Chinese Inflation Dropped Suddenly... Is Its Economy Slowing Faster Than Imagined?

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Includes: CHN, CN, CXSE, FCA, FXI, FXP-OLD, GCH, GXC, JFC, MCHI, PGJ, TDF, XPP, YANG, YAO, YINN, YXI
by: D. H. Taylor

Summary

In one month's time Chinese inflation dropped from 2.5% down to 0.8%.

The yuan continues to erode in value despite, or because of, higher interest rates.

The disconnect of inflation, interest rates and economic growth is telling that the Chinese economy may be slowing faster than imagined.

Chinese inflation dropped oddly last month; inflation fell from 2.5% to 0.8% year-over-year change. When I first saw it I figured it was a one-off. After all, how does inflation drop so precipitously in just a month's time? I figured that number would be revised upward. But, through the month I began asking myself when was the first time China revised any economic data? This month's inflation report came in with a reiteration that the inflation rate has indeed fallen as sharply as it has. Inflation is a demand driven indicator. If the inflation rate in China has dropped as quickly as it has this bodes poorly for economic growth. Chinese consumers in the World's #2 economy have come to a halt in spending. Also, this would bode poorly for base commodity prices if demand is dropping as quickly as it is. The economic world needs to start paying attention to what is going on in China. Very likely what happens there is going to affect what happens everywhere else in the world.

The world has known that China's economy is slowing down. But, that is relative. Chinese GDP is "only" growing at 6.9% year-over-year based on the latest economic release. Whereas a sophisticated economy would be fearful of growth rates at that level, a developing nation such as China would welcome that type of growth rate. However, that growth is coming mainly from debt.

This debt is burdening the economy a great deal because a lot of companies are not performing on their loans. This is weighing on banks. And, the Chinese government has insisted they are stepping in to clear out these so-called "zombie" loans. What the world is learning is that the real issue are loan guarantees from one company to another. These are hidden guarantees where one company co-signs loans for another company. If that first company defaults then the guarantee company is now on the hook and potentially could be taken over an economic ledge itself. These guarantees are quite large. No one really knows the absolute extent of them. And, with economic activity slowing as it is while at the same time the Chinese government is intent on cleaning out the dead loans from bak's books, the potential for this to be problematic and ripple through the economy is large.

There is another factor that is problematic with China, something that is finally being addressed. No one has much confidence in their economic data, not even the Chinese government. The problem is so bad that the government has created a task force to crack down on the false at a being reported. There is a real source of pride in regions. So, telling the world that your region is doing better than it actually is makes the region look better. But, the world is well aware of the fact that the data is questionable. Growth rates are not likely to be as high as they are. But, that also calls into question the inflation data. Is it really as low as what is being reported? After all, if you can fudge your GDP data you can fudge your inflation data equally. But, I will work with what the government prints.

The Chinese yuan is falling and has been for some time. The reasons are many-fold, and I have addressed a lot of them in other postings. There are extensive capital controls in China. Now, there are extensive loan controls that the government has put into place so that they can address real estate property bubbles occurring in major cities. Given the capital controls what Chinese nationals are doing is sending their money abroad to buy homes everywhere else in the world - Seattle and Sydney are two cities that have seen property bubbles and a fully altered real estate market due to this.

In the meantime, when you look at the massive drop in the yuan you can see the damage that is being done to the currency as Chinese nationals continue to send their money abroad:

But, here is what is odd to me: If the yuan is losing so much value then shouldn't base commodities become more expensive on a relative basis? The Chinese economy is far from consumer driven. Their economy is more export driven despite efforts by the government to steer the economy more towards inner, organic growth.

Here is another look at Chinese inflation versus the yuan and the disconnect it is having:

As you can see inflation just tanked whereas the USDCNH rate is steadily declining (Inverted chart). Generally, the two should follow each other.

Another indicator is the government's bond yield versus inflation. Generally, these two will follow suit. But, they are disconnecting:

While inflation is heading lower the government's benchmark interest rate is heading higher. Keep in mind that the government is making concerted efforts to limit capital availability and restricting banks and the money they loan. Money is becoming scarce. That will drive up interest rates. This is what is happening. I actually agree with this disconnect. It makes sense from the macro-perspective.

Despite how logical that is it will drive economic activity. As the government continues to clean out those bad loans businesses, and by consequence, jobs, will decline. The restrictions on money in the country are going to continue to limit loans. This will continue to drive the CNY lower as money flows out of the country looking for opportunities. As the currency continues to erode in value the pace of money leaving the country may steepen. As for base commodities, the world's second biggest economy is slowing down at a pace that is likely faster than economists are imagining. Base commodity prices will falter from this alone. They are, after all, the world's manufacturers.

I see continued protraction in the Chinese economy. But, eventually there will be a much greater pace of this. As for the government's interest rates the move higher is going to continue and may reach anywhere between 4.00% - 6.00%. This, while the economy contracts. Inflation is just another key indicator of what is truly happening in the world's #2 economy. It is slowing. And, given the pace of the drop the economy is slowing faster than the world imagines.

Disclosure: I am/we are short CNH, CNHS, (LONG USDCNH).

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.