Deflationary Forces Build Up

Sebastien Callebaut -

Weakening Chinese Conditions

China's producer prices experienced a sharp decline, reaching their lowest level in over seven years in June. Meanwhile, consumer prices approached the brink of deflation, intensifying the need for policymakers to implement additional stimulus measures to revive sluggish demand. The deepening deflation in factory-gate prices, coupled with consumer prices moving closer to deflation for the first time since February 2021, paint a grim picture for China's economic growth.

  • China's momentum in the post-pandemic recovery has slowed down significantly since the robust rebound witnessed in the first quarter, with weakened demand for both industrial and consumer products. This raises concerns about the well-being of the world's second-largest economy.
  • "We think the more challenging deflation environment and sharp slowdown in growth momentum support our view that the [People's Bank of China] PBOC has entered a rate-cutting cycle" as stated by economists at Barclays

The National Bureau of Statistics (NBS) reported that the producer price index (PPI) declined for the ninth consecutive month in June, falling by 5.4% compared to the previous year. This marks the most substantial drop since December 2015, surpassing the 4.6% decline seen in the previous month.

Shaky Consumer Prices

The consumer price index (CPI) narrowly escaped a year-on-year decline, in contrast to the 0.2% increase observed in May. This stagnation was primarily driven by a more rapid decline in pork prices. It dashed expectations for a 0.2% rise and represented the slowest pace since February 2021. Nomura predicts that consumer prices may decline by 0.5% year-on-year in July, even after factoring in a potential increase in service inflation due to the summer holiday season.

  • The lower-than-expected inflation figures had a negative impact on financial markets, resulting in the depreciation of the yuan and causing Asian stocks to dip into negative territory.
  • "We expect headline inflation to rise to around 1% by the end of this year. But this would still be soft and won't constrain the PBOC's ability to loosen policy further" according to economists at Capital Economics.
  • They further added, "That said, with credit demand weak, and the currency under pressure, we think the bulk of support will come through fiscal policy. We expect only another 10 basis points of policy rate cuts this year."

Real Estate, Energy And Chemicals Driven Declines

Beijing has established a target of around 3% for average consumer inflation in 2023, following a 2% increase in prices year-on-year in 2022. Last month, China implemented policy rate cuts to enhance liquidity and pledged to adopt measures to stimulate household consumption.

  • In terms of producer prices, the most significant year-on-year declines were observed in energy, metals, and chemicals sectors as both domestic and foreign demand weakened.
  • Bruce Pang, chief economist at Jones Lang Lasalle, remarked, "The accelerating decline in PPI reflects the still weak real estate and construction sector as well as the strength of industrial production"
  • Hu Yuexiao, an analyst at Shanghai Securities, stated that China's central bank is expected to further reduce lending rates. He anticipates reductions in the reserve requirements ratio and interest rates during the second half of the year.

However, economists caution that minor rate cuts are unlikely to have a significant impact on loan demand, as households and businesses focus on repairing balance sheets damaged by the effects of the COVID pandemic and repaying debts. Consequently, Beijing will need to rely on fiscal stimulus and alternative measures to stimulate demand.

Exporting Deflation?

As the world's second-largest economy, the People's Republic continues to grapple with the lingering effects of the COVID-19 pandemic, teetering on the edge of deflation. But this is may bring some good news as the sluggish performance of China's economy could indirectly contribute to reducing inflation in the United States.

  • The consequences of China's economic situation, as the largest exporter and industrial hub globally, extend far beyond its borders.
  • With its weakened economy comes a devalued currency, resulting in cheaper exports for foreign buyers, including those in the United States.
  • Furthermore, if China's economic engine continues to sputter, the country will consume fewer raw materials, exerting downward pressure on commodity prices, which are key drivers of short-term fluctuations in consumer prices in the United States.

In a notable study conducted by economists from Germany's central bank, they highlighted the significant impact of Chinese supply and demand shocks on prices in other countries. This potential shift could revive inflation in raw materials and potentially alleviate the recent downward pressure on U.S. consumer prices.

Disclaimer

Please note that this article does not constitute investment advice in any form. This article is not a research report and is not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products. Please note that the writer of this article is not registered as a financial advisor.

Credits

Photo by Madison Kaminski / Unsplash.