At the recent CPC Political Bureau meeting, the Chinese government changed its top-priority macro policy.

Instead of "tightening to prevent the economy from overheating and controlling inflation", the focus will be on "maintaining steady and fast economic development and fighting inflation".

The shift in policy shouldn't come as a surprise to the market, as China's economy is taking a hit from the global economic slowdown and rising inflation.

Combining the effects of the yuan's annualized appreciation above 10 percent, significant tightening in monetary policy and multiple hikes in reserve ratio, the economic growth slowed to 10.1 percent in the second quarter - back to the level in 2005. And inflation reached 8.7 percent in February.

Therefore, this policy shift is necessary in order to maintain long-term prosperity in China. Furthermore, we are seeing senior government officials visiting industrial areas to express their concerns regarding the small- to medium-sized enterprise (SME) sector, which suggests the policy shift is prominent.

Although the meeting didn't mention the direction of the interest-rate policy, we expect the interest rate will be maintained at this level.

Firstly, the inflation is showing signs of slowing. Since the peak inflation in February at 8.7 percent - even after the May earthquake in Sichuan, where approximately 7 percent of China's agricultural products are produced - the inflation is slowly moving into a downtrend.

Secondly, commodity prices are coming down. Crude oil has retreated from $147 to $123 a barrel (as of yesterday), which should soothe the inflation concerns for the rest of the year if the oil price continues to come down.

Thirdly, the global economic slowdown is starting to affect the SME sector, meaning further monetary tightening in both interest rate or reserve ratio will put enormous pressure on them. On the other hand, the interest rate is unlikely to be cut, as inflation is still a major concern and remains significantly above the government's target of 4.8 percent.

Furthermore, an interest-rate cut will signal a major slowdown in the Chinese economy, which could cause further market jitters.

As for the exchange-rate policy, the pace of appreciation in the yuan could slow sharply in the months ahead because of the government's efforts to stimulate economic growth. In fact, a marked change in behavior appears to have emerged in the performance of USD/CNY since the middle of July.

Alongside reduced turnover in the foreign exchange market, it is noticeable that spot USD/CNY has moved to trading in a relatively tight range. Combined with the slowdown in the US, currency appreciation is expected to be stagnant. As a result, a slowdown in the growth of the nation's foreign reserves - currently at $1.8 trillion - as the reduced promise of currency appreciation will see a significant decline in hot-money inflows.

However, other key points in the arrangement included: speeding up economic restructuring and the transition of growth patterns, intensifying efforts to save energy and cut emissions and improving people's living and promoting post-quake reconstruction. All of those involve government spending.

With such a high foreign reserve, China is more than capable of achieving all that and being able to maintain decent economic growth, even in a global-slowdown environment.

The author is director of Convoy Asset Management Limited.

(HK Edition 08/05/2008 page3)