Inflationary pressure spreading outside food - China Economic

  • The economic data released this weekend showed that consumer price inflation in November surged to 5.1% y/y from 4.4% y/y in the previous month. Although the increase in inflation continues to be driven mainly by higher food prices, there were signs of more widespread price increases. Property prices edged slightly higher for the second month in a row, suggesting that the impact on the property market from the government’s tightening measures earlier this year has started to wane. 
  • Growth in industrial production continues to improve and suggests a modest acceleration in GDP growth to around 9% q/q AR in Q4 from 7.6% q/q AR in Q3. Demand indicators also suggest stronger growth. Private consumption continues to look resilient, although there are signs that higher inflation is starting to weigh on private consumption. More surprisingly, construction activity appears to be improving again. Finally, contrary to the previous quarters, exports and inventories now appear to be adding to growth.
  •  Looking ahead, we expect GDP growth to accelerate further in the coming quarters and exceed potential growth in H1 11. The November data suggests there is upside risk to our forecast for GDP growth in Q1 11 (9.6% q/q AR). We still expect GDP growth to slow in H2 11, as the Chinese government gradually steps up its monetary tightening.
  • We continue to expect inflation to peak at 5.5% y/y in January, but remain elevated above 5% into Q2 11. During H2 11, inflation is expected to decline substantially, as the impact from higher food prices (both domestically and globally) is expected to be substantially less next year. With growth exceeding potential in H1 11, core inflation should continue to increase and there are mainly upside risks to our inflation forecast.
  • In our view, China’s monetary policy is currently too accommodative and the People’s Bank of China (PBoC) is behind the curve in its monetary tightening. Real deposit rates are negative and while credit growth has slowed compared with last year, it still exceeds nominal GDP growth substantially. 
  • We expect the pace of monetary tightening to increase next year. The targets for credit growth will probably be reduced and the possibility of the introduction of more explicit quantitative controls on credit cannot be ruled out. In addition, we expect four interest rate hikes over the next year. We still think that a rate hike before year-end is likely, although the PBoC’s decision not to hike last Friday could indicate some reluctance to raise rates. Finally, we expect faster appreciation of CNY to be part of the Chinese policy response.
  • While we see some upside risk on GDP growth in H1 11, there is an increasing risk that a slowdown in H2 11 could prove more pronounced, because PBoC could be forced into relatively aggressive monetary tightening next year – particularly if inflation develops less favourably next year.

Price increases have become more widespread

Inflation increased sharply again in November to 5.1% y/y (consensus: 4.6% y/y) from 4.4% y/y in October. Using our own seasonal adjustment, consumer prices increased 0.9% m/m in November following a 0.6% m/m increase in the previous month. As in October, the increase in inflation was largely driven by higher food prices. Again using our own seasonal adjustment, food prices surged 1.9% m/m (11.7% y/y) in November on the back of a 1.7% m/m increase in the previous month.

It appears that consumer price increases became more widespread in November. Our measure of core consumer prices (which excludes food, residential and transport expenditures) increased 0.1% m/m driven not least by higher prices for clothing. Still, our core inflation measure is only up 1.1% y/y and in itself this is not alarming. However, it appears that the decline in core inflation has come to an end. That core inflation has again started increasing is consistent with GDP growth again accelerating in Q4 after having been below potential in both Q2 and Q3. With GDP growth poised to accelerate further in H1 11, core inflation should continue to increase in the coming quarters.

In addition, the residential component has now also started to boost inflation again. In line with developments in the property market, the increase in residential components has also eased sharply since the beginning of 2010. However, in November, the residential component increased sharply by 1.2% m/m. This is also consistent with the latest development on the property market, where house prices in November increased for the second month in a row – albeit only slightly. In addition, house sales for China as a whole have recovered from the initial drop in sales in the wake of the government’s regulatory tightening measures targeting the property market during the spring this year. Hence, it looks as if the impact from the government’s tightening has started to wane.

