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Investment Research

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General Market Conditions

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Consumer prices in May came in broadly in line with expectations at -1.4% y/y.

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While headline CPI is likely to remain in negative territory for most of this year, deflationis no major threat to the Chinese economy. Our forward-looking indicators all suggestinflation will pick up.

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With only a modest output gap, we expect the People’s Bank of China to tighten monetarypolicy in H1 10 and resume the gradual appreciation of CNY at some stage.

Details

Consumer prices in May came in broadly in line with expectations at -1.4% y/y (consensus:-1.3% y/y). Lower food prices and lower rent continue to be the main drivers behind the sharpdecline in consumer price inflation over the past year. However, the drop in food prices haseased because of a sharp increase in vegetable prices, while meat prices continue to easefollowing the surge early last year. Sequentially we estimate that consumer prices in Chinahave been increasing in recent months and hence the decline in headline year-on-year inflationis solely due to the base impact from last year.

Assessment & Outlook

Hence deflation should not be a major concern. Deflationary pressure is currently easingsignificantly and our forward-looking indicators suggest inflation should pick up and it cannotbe completely ruled out that inflationary pressure will re-emerge next year.House prices have increased in recent months, suggesting that the decline will soon end. Inaddition, energy and commodity prices have increased recently and the government’sliberalisation of some administered prices (water and energy) should add somewhat to inflationlooking forward. Finally, the recent extraordinarily sharp increase in money supply growth is astrong indication that inflation in China will pick up next year (see chart on next page).We expect consumer price inflation to remain in negative territory for most of this year(mainly due to the base impact from last year) and then increase substantially from early nextyear (see chart).

Implications

We are unlikely to see further interest rate cuts from the People’s Bank of China (PBOC).Despite the strong headwinds from the global economy, it appears that China has been able tomanage a soft landing of its economy. China’s output gap has only increased modestlycompared with the US and Europe (see chart on next page) and hence China will probablyhave to return its monetary focus on price stability before central banks in the US and Europe.For that reason we believe China will tighten monetary policy in H1 10 (possibly byreintroducing lending quotas). A modest output gap and continued need to contain inflation isour strongest argument for China at some stage resuming its gradual appreciation of CNYagainst USD.

10 June 2009

Senior Analyst

Flemming J. Nielsen+45 45128535flemm@danskebank.dk

Flash Comment

China: Negative inflation but deflation no concern

Consumer prices, May (% y/y)

Act Con DB LastCPI -1.4 -1.3 -1.3 -1.5PPI -7.2 -6.9 na -6.6

Source: Ecowin and Danske Bank

CPI inflation to remain negative until late 2009