JPMorgan Chase is fully aware that China’s government departments are deeply divided on whether interest rates should be raised. Each

department and government agency has its considerations. The emergence of such differences in China is not entirely surprising. The key question for investors is how much of an impact this disagreement will have on China's eventual formulation and execution of its monetary policy. We

we believe that ultimately, the central government will make decisions based on the views of the central bank.

Following this logic, the challenge facing China is how to achieve the independence of the central bank in formulating and executing monetary policy. This may be able to resolve differences between government agencies and various departments on interest rates and monetary policy. China began to raise interest rates at the end of October, once again proving that China's top leaders can make the right decisions at the right time. Next, China's change in fixed exchange rate policy should not be an exception. In fact, China

Recent changes in interest rates have vindicated JPMorgan's view.

Because we have noticed that the latest interest rate hike means that China's government departments will rely more on market-oriented policy tools to manage the current economic cycle. We believe that the next step in policy normalization will be to change the current exchange rate system. This is the biggest difference from the previous round of tightening policy.

The biggest debate over the current exchange rate regime is whether China needs to increase its currency flexibility to address the economic challenges it currently endures. Under the fixed exchange rate mechanism, China lost its monetary policy autonomy. Structurally, China

has positioned itself to introduce more flexibility into the exchange rate mechanism. We believe that as time goes by, China will reform the fixed exchange rate mechanism in the next three to six months. In fact, from a cyclical perspective, under the current circumstances, in order to better and more efficiently deal with inflationary expectations, China needs to adjust its exchange rate mechanism. adjustments, especially in the face of inflation that is pushing up import costs.

Considering that administrative tightening policies have been adopted and an interest rate hike cycle has begun, interest rate hikes will also become a demand-driven inflation and put pressure on China’s domestic consumer prices to rise. , but the pressure is not great. China's inflationary pressure is likely to come from external factors, such as high prices of oil, raw materials and commodities. Noting that food prices have begun to stabilize, authoritative departments have gradually increased their attention to the components of African food in the CPI, which reflects that China's inflation may be due to oil prices and other import costs.

November's CPI fell by 0.4% on a monthly basis. This surprising drop was mainly due to changes in food prices.

Although the CPI released last month The upward pressure on non-food prices has also eased in the third quarter.

Based on a year ago, food prices rose just 5.9% annually, the smallest increase since February

New inflation is worrying

The recent slowdown in CPI growth is due to slower growth in food prices, while non-food price inflation remains

Still going strong. Monetary growth implies a reduction in inflationary pressures, and the threat from wage-driven inflation is likely to be exaggerated. The increase in import costs is the most important threat to inflation in 2005. Adjusting the RMB exchange rate

is the best solution.

China’s October economic report was surprisingly good and became an important manifestation of the significant reduction in the upward pressure on CPI

Compared with a year ago, the broad consumer price index reached 5.3% in July and August, fell to 5.2% in September, and fell further to 4.3% in October %. Indeed, on a monthly basis, the broad consumer price index fell by 0.1% in October, the first time this indicator has declined since June 2003. . Although consumer price inflation has begun since the beginning of 2003, it is mainly due to the sharp rise in food prices. Accordingly, after a good harvest, the broad consumer price index reflects the stability of food prices. Monthly comparison, in October, the CPI food component fell by 0.

9%, and last month saw the smallest increase since March: an annual increase of 10.0%.

During the period, non-food prices maintained their moderate levels but at the same time grew steadily: the annual rate of growth in October was 1.3%, the highest since August 2001. Fast speed. The focus of inflationary pressure is no longer food factors, but has become more widespread cost-push inflation. JPMorgan Chase's view is that inflation will further moderate and may reach an annual growth rate of 3% in 2005.

This is why we believe that modest interest rate increases should total 100 basis points over the next 12 months. These forecasts are based on the assumption that the fluctuation range of China's RMB exchange rate will relax over the next six months, which will lead to a moderate appreciation of the RMB. .

Slower monetary growth

From a historical point of view, China's inflation closely follows the growth of the total currency and has become China's currency

law. Especially after the number of M2 bottomed out in 2001, M2 achieved accelerated growth from 2002 to 2003. This was the reason why CPI-type inflation began to grow since the beginning of 2003.

Paved the way. In a broader sense, M2 growth peaking earlier this year means that CPI-type inflation will enter 2005. However, this pattern was temporarily interrupted by this year's credit tightening measures, which led to a rapid decline in M2 and bank loans since the second quarter of this year. Misleading indicators of real liquidity conditions suggest that a similar amount of loanable funds has rapidly flowed out of the formal banking system and into underground gray credit markets.

The official M2 indicator once again underestimated the actual liquidity. In the excessive year, the growth of M2 significantly exceeded the growth of nominal GDP by 7- 8%. Rising official interest rates in the coming months may ultimately cushion currency growth as they pull some liquidity back into the formal banking system. But

However, in contrast to this abnormality, underground credit still continues.

Import costs lead inflation

Concerns about inflationary pressures next year involve changes in labor market conditions. Since the end of 2003, the unprecedented labor shortage problem has become increasingly serious, especially among export companies in the Pearl River Delta region. According to estimates, the labor shortage gap reaches 2 million people, which mainly refers to workers from rural areas in the traditional sense. The worry is that China will eventually face constraints on labor supply, even in jobs with low technical content

This pressure from labor shortages is likely to lead to continued wage push in China

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Dynamic inflation.

Our view is that recent developments have reflected labor market frictions, not a full-scale labor shortage.

