising FX inflow were the major reason for PBOC to raise the required reserve ratio on 25 March by another 0.5 percentage point. This was the second time the ratio was raised this year, bringing it to the record high of 15.5% (Exhibit 2). That the PBOC has kept interest rates unchanged reflects the dilemma it faces. With US interest rates already below CNY interest rates and trending downward, raising CNY interest rates will only attract more capital inflow, making the control of money supply even more difficult. The PBOC may raise the required reserve ratio two to three times more in the months ahead, but it will raise the interest rates cautiously.

CNY appreciation accelerated, but only against USD

Mounting inflation at home, high commodity prices abroad and persistent weakness of the US dollar have also prompted the PBOC to accelerate the appreciation of the CNY against the US dollar. The USD/CNY mid-rate reached a record low of 7.0130 on 27 March, representing an appreciation of 4.2% against the greenback since the beginning of this year. Between 22 July 2005 when PBOC pegged the CNY to a basket of currencies and 31 March 2008, the CNY appreciated by a total of 18.0% against the US dollar (Exhibit 3).

How much further the CNY will appreciate this year will depend as much on how weak the US dollar will become as on how great the impact of the appreciation will be on the domestic economy. A stronger CNY will help reduce import prices of commodities and domestic inflationary pressure. But the cost for this will be a slowdown in export growth. So far, the CNY has only appreciated more notably against the US dollar.

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