DJ Forex Focus

Ignore China at your peril.

Global financial markets are itching to celebrate the end of the global recession. Western stock markets have been pushing higher. Talk of interest rate rises has returned and some high-yielding currencies, such as the Australian dollar, have pushed to new highs for the year.

However, Beijing is about to stop the party.

Chinese officials have long made it clear that they are keen to calm China's overheated economy. Sure, strong Chinese growth has been instrumental in helping the rest of the world recover, but now, the risks of a hard landing for China are too high.

Beijing has already been trying to massage its stock markets lower. Since it reached a new, record high earlier this month, the Shanghai Composite Index has fallen about 12%.

Early Monday, the index had fallen another 5%.

The decline accelerated at the end of last week on reports that the government will call a halt to new steel industry startups for the next three years - another measure aimed at curbing the country's relentless economic expansion.

For the moment, the authorities are still avoiding the most obvious method of slowing down growth - tightening monetary policy and reducing liquidity.

The need for such a move is certainly growing. During the first half of this year lending by Chinese banks reached a record high CNY7.37 trillion ($1.1 trillion), well above the government's own target of CNY5 trillion.

This rampant lending not only fueled the stock market rally but now poses an increased risk of bad loans to the financial sector.

However, Hans Redeker, head of global foreign exchange strategy at BNP Paribas in London, doesn't expect Beijing to slam the lending brakes on either through an increase in bank reserve requirements or higher interest rates until October, once the 60th anniversary of the People's Republic proclamation is over.

In the meantime, Redeker suggested, "the Shanghai stock market will be the canary in the coal mine."

The canary certainly stopped singing last Friday, when the composite index fell 3% reversing much of the optimism that had been swirling around global financial markets after both Germany and France reported unexpected gross domestic product growth in the second quarter and futures markets started pricing in a rise in Australian interest rates before the end of the year.

Of course, not all markets were listening. European stocks carried on their merry way, adding to previous gains. However, both the high-yielding Australian and New Zealand currencies were quickly dragged back down from their new highs as investor appetite for risk once again started to fade.

Analysts such as Redeker say that the Australian currency may well have now seen its top. And, now that the canary has probably stopped singing, it will head back down against the dollar.

Early Monday, global sentiment is being undermined not only by tumbling Chinese stocks but also by the news over the weekend of the collapse of Colonial BancGroup Inc. in the U.S., the fifth-largest bank failure in U.S. history.

This came after more disappointing economic news from the U.S. including a sharp fall in consumer prices that will reduce any expectations for a rate rise.

Japanese GDP data showing 0.9% growth in the second quarter failed to help the market's mood as the main focus was on a decline in capital expenditure.

By 0645 GMT, the dollar was down at Y94.53 from Y94.83 late on Friday in New York. The euro was down at $1.4135 from $1.4190 and at Y133.63 from Y134.53.