DJ Forex Focus

With China showing signs of turning off its economic turbo jets, the chances for a dollar rally are improving.

The importance of any shift in Chinese policy was illustrated early last week when just market talk of fears of an asset bubble sent international investors fleeing for safe havens.

It took an explicit reassurance from the Peoples' Bank of China later in the week that interest rates aren't going up to lure the investment community back into risky assets.

The problem for investors is this: China is pivotal for the global economic recovery.

However, Beijing is nervous that the massive lending it undertook in the first half of this year is overheating its economy and creating an asset bubble in stock markets across the region.

Any hints that the Chinese authorities are about to put their foot on the monetary brake have led to an immediate shakedown in global financial markets as investors lose confidence and pull out.

The last thing they want to hear at this stage is that China's growth will slow and that the global economic recovery is at risk.

Nevertheless, indications are that while the PBOC might leave monetary policy alone for now, Beijing is turning down the fiscal fuel jets that helped to achieve massive 8% growth in the first half.

As much as $1 trillion, or the equivalent of 22.5% of GDP, was poured into the Chinese economy in the first six months. Reports suggest this turbo charge is now being cut off, with new data showing that July bank loans were down at CNY500 billion from CNY1 trillion in June.

"This sort of data could raise fears that the clamps have been put on lending to such an extent that economic recovery could be crimped," warned Steve Barrow, senior currency strategist with Standard Bank in London.

If this happens and investors feel the global recovery is being put in jeopardy, risk aversion will return and the safe-haven dollar will once again find itself back in favor.

Developments in China could also be helping the dollar in other ways.

As last week's Sino-American summit showed, Beijing appears to have dropped the whole issue of reserve diversification for now and its appetite for U.S. assets appears as strong as ever. Although the auctions of two-shorter-dated bond auctions earlier in the week were disappointing, a seven-year auction on Thursday proved that demand from overseas central banks hasn't diminished.

Dollar-favorable flows are coming from Chinese equities as well. According to Neil Mellor, a senior currency strategist with Bank of New York Mellon in London, his bank's iFlow data suggest a marked reduction in foreign investment in Chinese stocks over the last month.

This will slow the build-up of dollar reserves and reduce Beijing's need to diversify into euros.

Mellor suggested this might well explain the failure of the euro to make much headway against the dollar in recent weeks despite the overall market improvement in risk appetite.

Early Monday in Europe, disappointment that last Friday's U.S. GDP figures were not quite what they seemed left investors showing little interest in pushing currencies one way or another. Although the GDP data showed the economy shrinking by only 1.0% in the second quarter, consumer spending fell during that period by 1.2%, compared with a 0.6% rise in the first quarter.

At the same time, however, expectations for the Institute of Supply Management manufacturing survey later in the day are high, with forecasters looking for rise to 46.5 from 44.8.

By 0645 GMT, risk appetite had slumped enough to push the euro down to $1.4240 from $1.4255 late Friday in New York, according to EBS.

Earlier, the euro had risen to a two-month high at $1.4310.

The dollar was flat at Y94.66 while the single currency fell to Y134.84 from Y134.95.