CPI inflation was unexpectedly low, the trade surplus unexpectedly high

The stock markets have had a mixed week so far.  On Monday the SSE Composite declined by 2.7%, before regaining a fraction of that on Tuesday to close up 0.1% and another 0.2% Wednesday.  Banks and real estate developers again led the decline.  Things weren’t helped by August car sales which, as I wrote Friday, Lehman Brothers had correctly predicted would decline, although by 6.2% rather than the 10% they predicted.  Some people are saying this decline is temporary, but on the back of several months of rising car inventories it is nonetheless ominous.

The most interesting news this week has been the slew of numbers released earlier today by the National Bureau of Statistics.  Of these the most eagerly anticipated, CPI inflation for August, was surprisingly good, coming in at 4.9% year on year, which is well below July’s 6.3% and also well below market expectations of around 5.5%.   The decline in CPI inflation was driven mostly by declining prices in pork and vegetable oil.

Quite honestly I am puzzled by this unexpectedly low CPI inflation number.  Part of me would like to conclude that I have been overly alarmed about the threat of inflation all year, and that inflation is no longer the risk that I always assumed it was.  That would certainly be good news, and would give the government greater room for maneuver on the money and credit side, although Mark Williams at Capital Economics says in his research piece today that he actually thinks there is a risk of deflation next year.

But I am still puzzled.  Money growth has been so rapid in the past couple of years, and probably credit growth too if you count all loans in the formal and informal banking sector, that it seems very strange that inflation could come down so quickly.  Is it possible that the huge decline in stock market prices and the smaller decline in real estate prices have had a correspondingly large impact in reducing money in the system?  Or did food prices shoot up so quickly early this year for what were extraordinary reasons, and now as they revert to some more reasonable level of implied inflation they are causing a sharp but temporary decline in inflation.  Or could it even be that price controls and other administrative measures (e.g. selling of food stocks) have seriously tainted the CPI numbers?  I am not really sure.

And there are still other things that are hard to reconcile with the CPI numbers.  All the decline in CPI occurred in the food sector – non food inflation was steady at 2.1%.  More worryingly PPI inflation remains high and actually accelerated slightly year on year, from 10.0% in July to 10.1% in August.  Yesterday I was at the office of a friend of mine, Columbia professor Dan Rosen, and he showed me a graph he had prepared setting out CPI and PPI inflation over the past several years.  What was striking about the graph was that the two numbers were extremely closely correlated until the past few months, when they diverged sharply.  This month’s data causes the divergence to widen even further.

One can easily make the case for a strong correlation between the two, but it is very hard to explain why they might diverge so sharply without, at some point, one feeding into the other.   Of course if oil and other commodity prices continue to drop, their decline will help ease PPI inflation in the future, but it seems to me that it will need a lot more than this to bring the two into line again.

Yesterday’s Bureau of Statistics release also included trade data.  Imports grew last month at a 23.1% in August, down sharply from 33.7% in July.  It would be easy to credit the slowdown in growth to a decline in world commodity prices, but Mark Williams claims that the decline in commodity prices only accounts for half of the slowdown in growth.   The Olympics may have distorted the numbers, so it would be risky to draw conclusions with too much confidence, but the reduction in import growth may reflect a decline in domestic demand growth, something that I have been expecting.

Export  growth also slowed, to 21.1% year on year in August from 26.9% in July.  That left the trade surplus for August at a record $28.7 billion – a number which will help ensure that China’s money supply will continue expanding sharply in August.  Growth in nominal fixed asset investment moderated slightly from 29.2% in July to 28.1% in August.  I think this is still a little high given the slowdown in foreign and domestic demand growth, and suggests that export growth will remain relatively high in the coming year (relative, that is, to slowing international demand) and that the threat of rising inventories remains strong.

What are the policy implications of the most recent batch of numbers?  I would hope that no one draws too much confidence from the first set of post-Olympic data, since there may be all sorts of temporary distortions in the numbers, but it seems pretty clear that the pro-growth camp will have been strengthened.  Anyone who has been arguing that the risk of inflation is no longer a real constraint on policy will have been heartened by the most recent CPI numbers, and if he has also been arguing (as is likely to be the case) that the real threat is that of a sharp slowdown in growth, the numbers are more or less aligned in his favor.  One consequence is likely to be a further relaxation of price controls.  My guess is that there will also be increased pressure for fiscal expansion to counteract a perceived slowdown in domestic and foreign demand, and that concerns about a too-loose monetary policy will subside further.

The record high trade surplus will put international pressure on China to let the RMB appreciate, but the southern exporting lobby will still argue – incorrectly, in my opinion – that slower export growth is a consequence of the rising RMB.  I am not sure how this pans out, but I suspect that the recent slowdown in RMB appreciation is more of a “head fake”, one aimed at slowing hot money inflows, than a real policy consensus.  Although the monetary camp continues to be weakened in the policy debate, I think there nonetheless continues to be real worry among policymakers about the pace of money growth in China.

On a separate note I have met a few investors so far in my trip to New York but Wednesday and Thursday I have a lot of meetings that will, I hope, give me a better sense of what they think about global conditions and about China.  I will try to write something about this later in the week.  For now I am still struggling with m jet lag, although I have to say the weather here has been really nice.

Originally published at China Financial Markets and reproduced here with the author’s permission.