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Analysis: Further tightening months away

By SONIA KOLESNIKOV-JESSOP, UPI Business Correspondent

SINGAPORE, Dec. 13 (UPI) -- The latest inflation data in China point that further tightening in monetary policies are now at least months away and that the impact of the administrative tightening measures that started in the second quarter is filtering through.

In November, China's Consumer Prices Index dropped to 2.8 percent year on year, from 4.3 percent year on year, a "surprising moderation," economists noted.

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The softening of inflation was driven by food prices once again, which account for over 30 percent of the CPI basket. Food prices fell 1.2 percent month on month due to a bumper agriculture harvest. On an annual basis they grew 5.9 percent, down from 10 percent in October. The year on year inflation rates of most manufacturing and service items were largely unchanged. Core inflation (excluding food prices) dropped a bit to 1.2 percent year on year in November from 1.3 percent in October.

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Hong Liang, China Economist at Goldman Sachs believes the fall in CPI inflation reflects the lagged effects of the administrative tightening which started in the second quarter of 2004. "Therefore, with the recent ease in inflation any further tightening measures, we believe either administrative or a rate hike, will be off the table in the near term," she said.

This sharp moderation in inflation will delay any further tightening measures until evidence of overheating re-emerges, added CSFB chief Asia economist Dong Tao. "Given that the government's tone to its tightening initiatives favored maintaining the status quo at the Central Economic Working Conference, we expect no immediate policy changes, which should boost confidence among leaders in Beijing," he said in a research note.

CPI was not the only inflation surprise. Producer Prices Index (PPI) Inflation also slowed to 8.1 percent year on year in November from 8.4 percent in October and economists said this should help ease any central bank concern that PPI may spill over to CPI.

"As the pass-through from producer goods inflation to CPI is only 20 percent, according to our calculation, and the PPI is likely to edge lower on weakening oil prices, we become even more confident that next year's average CPI will not be significantly higher than our forecast of 3 percent," noted Jun Ma, economist at Deutsche Bank.

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This dual easing inflation will takes off pressure for significant rate hikes. Ma said the latest inflation reports "provide a stronger argument for stable macro policies and against any drastic rate hikes and additional administrative tightening next year."

But while economists were surprised by the magnitude of moderation in food inflation, several noted it may be premature to conclude inflation had peaked and therefore this was already the end of tightening.

"While the peak in food inflation looks to be behind us now, we see many

new sources of future inflation, like oil/commodities, rents, wage, and education/health care. These new contributors to inflation are likely to overtake food inflation in the first half of 2005 amid a reacceleration in growth and investment," Tao said.

Further inflationary pressure lay ahead in 2005 as China's economy remain vulnerable to an oil-induced inflation shock, some analysts argue, pointing that the country, as an emerging economy, is not yet energy efficient and also lacks a strategic oil reserve.

One important factor restricting the inflationary impact at present is the price of petrol at the pump in China is administered, and the authorities have been careful to limit the rise over the past few months. However, firms must buy oil on the market, where prices are linked with world prices, and the strong rise in oil prices will eventually filter at the pump.

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The Chinese authorities appear well aware of the danger of oil prices over food prices for inflation.

In the November 15th issue of Caijing Magazine, Zhou Xiaochuan, governor of the central bank, sounded a cautious note about the possibility that inflation was still a danger. Though he did not give anything away about the future course of interest rates and was careful to balance his comments, he did spend much of his time talking about inflationary factors, pointing to the importance of PPI and labor in considering future inflationary trends.

Zhou pointed to global factors like oil, other key raw materials and transportation costs in influencing inflation in China.

"We think it was significant that Zhou chose to emphasis these factors. He did not, like much analysis in the market at present, emphasis the dangers of deflation. He did not dwell on price falls in consumer goods in China, nor did he make much of food price rises as the factor driving the CPI rises," wrote Stephen Green, senior economist at Standard Chartered in a recent research.

The People's Bank of China raised its rates for the first time in nine years in October. While the hike was a very modest one, it had a significant psychological impact on the market, as many had through the political leadership had ruled it out.

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Rates are still likely to rise further, but any easing of the oil price would limit the extent and the pace of any tightening.

"Falling inflation is comforting news for the financial markets though it is unlikely to move the central bank away from tighter monetary policy," said Tim Condon, economist at ING Financial Markets. |However, we believe it will make way for a prudent tightening next year from proactive tightening this year," he added.

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