Unconventional wisdom: ChinaÆs deflation risk

The view that China is exporting inflation is wrong. On the contrary, China is facing a deflation risk.
The view that China has a tight labour market that would boost inflation is also wrong; labour shortage is still a distant event. Domestic structural and policy backdrops in China argue that there is no momentum for inflation to spread. Chinese exports are not a threat to AmericaÆs inflation. Rather the real threat lies in the myopic mentality among some trade protectionist politicians, who would end up pushing up US inflation rate if they get their way.

The myopic view
The average price of AmericaÆs imports from China turned positive for the first time in June (up 0.6% YoY). ChinaÆs domestic inflation rate has also been on the rise in recent months, reaching a 3-year high of 4.4% in June. All this has prompted fears about China exporting inflation, with the potential of wrecking havoc the global markets.

The fears are exaggerated, and the view of China exporting inflation is myopic Yes, ChinaÆs export growth has been robust, averaging 29% YoY in the first half of 2007 (up from 27% in 2006). But the strong sales overseas do not bring much pricing power to ChinaÆs exporters. In fact, ChinaÆs export prices to the US (as approximated by the US import prices from China) have barely risen above zero recently. Its export prices in renminbi terms are still falling at an annual rate of over 4%.

ChinaÆs deflation risk
The recent inflation spike in China has been boosted by food prices. The core inflation rate (excluding food and energy) has been stuck at around 1% YoY since 2005 (Chart 1). The domestic macro economic and policy backdrops are not conducive to spreading the volatile food and energy price inflation to the wider economy.

In fact, China is facing a deflation risk not inflation. If Beijing succeeds in curbing ChinaÆs export growth, it could add more downward pressure to ChinaÆs export pricing power, and hence the corporate sector. This is because BeijingÆs move has been targeting the low value-added labour-intensive sectors, such as textile. These sectors have been suffering from excess capacity, erosion of pricing power and falling profit margins, and they rely on exports for survival. Curbing exports will hurt them most.

Though rationalisation in ChinaÆs corporate sector has reduced excess capacity, it has not eliminated the problem. Over-capacity is still serious in low value-added manufacturing industries, where inventory levels have continued to climb (Chart 2). A fall in export growth will cut capacity usage, aggravate the over-capacity problem and trigger domestic price wars as manufacturers scramble to survive.

Chi Lo is the investment research director at Ping An of China Asset Management (Hong Kong) Labour market not inflationary

The view that China has a tight labour market that would boost inflation is also wrong. Contrary to perception, China has a labour supply glut. The authoritiesÆ policy to curb export growth will only add stress to the labour market. The reported labour shortage is both localised and concentrated in the young and skilled labour cohort. In fact, China is approaching a demographic ôgolden ageö, where the population dependency ratio is projected to fall to record low levels between 2010 and 2015, according to the United Nations. ChinaÆs labor force will continue to grow for another decade or so before it starts to fall.

Under normal market conditions, wage rates are a reflection of marginal productivity. Thus, higher wages for the young and skilled workers do not necessarily mean rising unit labour costs boosting inflation. In this aspect, rapid productivity growth (Chart 3), brought about by urbanization, high level of investment and technological changes, has been a key factor in driving ChinaÆs rapid wage growth. Collective bargaining has played no role in it.

The large wage gap between the rural and urban areas and a still-large pool of surplus workers in the countryside suggests that there is no labour shortage. The perceived shortage is a result of bottle necks in the major manufacturing centres and labour immobility, due to geographical, technical and legal barriers.

Persistent capital spending over the years has caused substitution of capital for labour and raised labour productivity. This has reduced the economyÆs ability to create new jobs as output expands. With capital spending already accounting for over 40% of GDP, Beijing is trying to curb investment growth. This policy bias will slow job creation further.
Policy dilemma for Beijing

All this means that ChinaÆs monetary policy is caught between a rock and a hard place. If Beijing slams on the monetary brake, it could tip the economy into deflation. But an accommodative monetary stance will boost asset prices further into the bubble territory.

Excess capacity, labour supply glut and BeijingÆs policy to curb export growth suggest that the macro backdrop is too soft for food price inflation to spread in the economy. In particular, the labour supply glut will cap general wage inflation in years to come. Beijing is likely to use administrative measures to tackle the food-price inflation, such as increasing pork and other foods imports, and to cool the asset markets.

On balance, the Chinese authorities will likely refrain from pursuing a hash monetary stance because it wants to engineer an economic slowdown but not a bust. This is positive for both liquidity and earnings growth for the Chinese equity market over the medium-term. But short-term market volatility will remain high.

The real threat to American inflation

Imports from China have helped keep inflation down in the US and other developed economies. The fears about the inflationary impact of the recent rise in Chinese export prices are based on misunderstanding. The bulk of the increase was due to weakness of the US dollar. Cross-country price level differentials, not export price changes (which are affected by volatile exchange rate movements), are the key factor determining the effect of a low-cost producer, like China, on global inflation.

China has helped hold down global inflation mainly because its goods price levels are so much lower than the developed economies. Through international trade, low Chinese goods prices have pushed down the prices of all competing goods sold in local markets. Thus, even if Chinese export prices are starting to rise, they will still curb American inflation as long as Chinese prices remain lower than the global average and Chinese exports keep penetrating the US market.

The real threat to AmericanÆs inflation is not an increase in Chinese export prices. Rather, it s the protectionist measures that some myopic US Congressmen are trying to push through. If they get their way, they will cut off a key source of low-price imports, unleashing a wave of inflationary pressures in the US by removing the competitive stress from China. Be careful with what you push for , America.
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