China: Disinflation is back
Looking forward, inflation may get a lift during the Lunar New Year holiday in January-February. The risk of disinflation, however, has risen for the medium term on the following reasons:
• Weakening growth momentum: Both the official and Caixin manufacturing PMIs contracted in December. Faltering demand has weighed on factory prices. The prices of raw materials and manufactured industrial inputs slid over the course of 2018. Also, consumer confidence has been sapped by job insecurity and slower wage growth. That was evident by the across-the-board drop in discretionary goods spending from cosmetics to automobiles (Chart2). Fading credit impulse on the back of regulation tightening points to persistent weaker consumption (Chart3) that will dampen non-food inflation.
• Slumping energy prices: The fall in oil prices during Q4 reflected weaker demand in the global economy. Even output cuts by OPEC could not reverse the trend. Apart from China, growth has also slowed across major advanced and emerging economies. Real GDP in Germany and Japan contracted quarter/quarter in Q3. Yields on 5Y US Treasury notes fell below 2Y and 3Y notes last month, a development that heralded past economic recessions. Fuel demand as a result is likely to remain tepid amid gloomy outlook. Oil-related inflation in China (such as motor-fuel surcharges) will continue to trend downward. By our estimation, a 10% decrease in oil prices could drag China’s headline CPI inflation by 0.2 percentage points.
• Import price inflation pressures has eased: Import price inflation surged to 10.4% YoY in October from 2% in May on a sharp CNY depreciation (Chart 4). PBoC’s tougher currency management in November has since helped to stabilize USD/CNY around 6.85-6.95, as evidenced by the fall in the CNH 1M risk reversal to the lowest since May 2017. Demand for bearish options wagers remained weak despite last Friday’s announcement to lower the banks’ reserve requirement ratio (RRR) this month. A more stable CNY, coupled with Beijing’s plan to “reduce and remove” tariffs on American products, would help to cool import prices.
Deflationary expectation, when entrenched, is not positive for consumption. Sliding factory prices will further erode corporate profits and weaken the debt repayment ability of indebted companies. Authorities will, in our view, become increasingly aggressive in rolling out stimulus measures. The RRR cuts in the coming weeks are just the first steps to cushion the economy. We expect two more reductions in the RRR alongside reverse repo rate cuts later this year.
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