The central bank is likely to raise interest rates to stave off inflation if the US Federal Reserve (Fed) increases its rates in the second half, despite the mainland's declining economic growth, Barclays' economists say.

Barclays projects a 27 basis-point rise in the benchmark bank's lending and deposit interest rates, from 7.47 percent and 4.14 percent, if the Fed raises its rates by 50 basis points later this year.

Meanwhile, it expects the People's Bank of China to continue managing bank liquidity, in part by raising the reserve ratio by at least 50 basis points in the third quarter.

"However, we do not assume the Chinese mainland will adopt aggressive policy tightening in the near term in order to avoid the flow of hot money speculating on the higher interest spread," Barclays' head of China research Peng Wengsheng said.

The bank projects an annual average inflation of around 7 percent in 2008. That's taking into account the impact of fuel and electricity price adjustments, a stabilization in food prices, and given that inflation eased from 8.2 percent in April to 7.7 percent in May.

Barclays Head of Emerging Asia Research Peter Redward estimates that the Chinese mainland's economic growth is expected to slow down this year to 8.8 percent from 2007's 11.9 percent. He said fewer exports, weakening global demands, and rising cost pressures from energy and wages will all factor in the drop.

Similar to the US, the mainland is trying to launch policies that don't have a drastic impact on the economy, while at the same time trying to combat soaring inflation. The mainland's stock market has been struggling amid investor concern about the micro-tightening policy, economic slowdown and inflation.

"The chances of the government launching measures to boost the A-share market are big, as the government doesn't want to see the market keep dropping," Peng said, noting that the current valuation appears reasonable.

"The balance sheets of big Chinese companies are still healthy, but the impact of greater cost pressures will gradually be reflected in SMEs," he added. "The macro-economic factor will remain the determining factor in the stock market, as investor confidence won't pick up until the CPI peaks."

Redward believes that the price of oil is unlikely to drop in the short term and said it may top $170 a barrel. He said the investment bank's commodity team is very bullish on energy, although its price target is yet to be reviewed.

"Under this economic backdrop, there is an increasing chance of stagflation in Asia," Redward said, noting that clear direction in global equities won't materialize soon - not amid downward pressure from inflation.

"Surging oil prices will erode some Asian countries of foreign exchanges, such as South Korea and India," Redward said. "Meanwhile, we will see a food-price hike in Southeast Asia, which may cause political issues."

(HK Edition 07/05/2008 page2)