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Word on the forex grapevine is that China still has a bunch of tightening moves up its sleeve, as the Chinese government plans to shift from a “moderately loose” monetary policy to a “prudent” one.

Economic gurus are foreseeing four more rate hikes by next year, as well as further increases in the reserve ratio. Such aggressive tightening moves are aimed at draining excess liquidity and keeping inflation in check.

So far, the People’s Bank of China has already put quite a number of tightening measures in place. Way back in October, the central bank increased lending and deposit rates by 25 basis points in order to curb inflation.

This was followed by a couple of reserve ratio hikes in November, but it looks like China wants its monetary policy to be as tight as Conan’s jeggings!

What does the Chinese government hope to accomplish with these policies? To answer this question, let’s have a quick review of the monetary policy lesson in the School of Pipsology.

If you have been cutting classes in our forex school, here’s your chance to catch up!

Central banks usually use monetary policies to promote price stability and economic growth. These policies may come in the form of interest rate decisions, reserve requirements for banks, or even discount lending to commercial banks.

A restrictive monetary policy aims to slow down economic growth either by making borrowing costs more expensive or decreasing the money circulating in markets.

Meanwhile, an expansionary monetary policy aims to speed up economic growth using low interest rates and more money supply.

In China’s case, the People’s Bank of China is actively trying to cool down inflation. They’ve already decreased the money supply by stepping up the reserve requirement ratio for banks, and they’ve also made borrowing more expensive with interest rate hikes.

Now, just because China’s own currency, the yuan, isn’t as popularly traded as other currencies, it doesn’t mean these moves will have no impact on the markets. Because of the sheer size of its economy, China’s monetary policies tend to have a wide, rippling effect on the global economy.

There are many countries out there, especially those in close proximity, that is heavily dependent on China’s growth for their own economic development. Take Australia for example!

Australia is an export-oriented country whose exports amount to around 20% of its GDP. And guess who its largest importer is? That’s right! China accounts for over 20% of Australia’s total exports!

With numbers like that, it doesn’t take a genius to see that a growth slowdown in China can be damaging to the Australian economy, too.

Unfortunately, that’s exactly what may happen if China tightens its policies further. Should policymakers decide to tighten monetary policy knots in the future, it may cause economic activity in China to weaken and drain demand for Australia’s exports in the process.

This would definitely be a test of whether the Australian economy and its currency can keep from going down under, so I’d keep tabs on any updates regarding China’s monetary policy if I were trading the Aussie!