Inflation in China: Higher, But Unlikely to Accelerate

Spend Matters welcomes this guest post from H. Cole Hassay, economist at IHS.

China is finally escaping a persistent deflationary environment as price levels rise. However, inflation rates will not be increasing.

Producer prices in China rose at their fastest pace in five years in December, increasing by 5.5% year-on-year. This follows a 3.3% year-on-year increase in November. Price increases in upstream sectors, particularly in coal, steel and oil, were the main drivers in the price uptick. However, increases were seen across several industries, indicating that the rise in inflation was broadly based.

Meanwhile, consumer prices rose 2.1% year-on-year in December, slowing from 2.3% year-on-year in November. Movements in food prices have driven consumer price fluctuations. China is emerging from the deflationary environment that it has been stuck in for several years, with implications for buyers across the globe, especially those in the United States and China.

Over the past four years, excessive supply has persistently depressed prices in some of China's largest sectors - especially those dominated by state-owned enterprises. Though the latest data shows China is finally escaping this deflationary environment, it does not necessarily indicate China's oversupply problems are over. Rather, the rise in China's inflation rate is due to increases in government spending, which, in turn, has fueled demand. Authorities in Beijing recognize the need to close excess industrial capacity, but more progress is needed to balance markets.

While demand is pulling up prices, increasing costs from a depreciating yuan are also playing a role. In 2016, the Chinese yuan fell against the U.S. dollar by nearly 6%. This depreciation will be even more dramatic in 2017, with the yuan predicted to decline another 8%. A weaker yuan has increased import costs for Chinese manufacturers and contributed to the inflationary environment.

The yuan denominated materials price index (MPI), which measures the cost of raw materials for Chinese producers, increased strongly in 2016. Since its low point in early January 2016, the yuan denominated MPI rose 64% by year-end, indicating increased costs for Chinese buyers.

Rising raw material prices contributed to the inflationary environment in China. As producers adjusted to higher costs upstream, the prices for final goods rose. While rising raw material costs are inflating prices for the Chinese, this development could present a buying opportunity for American buyers. With a favorable exchange rate, Chinese goods can be purchased at relatively cheap levels.

Looking forward, the recent rise in producer price inflation is not likely to persist. The current inflationary environment is attributable to stronger demand, a moving exchange rate and higher raw material costs. However, the stimulus-fueled boost to demand is not sustainable. China's output gap (the difference between actual and potential GDP) has actually widened with stimulus-driven excess investment. This supply-side overhang will work to keep inflation at bay over the near-term. A continued favorable exchange rate and lower inflation should spell good news for U.S. buyers as we head through 2017.

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