Feeling deflated

China’s State Council and the moon goddess Chang’e have shared a preoccupation with soft landings in recent weeks.

Chang’e has given her name to the lunar probe mission that culminated in a deliberate crash landing on the moon. China’s leadership has been more concerned with events closer to home, and especially the shrinking of the price bubble that was threatening the domestic economy less than a year ago.

News that the country’s price index posted negative growth last month suggests that the inflationary genie is now back in the bottle. Indeed, commentators are now questioning whether deflation is now becoming the new economic threat.

Should we be concerned? What happened to fears of surging prices?

It’s a big turnaround. In February last year, China’s statisticians were reporting an 8.7% increase in prices in year-on-year terms on 2007. A year on and the consumer price index has actually fallen 1.6% versus the data for the year before, the first decline for seven years.

With the current emphasis on economic stimulus and job creation, it is easy to forget that inflation was the issue of the moment in mid-2008. Run-ups in the price of basic foodstuffs like vegetable oil and pork were being reported on a weekly basis in the local media. There were even much-publicised stampedes (and injuries) at supermarkets as shoppers tried to hoard supplies.

The surge in international commodity prices, as well as a rampaging domestic property market, ratcheted up the inflationary tempo. Share prices at the peak of the Shanghai market in October 2008 were also trading at a PE of 60 times.

For a government aware of the role of previous bouts of inflation in fanning social unrest, this was a worrying trend.

So the policy response was a heavy-handed one. State banks were pressured to rein in lending and reserve ratio requirements were lifted to a peak of 17.5% by June 2008. The rebate terms available to many exporters were reduced and the yuan was allowed to appreciate. Interest rates were increased, as were levies and taxes on property developers.

So, mission over-accomplished?

The latest figures do look like a dramatic reversal but the China Statistics Bureau is keen to point out that they are the result of a high base for comparison. If we wait for figures for later this year, they should be less dramatic.

The current numbers are particularly magnified by increases in food prices in early 2008. As food expenses constitute almost a third of urban household expenditure, they have a major impact on the overall inflation rate. An outbreak of blue ear pig disease, as well as snow storms at the beginning of last year, pushed livestock, dairy and poultry prices up to unexpectedly high levels.

Officials have been keen to stress that deflationary fears are overblown. “It doesn’t mean China is in deflation,” says People’s Bank of China Vice Governor Su Ning, of the latest data. He reckons the current context is not a “typical” one, confirming that the comparison numbers, as well as external factors like plummeting commodity prices, are having a distorting impact. February’s factory gate prices were down 4.5% year-on-year.

In fact, falling oil and ore prices, like reductions in the cost of food, are not bad things for the domestic economy. And HSBC concurs that fears of a deflationary hibernation are overstated. Like much of Asia, China is now experiencing a normalisation in price levels after an unusual surge over the previous year. This makes it disinflation rather than deflation, says HSBC, which is a much less dreadful ‘d word’ than the current discussions of debt and depression.

Growing pains for an emerging economy?

Some foreign commentators believe it suits Beijing to look overseas to find reasons for its growth slowdown (and the related inflationary cooling off). Instead they point to a downturn precipitated as much by domestic over-tightening as by international factors. Pierre Botellier, a former World Bank official now a professor at John Hopkins University, says that the construction sector was especially hard hit by the engineered slowdown, with greater total job losses than in the export zones.

More broadly, the current situation fits into the longer-term experience of China’s economy. Perhaps due to its rapid growth – and its recent emergence as the world’s number three in GDP terms – we can forget that the modern Chinese economy is a relative newcomer, and one which continues to undergo wrenching change.

Growth spurts among teenagers often lead to awkwardness, and China has suffered its own share of acne in economic terms. Seven years of deflationary pressures followed 1997, after which the official consumer price index was no higher in January 2004 than it had been in June 1997. This was itself policy-prompted as a response to the mid-1990s boom, in which inflation peaked at 25%.

But not so much of a problem this time?

It is too early to offer a definitive conclusion but China’s economy is in much more robust shape than most.

Policymakers are also rowing back frantically on last year’s anti-inflationary measures. A huge expansion in money supply is underway, for instance, with trillions of yuan being pumped into the economy via the stimulus package and aggressive lending from the state-owned banks. The yuan is depreciating again too and export rebates are back on the table.

There is of course a lag effect in seeing these policies start to feed through into domestic prices. Beijing is forecasting an inflation rate of 4% for the full year in 2009 – somewhat above the expectations of most foreign analysts. Some wonder too if the leadership is underestimating the deflationary risk in the hope of inducing an increase in domestic consumption. It already seems a challenge to convince the Chinese to spend – it could be all the more so when prices are expected to fall in the immediate future.

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