A reversal of loose-monetary policy cannot in itself be positive for commodity markets. With demand in OECD economies falling off a cliff at the height of the economic and financial crisis, Asian demand from China and India was able to absorb the excess barrels. As the demand recovery in the United States and in Europe, particularly outside heating oil, is still lagging, OPEC keeps on sending its barrels eastwards. Likewise, Chinese imports of industrial metals are still growing at very strong rates, supporting global demand growth which outside China is anything but inspiring.

If this liquidity were to be withdrawn quickly and sharply, the marginal buyer could disappear, and spare production and refining capacity could quickly depress spot prices and weigh on timespreads. In fact, in response to the news of tighter monetary policy in China, commodity prices sold off sharply across the board.

Still, the Chinese move needs to be put into context. First, liquidity growth is coming down from excessive and unsustainably high levels. Although declining in December, loan growth and M2 are still expanding at a rate of 31.7% and 27.7 Loan growth of over 34% during the past six months fuelled durable good expenditures, supporting physical commodity demand.

China loans and durable goods sales YoY growth
To put the RRR hike into perspective, new loans equaled RMB9.6 trillion last year and the current 50bps hike is equivalent to a drain in liquidity of RMB250 billion. Moreover, during the first week of January, Chinese banks extended an alarming RMB600 billion in new loans. Further credit tightening can be expected in coming months.

Second, FX reserves just climbed to $2.4 trillion in December and hot money
inflows have grown at $15 billion since September, both of which support a strong liquidity momentum in China. Third, tighter monetary policy will help bring the raging Chinese economic growth on a more solid and sustainable footing and counter potential asset price bubbles, particularly in the housing sector. Fourth, while our economists expect continued hikes in the RRR, this does not equate to an outright hike in the interest rate, but rather forces lending institutions to keep more cash on their balance sheets.

No RMB interest rate hikes on the cards before 4Q10
Near-term hikes in the deposit and lending rates can effectively be ruled out. Higher money rates, already significantly above those in the developed world, would only encourage further speculative hot money flows into the country. In other words, monetary policy is contagious and the US Federal reserve needs to keep interest rates unchanged for an extended period of time. Hence, the probability of a near-term interest rate rise in China is low. Our Asian economics team expects only one 27bp hike in the deposit rate and one 18bp hike in the lending rate in 4Q10.

Interest rate rises to have a negative impact on demand
A CNY revaluation is likely on the cards much earlier While conventional monetary policy tightening might not yet be on the cards, BofAML strategists adhere to the view that China will allow greater currency flexibility in 1H10, before any real monetary tightening.

A stronger CNY could boost oil demand in the short-run
What is the impact of a revaluation of the CNY for Chinese oil demand? In the short-run, the net effect of a currency revaluation could well be a surge in commodity imports, as the purchasing power of China’s consumers is enhanced through a stronger currency. Put simply, an appreciation of the CNY will make USD-denominated oil prices cheaper in local currency.

An export slowdown could feed negatively into oil demand
Over the medium-term, a revaluation of the semi-managed peg will be an attempt to slow down excessive export growth and reserve accumulation. Lower export growth would typically feed negatively into economic growth, potentially creating
negative feedback loops to oil demand growth. Historically, Chinese oil demand has been largely correlated with exports growth . Thus, while the short-term impact of a CNY revaluation on oil demand is likely positive due to an expansion in domestic consumption, it could reduce the pace of export growth. In BofAML analysis, the 2% appreciation of the CNY in 2Q05 is somewhat illustrative of what we are likely to see in the future. Following the three years post the revaluation,
Chinese exports grew more slowly at 26% pa and so did oil demand (6% pa), relative to the three years prior to the revaluation (34% and 11% pa, respectively)

But it will put China’s economic growth on a more sustainable path. While slowing down the economy is hardly constructive for oil demand, it lays down the foundation for a more sustainable mid-term growth path. The combination of higher purchasing power with a sustainable pace of economic growth geared towards domestic demand is supportive of Chinese oil demand.

China will likely choose to tighten money via FX, not rates
More importantly, an appreciation of the CNY is likely a better and more effective way to manage the impending need for a tighter monetary policy than to implement a set of steep interest rate hikes. While theoretically the impact of a CNY revaluation on Chinese oil demand growth is not clear, the data do point in a clear direction. On our econometric estimates, the impact of a CNY revaluation on Chinese oil demand growth will be decidedly positive (and significant), and so the effect from a higher purchasing power will invariably outweigh the negative economic impact from a CNY revaluation, particularly in the short-run.

China is leading growth and monetary exit strategies
Interestingly, after leading the global economy out of a recession, China is now also leading the Asian central banks in their exit strategy. This could encourage other central banks, like India, Korea, Singapore and Indonesia, to consider tightening policy as well. This should have positive feed-through to Asian currencies in general by increasing the purchasing power of domestic consumers in the Asian region, supporting Asian commodity demand.

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