Deflation Threat as CPI and PPI Decline Due to Shrinking Demand

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China’s CPI growth dropped from 8.7% in February to 4% in October. PPI growth dropped by 2.5 percentage points from September to 6.6% in October. Consumption demand is decreasing and industrial demand is shrinking. While celebrating the control of inflation, some economists are worrying that before the economy bottoms out deflation may recur.

On one hand, lower CPI growth is led by greater supply. A price incentive mechanism has led to sufficient agricultural product supply, especially of pork and poultry products. Due to shrinking external demand, export companies have also moved their focus from overseas markets to the domestic side. On the other hand, demand decline pushes the prices of almost all goods down. Among non-tradable goods, housing prices have fallen rapidly. This has also lowered CPI growth.

With overseas economies in a downturn, it is unavoidable that China’s exports will decline. Uncertainty over the future economy and employment is increasing. Consumers are unwilling to spend money, and "preventative" deposits are rising sharply. In September this year, bank deposits increased by 21.1% year on year, the highest rise since the 1997-98 East Asian financial crisis.

According to National Bureau of Statistics figures, CPI grew by 4% year on year in October, a growth rate 0.6 percentage points lower than in September. In that number, food prices rose 8.5%, 1.2 percentage points lower than the previous month, and non-food prices moved up 1.6%, 0.4 percentage points lower.

Due to price cycle influence, greater supply cut the pork price by 1.2% year on year. Although grain prices didn’t rise significantly during the inflation period, demand decline and the coming of the harvest have forced them down slightly, though they may rebound with the government’s proposed higher grain purchasing prices.

Shrinking external demand means more textile products and clothing are for sale on the domestic market, and prices for these products have dropped 1.3% over the previous year. Clothing prices alone fell by 1.6%.

The government’s adjustment to the real estate market has also affected spending on housing. In August this year housing prices rose 7.1% over the same month last year, but growth dropped to 4.6% in September. Growth of prices for construction materials and housewares also slowed, from 9.1% in September to 7% in October. Rental growth dropped from 3.5% to 2%. 

Year-on-year PPI growth dropped quickly in October, from 9.1% in September to 6.6%. The rapid fallback of PPI growth may have expanded room for non-food price decline, but due to the transmittance obstacle between CPI and PPI, any influence is limited. 

Lower PPI growth helps to relieve companies�upstream pressure for raw materials, but as a signal of market regulation, dropping PPI also indicates weakening industrial demand.

Purchasing prices for raw materials, fuel, and power rose by 11.0%. Among the total, prices for fuel and power, black metal, and raw chemicals rose by 24.6%, 17.7%, and 5.7%, respectively, while purchasing price for non-ferrous metal dropped by 8.2% year on year.
   
Qi Jingmei, senior economist for the State Information Center, said that as international prices were dropping for crude oil and bulk commodities, including non-ferrous metals and grain, connected domestic prices were also being pulled down. Meanwhile, because of the domestic economic slowdown, companies are cutting production and selling stock, reducing demand on the domestic raw material market and increasing supply in a short time.

In August, PPI grew by 10.1% over the same month last year, the highest level in the recent 10 years, but then dropped sharply. As PPI is a leading indicator of CPI, the decline of PPI growth means China’s inflation problem has been greatly relieved.

Meanwhile, depressed production prices signal more depressed production. The Purchasing Managers�Index (PMI) and figures of power production released earlier this month both show companies have cut investment in production due to pessimistic expectations.

Qi Jingmei that said since companies could only increase production volume after effectively clearing inventory, PPI might continue to drop over this quarter and then rebound to about 4%-5%.

Among figures released this week, PPI may not be the one to see the largest decrease. It has been reported that in October value added of industrial enterprises above designated size (i.e. all state-owned enterprises and those non-state-owned enterprises with an annual sales income over 5 million yuan) grew by only 8% year on year, the lowest level since 2001. Some market analysts believe the economic simulation policy released yesterday by the State Council has to do with October’s worsening industrial figures.

Morgan Stanley issued an urgent report yesterday, saying the global financial crisis, characterized by large scale deleveraging, will lead to substantial shrinking of the world’s economies. Morgan Stanley’s global economic group has lowered estimations for the G3 economies, and cut expectations for China’s 2009 GDP growth from 8.2% to 7.5%.

According to the report, the external environment for the Chinese economy has become more challenging. Despite the government’s powerful policy support, China’s asset price adjustment will last longer and fall deeper.

Among the government’s economic stimulation policies, investment in affordable housing, higher grain purchasing prices, and other investment relevant to people’s well being will affect consumption directly. But except for higher grain prices, other measures will not influence CPI immediately. If the government can launch energy price reform at a proper time, it may slow CPI decline. More investment, price reform, and consumption stimulus may help to avoid serious deflation next year.