The slight increase to China’s consumer price index (CPI) August has raised speculation that the PBOC may increase interest rates in the near future. We do not think that this is likely, as controls on credit aggregates appear to be having the intended effect of slowing growth to new investment.
That said, there is still a lot of liquidity in the system, especially in the form of cash on the balance sheets of SOEs, and recent investment and output figures point towards stabilization to growth rather than a hard landing scenario. Nevertheless, a further deceleration to overall output growth is possible, and likely, in our view, and under such circumstances the PBOC will not raise rates. Households continue to tolerate negative yields on bank deposits, and the current state of affairs provides a nice subsidy to commercial banks at a time when they need to shore up capital.
The pace of increase to consumer prices is well above the target range set out by the NBS and various other agencies earlier this year, and above what we believe to be the political comfort zone of around 3%. However, this cycle of food-price driven CPI does not appear to be exceptional in the context of the past 5-years, and if anything is relatively mild compared to episodes seen in 2007 and 2008, for example.
The questions of when and at what level will China’s CPI will peak remain. Looking at sequential month-over-month data for food prices for August there are a couple of things worth noting. Assuming that prices for fresh fruits and vegetables will gradually deflate (and we do), the next wave of price increases will probably come meat and poultry. Consistent increases to grain prices, not to mention increases to basic agricultural producer prices generally, appear to be leaking down through the production chain, as raising expensive piglets translates into more expensive pork, for example.
This trend could be exacerbated by a weak autumn grain harvest, which we think is a likely outcome given a combination of meteorological and anecdotal data. But it could also be countered by a combination of administrative price controls and producer subsidies, which we also think likely. Still, agricultural producer price increases trickle down into the consumer economy directly, whereas excess capacity in the manufacturing economy ultimately protects households from significant price increases to consumer items.
Stripping food prices out of the consumer price equation, the overall trend looks mild in comparison to that leading into 2008, which, by the way, was also a food story at the time despite worries about overheating on the supply side. Year-on-year measures of growth to core and non-food consumer prices do not appear to indicate that we should expect overall CPI to break 4.5% any time soon, that is barring developments in the countryside above and beyond baseline assumptions.
On the supply side of the economy, growth to producer prices appears to have peaked. This is a major reason why we think it is unlikely that the PBOC will move on rates. If there was a time to raise interest rates it was about a year ago, and more generally there has never been much of a discernable link between the level of interest rates, growth and inflation in China.
Perhaps most notable in the chart below is the decline to the reported PPI for raw materials, an important measure of the extent of excesses in investment and output. With new investment project starts in China down this year on a net basis and various weak signals coming out of Germany, the US and Japan, raw materials prices are likely to remain subdued.
All in all the inflationary environment in China appears to be somewhat benign. Depositors with China’s commercial banks may not think so, but that is more of an interest rate problem than a function of spiraling consumer prices. People love to gripe about pricey bananas, cabbage and pork, but when the impact of price increases for daily food items are weighed against trends in prices for consumer durables, electronics, or heavily subsidized auto purchases, for example, their grievances are less compelling.
That said, low income households and retirees are not queuing up to buy appliances and new cars en mass, and with a political transition approaching in China the senior and aspiring senior leadership may well take steps to take some of the sting out of rising food prices. One such measure could be to raise rates paid on household deposits at China’s commercial banks so that they at the very least no longer lose money from not consuming, or in other words earn a negative return on their deposits once CPI is factored in.
This is unlikely, however, and the ‘producer biases’ in the form of cheap funds for state-owned commercial banks and state-owned borrowers still take precedence.
As we have noted elsewhere, we expect the credit controls that have been in place for much of the year to remain until at least the middle of Q4 until a combination of targetted industrial policy initiatives and the start of the 12th Five-Year Plan boosts new investment and project starts.
With this in mind, although the supply side inflationary environment looks relatively benign (relatively) at the moment, earlier data from the PBOC has shown the PRC’s output gap to be relatively narrow. A rebound in galloping investment growth and project starts could change the producer price situation relatively quickly when and if it were to occur. We are not there yet, however.
Disclosure: No positions