In particular, because of rising agricultural product prices, the increase in relative income has led to a decrease in the rural labor force rather than the urban labor force, and the opportunity cost of rural laborers to work in coastal manufacturing centers has increased. This will most likely mean some adjustments to the wages of these low-income workers, which will also improve alongside rising rural incomes. However, there is no substantial threat to rising inflation. In fact, the overall income of employees is growing together with nominal GDP, which does not imply that the increase in overall wage levels will push up inflation.

Import cost inflation is the most important factor considered by policymakers. Looking ahead to inflation

in 2005, the main upward risk comes from the continued rise in import costs, especially the import of oil, raw materials and other

commodities, especially considering that Domestic resource constraints are unlikely to ease in the near future. In China's latest monetary policy implementation report, the People's Bank of China expressed notable concern about the continued rise in the cost of energy-related and industrial raw materials. Indeed, although the upward pressure on the broad consumer price index has significantly eased, the rising pressure on inflation caused by PPI shows no signs of slowing down. According to calculations by the People's Bank of China, overall import prices have consistently continued to rise, with an annual growth rate of 15.5% in the third quarter. If it continues unchanged, this trend will bring continued risks of increasing inflationary pressure on downstream industry product manufacturing inflation

.

Killing two birds with one stone

Relaxing the fluctuation range of the RMB will kill two birds with one stone. Now, inflation expectations will become the focus of China's policy formulation. Because the most serious threat to inflation in 2005 comes from external factors,

In inflation driven by rising import costs, according to the basic principles of economics, the most feasible way is to rise

Value in RMB. A large number of other important factors have shown that the Chinese economy needs a more flexible exchange rate mechanism, and now the time has come. For example, in the middle of managing China's own business cycle, China needs to give its central bank more initiative in monetary policy formulation and execution.

Another potential benefit of moderate RMB appreciation is the monetary increase in the purchasing power of middle-income families.

This will help

support the government departments in revising the economic growth model, making China more inclined to promote China's economic growth through domestic consumption. This will become the macroeconomic policy in 2005. an important goal of policy. In this sense, inflationary pressure from import costs should be alleviated, which will give policymakers more weight to implement a more flexible exchange rate mechanism.

Tactics and strategic factors for appreciation

JPMorgan Chase believes that China is in a strategic stage of deciding whether to appreciate the RMB. Now is the time to decide when and how to take the first step towards RMB appreciation.

JPMorgan Chase's latest survey shows that China's domestic financial industry has reached a consensus: China will have to relax

the range of fluctuations in the RMB exchange rate to allow the RMB to rise against the US dollar. The tone of China's public discussions has also changed

It is no longer whether the yuan should appreciate, but "how" and "when" it will happen.

This means that China There has been a very significant change in perspective. Taking into account the technical arrangements, China is accelerating its research on relaxing and deepening the reform of the capital market, especially the derivatives and futures markets (including index futures and derivatives, tradable index funds, interest rate and foreign exchange futures, interest rate exchanges and foreign exchange exchanges, etc.), the People's Bank of China also requires the Shanghai Futures Exchange to develop risk management financial products as much as possible.

At the same time, there are also some reports that residents in China's coastal cities have also converted their U.S. dollar savings in banks into RMB deposits, and many banks have reported that they are not allowed to Do not increase certain "daily restrictions" on residents converting foreign currencies into RMB. Local media also reported that for the first time in history, U.S. dollars in China have become a currency that people "don't want" to hold. The People's Bank of China recently raised the U.S. dollar deposit interest rate - a small increase compared with China's adjustment to the yuan deposit rate in late October. This has no impact on people's behavior. Didn't have much substantive impact. If this trend continues, it could complicate the People's Bank of China's efforts to further raise yuan interest rates.

The current exchange rate mechanism

Allows the relaxation of the fluctuation range of the RMB

As JPMorgan Chase has pointed out several times before, in principle, the current exchange rate management - China Calling it "government-managed exchange rate floating" allows for some appreciation of the yuan without having to change the exchange rate mechanism. This point is often forgotten by market commentators. China can allow exchange rate flexibility to be relaxed without announcing that it will "reform" the exchange rate mechanism. After China devalued the renminbi in 1994, from 5.7 yuan per U.S. dollar to 8.7 yuan per U.S. dollar, it later appreciated the renminbi to a level of 8.3, which formed the "

A government-managed floating" exchange rate mechanism. It was only after the Asian financial crisis that the People's Bank of China finally intervened and transformed the "government-managed floating" exchange rate mechanism into a de facto near-fixed exchange rate pegged to the U.S. dollar

Rate mechanism. Therefore, the People's Bank of China only needs to change its interference behavior, without reforming the exchange rate mechanism

, allowing the exchange rate of the U.S. dollar against the yuan to fall again. In theory, this could happen at any time without the need for formal announcements from government agencies.

Considering the rapid depreciation of the U.S. dollar after the U.S. election, China must decide whether the RMB needs to

appreciate by about 5% at a time against the U.S. dollar. At that time, the Chinese government The department may relax the fluctuation range of the RMB exchange rate

or shift to pegging it to a basket of currencies. Such action is necessary to stem expectations of further RMB appreciation, especially given that China's RMB real effective exchange rate index? Sexually weakened. We believe that China is extremely unwilling to take the step of one-time significant appreciation of the RMB - this may be the main reason why China has recently publicly opposed the appreciation of the RMB. However, the depreciation trend of the US dollar is somewhat beyond the capabilities of the Chinese government departments. Finally, China may not be able to choose an ideal time to change the RMB exchange rate. Considering the inevitable weakening trend of the US dollar, the sooner the RMB appreciates, the more beneficial it may be to the Chinese economy. At the current US dollar interest rate and exchange rate levels, it is impossible for us to rule out the possibility of the RMB gradually relaxing the range of exchange rate fluctuations.