While leading indicators in June showed continued moderation in economic activity, near-term inflation risks remain significant on the mainland.

The National Bureau of Statistics (NBS) manufacturing PMI posted a greater-than-expected decline in June, falling to a 28-month-low of 50.9, versus a market consensus of 51.5, from 52.0 in May and 52.9 in April. Headline PMI dropped 2.1 percent month-on-month, compared with a 3.3 percent decline in June 2010.

The other two leading indicators also painted a similar picture, with the HSBC PMI falling close to the expansion/contraction threshold of 50 (50.1 versus 51.6 in May), and the MNI business sentiment survey dropping to 57.8 from 61.2 in May.

Overall, the June leading indicators show continued moderation in economic activity. The PMI production index fell to 53.1 from 54.9 in May and 55.3 in April. The pace of softening in domestic demand likely was faster than expected, as suggested by the consensus forecast, and warrants close monitoring.

The PMI new orders index declined to 50.8 from 52.1 in May, and the import index dropped below 50 for the first time in 10 months, falling to 48.7 from 50.5 in May. The new export orders index also fell to 50.5 from 51.1, in line with the expected weakness in external demand. Continued inventory adjustment can also be seen in the further decline in PMI raw materials inventory index, possibly on expectations of lower prices ahead.

The input cost sub-indexes point to a possible easing in pipeline inflation. The NBS PMI input cost index declined to 56.7 from 60.3 in May, and the MNI input cost index slipped to 66.3 from 68.8 in May.

However, the near-term inflation risks remain significant, in my view. Domestic food prices surged in June, and I forecast June CPI inflation likely increased 6.1-6.3 percent year-on-year (YoY) during the month. High-frequency data show meat prices increased 46 percent YoY and egg prices 25.5 percent YoY. Moreover, crude oil prices rebounded quickly after declining initially in response to the IEA's announcement that it would release 60 million barrels of oil from its emergency stockpiles.

Credit availability remains tight in the country, with a rising cost of capital in unofficial markets (outside the banking system), especially for small and medium-sized firms, as suggested by MNI credit availability and interest rate indices. Moreover, the seven-day repo rate breached 9 percent on extremely tight inter-bank liquidity conditions following the reserve requirement ratio (RRR) hike on June 14.

The People's Bank of China (PBoC) has guided central bank bill issuing rates higher at two consecutive auctions, eg, the one-year central bank bill rate rose 19 basis points, to 3.4982 percent from 3.3058 percent, which is viewed by markets as a sign of an imminent rate hike.

I maintain the call for one more interest rate hike in 2011, likely in early to mid-July, around the release of the June CPI and GDP data for the second quarter on July 15.

The author is vice-president and China economist at Barclays Capital Asia Ltd. The opinions expressed here are entirely her own.

(HK Edition 07/05/2011 page2)