 Inflation expected to peak in Q1 11

Looking ahead, we think the year-on-year increase in consumer prices could actually drop to around 4.7% in December. This is because there has been a drop in some food prices in December (particularly vegetables) according to the government’s weekly statistics for agricultural commodity prices. In addition, in December we should start to see an impact from the government’s recent measures to curb price increases. For example, several cities have implemented direct price controls on consumer necessities and the central government has raised penalties for ‘price manipulation’ and ‘hoarding’. Finally, in December, there will be a big base impact from a relatively large increase in consumer prices in December last year. However, in January, we expect to see another large jump in consumer price inflation, possibly close to 5.5% y/y. This is partly due to a larger seasonal impact from the Chinese New Year holiday in January 2011 compared with January 2010 (Lunar new year 3 February 2011, compared with 14 February 2010).

Mainly upside risk to our inflation forecast

We expect CPI to peak in January 2011, but remain elevated above 5% for the rest of Q1 11. From Q2 11 and particularly from H2 11, we expect inflation to start to ease substantially. This decline in inflation is solely driven by the expectation that food price increases will ease substantially next year. First, because the spring harvest in China should ease some of the domestic price pressures, and second, because food price increases on the global market are expected to be less next year. With Chinese growth expected to exceed potential, non-food is expected to add further to inflation in the coming quarters (please see front page for chart with inflation forecast). This underlines that there mainly is upside risk to our inflation forecast.

November data confirms growth is accelerating

The November data released on Friday and Saturday supports our view that Chinese growth is again accelerating. However, so far, it only appears to be a modest acceleration. According to our own seasonally adjusted data, industrial production in November increased 1.4% m/m following a 0.4% m/m increase in the previous month. Year-on-year industrial production increased 13.3% (consensus: 13.0% y/y). With one month still left, it now looks as if industrial production is on track to increase 12% q/q AR in Q4 after increasing 8.3% q/q AR in Q3 and 10.4% q/q AR in Q2. Industrial production is our best indicator for GDP and currently it suggests GDP growth around 9% q/q AR (up from 7.6% q/q AR in Q3). Hence, industrial production so far only suggests a modest acceleration in growth and growth not yet above potential. That said, the two manufacturing PMIs both suggest that the acceleration in growth is currently stronger (see chart).

Domestic demand in China still looks strong, although there are signs that higher inflation has started to weigh on private consumption. Retail sales in November bounced back 1.8% m/m (seasonally adjusted) following a weak October when retail sales were flat. Nonetheless, the trend in growth in real retail sales has been down in recent months due to higher inflation, and growth in real retail sales now suggests growth in private consumption is slightly below trend. However, other indicators for private consumption paint a more resilient picture. Auto sales have again accelerated and are on track to increase around 12% q/q in Q4. In addition, production of durable consumer goods remains exceptionally strong even after excluding autos (see chart).

More surprisingly, there are signs that construction activity has started to improve.  Because we think the quality of the Fixed Asset Investment data is poor, we tend to rely more on production of building materials and projects under construction as indicators for construction activity. These indicators have so far painted a much weaker picture of construction activity in 2010 than the fixed investment data suggests (see charts).

However, these indicators now suggest that construction activity is picking up again. Our estimate for production of building materials increased for the second month in a row (up a solid 2.9% m/m) and projects under construction have also improved slightly. In addition, imports of iron ore (mainly used for steel production) have also increased sharply in the past two months after declining since the start of the year (see chart on previous page). The explanation might be the annual credit cycle, where banks and governments focused on annual targets tends to boost credit and investment in Q1 when they have room within the new year. It happened in Q1 10 and appears to be happening again in Q1 11.

The foreign trade data released last Friday indicated that growth in exports is now again picking up following a substantial slowdown since Q1 10, see Flash Comment – China: PBoC raises reserve requirement again. In addition, the strong import growth in November – not least of commodities – suggests that inventory cuts have eased. Hence, both exports and inventories now appear to be adding to growth, contrary to what happened in Q2 and Q3 earlier in the year.
Full report: Inflationary pressure spreading outside food - China Economic