More complicated than it looks
28 March 2017
After 54 months of deflation ending last September, China’s producer prices are rising rapidly, up 7.8% year-on-year (y/y) in February - a turnaround of 14 percentage points from its trough in late 2015. This week we look into the causes and implications of rising producer prices to discern how much of the price movement is caused by domestic factors (supply side cuts) versus external factors (global commodity prices) and look at the impact it has on consumer prices both within China and globally. China’s supply side reforms in the form of production and capacity cuts are often cited as the cause behind the current price surge. We find that although these cuts are playing a role, other factors are also contributing to higher producer prices: namely, improved domestic demand and domestic price speculation. Global factors are also playing a role, including higher oil prices, improved global ex-China commodity demand, and RMB depreciation. Nevertheless, due to China’s dominance in commodity markets (such as iron ore where China consumes 70% of global supply) it is hard to deduce how much of global commodity movements are actually China-driven versus global supply/demand factors. On prices, we find that PPI movements have had little impact on domestic Chinese consumer prices or export prices over the last five years and this trend is likely to continue.
Breaking down China’s PPI into commodity and non-commodity components shows that the fluctuations in aggregate PPI inflation are driven predominantly by commodity prices; non-commodity producer prices have been fairly stable (see Chart 8). Indeed, research by Barclays shows that commodity prices can explain nearly 90% of the increase in PPI over the past year. What is less clear, however, is whether the price increases are driven more by China or global factors. Using China’s import price index as a proxy for the impact of global prices, given that commodity imports have accounted for 30-40% of China’s total imports over recent years, it’s clear that imported commodity prices have played a role in China’s rising PPI. But, as mentioned above, is it simply Chinese demand and supply cuts that are driving up global prices? There is evidence that improved Chinese industrial activity and supply cuts are playing a large role. Using the Li Keqiang index as a proxy for industrial activity, and our own in-house measure of industrial production, the rebound in industrial activity correlates well with the strong rebound in producer prices (see Chart 9). The impact of supply-side cuts is harder to disaggregate. And it’s possible that the mere announcement of supply- side cuts had as big an impact as actual cuts, as evidenced by heavy speculation in the domestic futures markets and the fact that other than coal production, output has not been significantly reduced. Aluminium is an excellent example: despite production increasing 23% year-to-date, prices have rallied 13% on expectation of future capacity reductions. Lastly, the impact on consumer prices has so far been muted compared to past cycles and we believe this will continue. In past inflation cycles, price rises were generally broad-based causing pass-through to CPI; however, the current cycle is different in that price pressures stem from a stimulus-driven demand boost and inelastic supply due to artificial production targets in steel and coal sectors. We expect the increase in energy prices to contribute to slightly higher CPI, but the pass through to be limited. Moreover, a tightening bias and a less aggressive capacity reduction agenda means PPI has likely peaked and CPI will stay range bound.
Alex Wolf, EM Economist