China tightening to weigh on commodities

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20 Nov 2010

comodities_perfect.jpgSteps to curb inflation in China could further dampen a sharp rally in commodity prices this year. Speculation that a rate move could be just around the corner grew after an official Chinese newspaper suggested that Friday could be a convenient time to raise rates before banks settle accumulated interest on the 20th day of the month, and Chinese Premier Wen Jiabao emphasized that his government is preparing steps to tame price rises.
With inflation running at a 25-month high, raising interest rates or taking measures to cap domestic prices could constrain commodity demand or drain liquidity from markets.
The following scenarios look at what might happen and the potential impact on China's commodity markets.
China raises interest rates again
 The People's Bank of China (PBOC) surprised the world with its October interest rate hike, the first since December 2007. But it did not close the gap between interest rates and inflation and it did not stop a rally in China's commodity futures markets.
Most investors are now asking "when" rather than "whether" interest rates will rise again.
But China runs a risk if it presses the trigger too soon: so far, China has front-loaded its monetary tightening, striking before the market expected it to do so.
Having played one ace, the PBOC may be wary of using another before it needs to, in case speculators flock back to the market, sensing a lull.
Beneath the froth of liquidity, China's fundamental demand for most commodities is expected to stay strong, which would help support underlying prices.
"The government realises they have massive demand that will keep prices under tension. There must be a heightened level of concern after CPI data," ANZ's senior commodity analyst, Mark Pervan, said.
The government has said it aims to increase supplies of commodities and to crack down on hoarding, sending a message that it aims to prevent speculators from exploiting the situation.
Under a tightening scenario, analysts expect markets like rubber and zinc, which have seen significant inflows of speculative money, to fall hard, while markets like copper, which have a more solid fundamentals underpinning them, may hold up better.
Foodstuffs are likely to be hardest hit, highlighting Beijing's focus on consumer inflation.
In recent months, analysts have blamed excess liquidity for pushing up commodity prices across the board, but especially cotton , sugar and rubber .
Rising prices for agricultural commodities such as soybeans , corn and wheat have also prompted farmers to hold onto their crops after the harvest, restricting supply and giving prices another upward push.
The feed-through into food prices, which make up one third the inflation basket, and the risk of civil unrest is likely to be a much bigger concern for policy makers than the danger of boom and bust caused by speculative funds in the market.
China raises RRR again
 The PBOC has already tightened banks' balance sheets four times this year by raising their required reserve ratios (RRR). This makes it harder for them to lend but doesn't touch other sources of money supply, such as the revenues from China's trade surplus or the savings that ordinary citizens have squirreled away.
The increases in reserve ratios have had little impact on commodity prices this year after the initial shiver following each tightening move. Many investors have chosen to see such measures as shoring up economic stability rather than worrying about the short-term fall in liquidity and the potential impact on demand.
But even if raising reserve rations has had little impact on commodity prrices, it sends a signal to the market that the government is intent on draining excess liquidity whenever possible.
China does no more tightening but keeps the fear alive
China's central bank may not need to actually tighten monetary policy. Just talk of a rate rise may be enough to chase off speculators for now.
The PBOC has already flipped most economists' forecasts. Before its latest hike on Oct 19, most economists were not expecting any movement on interest rates until 2011. Now many expect another move to come before the end of 2010.
Having created that buzz, the PBOC might even decide to keep its powder dry. Just talk of an impending interest rate rise sent commodity futures tumbling to their daily limits on Nov 12.
Although the rumour proved unfounded, many futures contracts have fallen since then, making it a bigger success in turning around the market than the actual interest rate rise on Oct 19, which barely put a dent in many commodity prices before they continued their upward march.
In the longer term, chasing speculative money out of the agricultural commodity markets could also help bring down food prices, but it risks attracting complaints about the freedom of China's financial markets, a sensitive topic for the government.

Source: Zee News

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