From Deflation To Reflation

| About: iShares China (FXI)

By Robin Anderson, Ph.D., Senior Economist, Principal Global Investors

If there's one statistic that symbolizes the tremendous amount of excess capacity globally and, in turn, its deflationary impact on prices, it would be the Chinese producer price index (PPI). Looking at year-over-year changes, Chinese producer prices have been declining for the past 54 months.

Since the end of the 2008 global financial crisis, China has overinvested in industrial goods. The Chinese government has poured money into its industrial sector to buoy overall economic growth, and that over-investment has resulted in supply gluts of everything from paper to cement. For example, a February 2016 Economist article showed capacity utilization rates, which compare actual output to how much can be produced, falling sharply for a broad range of industrials over the last seven years.

There's no doubt that the sheer scale of China's industrial sector is staggering. Just take a look at one statistic that got a lot of attention a few years ago. China produced more cement from 2011 to 2013 than the United States did in the entire 20th century. Here's another statistic: according to the Wall Street Journal, by 2020 Shanxi province's excess power capacity will be equivalent to Turkey's power grid as of 2011. That's right; by 2020, one province in China will produce the same amount of power as the country of Turkey!

Indeed, too much supply from all this productivity capacity has forced producer prices down sharply. Oversupply of commodities globally, which came about as a reaction to the Chinese demand-driven run-up of commodity prices in the 2000s, also forced prices down. In fact, according to the Royal Bank of Australia, about half of the drop in Chinese producer prices from 2014 to early 2016 came from the collapse in commodity prices. Declining producer prices have delivered a one-two deflationary punch in China's industrial sector - with lower prices, revenues and profits go down and lower prices make current debt harder to pay off.

Nevertheless, the long slide of producer prices may soon be ending. Producer price deflation seems to have bottomed earlier this year at -5.3% (in year-over-year terms) and has sequentially improved up to -0.8% as of August. The rebound in commodity prices explains a lot of the gains in producer prices. A weaker Chinese yuan helps too. There are also some tentative signs of inventory reduction. JPMorgan (NYSE:JPM) analysts estimate finished goods inventories dropped 12.7% in the second quarter on a quarter-over-quarter annualized basis.

Improving producer prices are helping to reflate the Chinese economy. With higher prices, company revenues and profits are increasing. In fact, industrial profits were up at the fastest pace in three years last month (up 19.5% year-over-year). Nominal growth is up as well. According to calculations from the global research firm GaveKal Group, nominal growth of the secondary (or industrial) sector has increased from 1% to 6.1%, overall nominal GDP growth increased from 7.1% year-over-year to 8.2% from the first to second quarter. Higher prices will help moderate the size of debt burdens too, which is particularly meaningful for the industrial sector, where a lot of analysts believe the most recent rapid rise in debt accumulation is centered. Over the long run, there are still plenty of imbalances in the Chinese economy, but the reflation of industrial prices does provide some near-term relief.