Unconventional wisdom: ChinaÆs 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)