Figure 1: China’s Consumer Price Inflation Struggles to Pick Up (% y/y)
Source: CEIC, Continuum Economics
China’s headline consumer price inflation has been weak despite a strong economic recovery. Headline CPI inflation was only marginally above zero at 0.2% y/y in December after slipping into deflationary territory (Figure 1) in November. A remarkable slowdown in food inflation and a decline in services price inflation due to contraction in services demand have also weighed on headline inflation in recent months. This was reinforced by the pass-through of large currency appreciation. A high base of comparison may put further downward pressure on CPI inflation in January. We expect headline inflation to ease to -0.1% y/y in January. Overall, inflation is likely to moderate slightly to an average of 2.1% in 2021. Once short-term volatility fades, we expect underlying inflation to move closer in line with improving consumer demand.
China’s CPI inflation has been mainly driven by food price inflation, which has slowed from a peak of 20.6% y/y in January 2020 to 1.2% y/y in December, predominantly driven by a fall in pork prices. These continued to stabilize as a result of diminishing impacts of African swine flu and the government’s multipronged measures to restore supply. So far, the numbers of live pigs and breeding sows in stock have recovered to over 80% of the level seen in normal years, according to data from the Ministry of Agriculture and Rural Affairs.
A contraction of services demand due to the pandemic has weighed on services price inflation. Transport/communication and residence inflation have been in negative territory since March 2020, while education/entertainment inflation also eased during the same period. However, with the catch-up in consumption activity and recovery in domestic demand, we expect the deflationary pressures in services price inflation will diminish.
Headline PPI inflation improved in late 2020, reflecting easing deflationary pressure (Figure 1). The demand for consumer goods still lagged, while the demand for producer goods (particularly mining/quarrying and manufacturing) has improved. This partly reflected the different paces of recovery across sectors in China. While production, investment and exports have led the recovery, the pickup in consumption has been lagging behind.
A Conundrum for Policymakers
China’s strong economic recovery and weak inflation momentum pose a dilemma for policymakers. The People’s Bank of China (PBoC) has introduced a series of monetary easing measures following the virus outbreak in H1 2020, including interest rate cuts, credit support, and increased aggregate financing. As economic recovery further gained traction, the PBoC has taken subtle steps to normalize its credit policy while keeping interest rates unchanged. Despite the outlook of a strong growth rebound, we believe policymakers will remain cautious in withdrawing stimulus. We continue to expect the 7-day repo rate to remain at 2.2% in 2021, and the 1yr and 5yr loan prime rates to stay at 3.85% and 4.65%, respectively. A gradual increase in interest rates is only seen in 2022.
On the fiscal side, we expect the government to gradually wind down its stimulus this year, as the economy returns to pre-pandemic level. Following months of loose fiscal policy, policymakers have started to focus on excessive building-up of financial stability risks. Fiscal efforts are likely to target selected growth areas such as new infrastructure investment and high-tech growth areas.