Mainland officials surprised investors by raising the electricity prices for the second time in two months, while the market did not expect anything until after the Olympics. The prices were raised by an average of 0.02 yuan per kwh or approximately 5 percent in the wholesale sector. However, the retail prices remained untouched.

The influence of price control policies highlight the current slow transition from upstream to downstream inflation which keeps higher costs from hitting consumers and businesses. Nevertheless, China's exports have slowed significantly as external demand weakens. An Organization for Economic Co-operation and Development (OECD) leading indicator, which is strongly correlated with and tends to have a six-month lead over China's export growth, suggested further downside in the coming months. Furthermore, cumulative yuan appreciation of more than 20 percent against the US dollar since July 2005 has also been blamed as a key factor in weakening the export performance.

Against this background, we have argued that the government's macro policy should change and help its exporters handle the difficulties. Hence faster yuan appreciation has been questioned, and arguments were raised over whether depreciation in yuan is more appropriate in helping local exporters in the short term.

Although faster currency appreciation can fend off some external inflation pressure, inflation is set to ease on a base effect as well as falling food and energy prices which can provide rooms for slower currency appreciation.

Easing inflation should create rooms for energy price normalization, and gradually realign domestic fuel prices to international levels.

Furthermore, energy price normalization is likely to replace currency appreciation for growth rebalancing effort in the coming periods.

Currency appreciation directly hits the wider export sector, especially small, inefficient, low-valued and labor-intensive manufacturers, which are likely to be forced out of the market as a result, leading to job losses and further economic slowdown. However, energy price normalization directly affects inefficient and energy-intensive sectors as higher costs of energy inputs squeeze profit margins.

Both currency appreciation and energy price normalization can help address underlying imbalances in the economy, but under the current circumstances of weakening global growth, energy price normalization is likely to have the least negative impact on the economy among the two options.

The author is director of Convoy Asset Management Limited

(HK Edition 08/26/2008 page3)