The prevailing narrative that China will export deflation abroad and push all other central banks to be more dovish is a classic example of wishful thinking.
There are plenty of reasons to be skeptical. There is no doubt that Chinese inflation is in a soft patch, but China is not in deflation and a surge of inflation pressures lies ahead that markets are not well-prepared for.
What sparked deflation talk is that Chinese consumer prices fell by 0.3% at an annual rate in July, the first drop since a brief spell in early 2021 and before that since the 2008 Global Financial Crisis. Lost in the discussion is that inflation quickly turned positive after those prior episodes.
There is a wall of worry about China. This is because of challenges in property markets, the shadow banking system and key export markets alongside an aging population, supply chain reshoring and high levels of general government debt that may limit flexibility alongside modest monetary stimulus to date.
These considerations will weigh on China’s economy in the years ahead as it seeks more balanced and domestically driven growth. But these challenges do not necessarily mean that the economy faces as dangerous a problem as deflation. Let’s get our definitions straight.
Most economists would define deflation as a sustained, economy-wide decline in a broad array of prices that affects behavior by postponing consumption and investment into periods when cheaper prices are expected to prevail. That can be a devastating spiral effect that is difficult for policy to turn around even if there is room to do so. Think the 1930s or, to a lesser extent, Japan over much of the past 30+ years.
“ Consumer prices are not widely expected to continue falling. ”
Using this definition, China is nowhere close to deflation. The drop in consumer prices in July was due mainly to year-ago base effects. In layman terms, there was a sharp increase in inflation in July 2022, so this year’s rate looks puny.
At the core level of inflation, the gain last month was the largest for the month of July in this century. Food prices helped keep down consumer prices in July. Excluding food, prices were flat. Excluding food and energy, consumer prices were up by just under 1%, which is soft but not falling.
A key missing ingredient to a deflation call is that consumer prices are not widely expected to continue falling. Consensus forecasts look for a return to 2% inflation next year. And inflation expectations are firm. The People’s Bank of China’s (PBOC) one-quarter-ahead urban depositors price-expectations index continues to indicate that only a small handful of consumers expect overall prices to decline. Ditto for house prices.
Absent reliable market-based measures of inflation expectations, China’s sovereign bond yield curve remains gently upward sloping across all maturities, likely reflecting term premia and implied levels of modest inflationary pressures.
Asset prices require monitoring, but so far there is little evidence of widespread and significant asset deflation. Resale and new house prices are roughly unchanged in year-over-year nominal and real terms; talk of measurement error behind worse declines is focused upon resales (not new homes) and select markets without controlling for compositional shifts.
Many countries have experienced similar house-price volatility without experiencing true economy-wide deflation, such as Canada’s 15% resale price drop until earlier this year alongside accelerating inflation.
Chinese equity indices are about 15%-20% off their 2021 peaks, which is a correction from the overshooting gains of 2019-2020. The Shanghai Composite
CN:SHCOMP
index remains about 2% higher so far this year and has a price-earnings ratio of more than 14.0, while the Shenzhen Composite’s
CN:399106
equivalent sits at about 35 times earnings and is flat year-to-date; neither of which can be fairly labelled as deflationary collapses.
Similarly, many countries have experienced stock-market volatility of such magnitude without triggering deflation; consider the S&P 500
SPX
over the years and the high incidence of equity ownership among American households.
Chinese economic leaders have enormous untapped room for applying stimulus should the deflation threat become real. The PBOC is among the rare number of major global central banks that have not embraced quantitative easing. It has ample room to lower its key policy rates and to inject liquidity.
A creative toolkit of unconventional monetary policy instruments has been explored in limited fashion over the years and if other central banks offer any guide, then it may be wise to err on the side of assuming that enormous policy flexibility exists.
Inflation soft-patch
Forward-looking indicators suggest that China is merely in an inflation soft-patch from which it will quickly transition into a hotter environment. For one, the yuan
CNYUSD,
continues to depreciate and is a cumulative 15% softer against the U.S. dollar
DX00,
since early 2022. Imports account for almost 60% of Chinese GDP and goods imports account for two-thirds of that. If history’s correlations and empirical evidence offer any guide, then this magnitude of depreciation could drive headline inflation higher by multiple percentage points into 2024 while stimulating exports and currency translation effects on earnings. Lagging effects will force Chinese consumers to pay more for a broad array of items.
Another driver of high inflation is likely to come from several key commodity prices as the economy moves into 2024, and not only through exchange rate conversion. Chinese consumer inflation swings over the years are often driven by relative commodity price movements.
One interesting twist: It’s clear that China is now capitalizing upon Russian oil discounts and undermining Western sanctions. The value of overall oil imports into China has moved sideways over the past year while the volume of imported oil has soared, implying lower overall imported oil prices despite increases in benchmarks like WTI
WBS00,
and Brent
BRN00,
This strategic stance is contributing to softer gasoline prices than a year ago and softer overall CPI inflation. This may free up disposable income to spend on items in the core CPI basket, and will eventually shake out of the overall CPI numbers.
So rather than a deflationary spiral, the opposite could be closer to the truth. Surging inflation may lie ahead into 2024, especially if the above arguments are accompanied by further yuan softness on Federal Reserve-PBOC policy divergence — let alone should tensions in the Taiwan Strait take a turn for the worse.
Derek Holt is vice president & head of capital markets economics at Scotiabank in Toronto.
Plus: Outlook for China’s property sector is grim, but it isn’t the only drag on its economy
More: Global investors expect China to deliver a massive fiscal stimulus. Here’s why it may never arrive.
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