Commodity Online
The tightening of monetary policy in China has impacted crude oil prices in the short term and looks likely to have further influence on oil prices upto 2011. Bank of America-Merrill Lynch(BofAML) has pointed out in an analysis that it estimates a 25 bps hike in the one year lending rate to bring down Chinese year-on-year oil demand growth by 1-2 percentage points.

BofAML’s Asian economics team expects only one moderate interest rate hike in the fourth quarter of 2010. This is partly because the US Federal reserve needs to keep USD interest rates unchanged for an extended period of time to help the ailing
economy. As a result, much higher interest rates in China would only encourage further hot money flows. Instead, an appreciation of the Chinese Yuan (CNY) would be a more effective way to manage the impending need for tighter monetary policy in China.

BofAML expects to appreciate to 6.7 by the end of Q1 and to 6.5 by the end of Q4. Arguably, lower export growth would typically feed negatively into economic growth in the mid-term, potentially creating negative feedback loops to oil demand growth in 2011. But an appreciation of the CNY in 1H10 would make USD-denominated oil prices cheaper in local currency, having a positive impact on Chinese oil demand in the short-run.

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BofAML analysis said the effect from a higher purchasing power will invariably outweigh the negative economic impact from a CNY revaluation, particularly in the short-run, suggesting that tighter money in China could be bullish for commodities.

China has started to tighten monetary policy
In a surprise move, the PBoC, China’s central bank, this week hiked the reserve requirement ratio (RRR) by 50bps. This followed an earlier policy decision to hike the interest rate at which 3-month bills are auctioned into the market by 4bps to 1.3684%. In a move to drain excess liquidity from the banking system, to control rising inflation expectations and to curtail potential asset bubbles, policymakers in China surprised the markets and tightened policy earlier than expected. This marks a clear inflection point from China’s previously super-loose monetary policy. Apparently encouraged by positive economic news with exports
bouncing back sharply to 17.7% yearly growth in December, China’s policymakers are now in liquidity withdrawal mode.

Excess liquidity growth has a tight relationship to commodities. A while ago, BofAML estimated that a 1% increase in money supply globally translates into a 1% increase in oil demand four quarters later. In China, loan growth of over 34% during the past six months fuelled car and housing sales as well as other durable good expenditures, all of which directly supported physical commodity demand .

The current liquidity trends in China have driven oil demand back to long-term growth trend rates. After slowing down sharply to an average of -2.8% yearly growth in 4Q08 and 1Q09 at the height of the economic crisis, total apparent petroleum product demand in China is now back up at 15% from the depressed levels of 4Q08.

This rampant liquidity growth made in China was a major driver behind the commodity price reflation experienced during 2009.