Thomas Shik Acting Chief Economist thomasshik@hangseng.com Inflation Outlook and Monetary Easing Although annual consumer price inflation rose for a second consecutive month in July, the underlying trend of inflation has remained weak in mainland China. Smaller rises in food costs, falling oil prices, slowing economic growth and the earlier strength of the renminbi should help contain inflationary pressure in the months ahead. We forecast a 1.5% rate of inflation for 2015 up slightly from the 1.3% recorded for the year to date, but below the 3% target set by the Central Government. With modest inflationary pressure, the People s Bank of China (PBOC) may engage in further easing of policies to help stimulate the economy. We expect the PBOC to lower the required reserve ratio (RRR) by 150 basis points and cut benchmark interest rates one to two more times before the end of the year. August/September 2015
Mainland China s annual consumer price inflation rose for a second consecutive month to 1.6% in July (Exhibit 1) the highest since October 2014 due partly to pork prices jumping by an annual rate of 16.7% over the month. In our view, however, the underlying trend of inflation has remained weak, reflecting smaller price rises in overall food costs, declines in oil prices, the broad economic slowdown and the earlier strength of the renminbi (RMB). These factors are still in play. Although the drag from the earlier declines in oil prices on inflation should start to fade, world crude prices have begun to fall again recently. Meanwhile, the RMB weakened by about 3% versus the US dollar in mid- August after the People s Bank of China (PBOC) decided to align the daily mid-rate for the currency more closely to the market exchange rate, but now appears to have stabilised, with the central bank commenting on August 13 that there was no basis for the currency to continue to depreciate. We forecast Mainland consumer price inflation to reach 1.5% for 2015 up slightly from the 1.3% recorded for the first seven months of the year, but far below the 3% target set by the Central Government. With modest inflationary pressures, the PBOC may engage in further easing of policies to help stimulate the economy. Our expectations are for the PBOC to slash the required reserve ratio (RRR) by 150 basis points and cut benchmark interest rates one to two more times before the end of the year. Exhibit 1: Consumer Price Inflation August/September 2015 2
CPI basket items and their weights Before drilling down into how the various factors mentioned above have affected the overall rate of inflation, it should be noted that there are eight major items that make up the consumer price index (CPI). The weight of each item is not publicly available, but we have used urban household expenditure data in conjunction with relevant information from several other official sources to generate some reasonable estimates in this regard. After determining the likely weights, we can calculate the weighted average of the price increases of the eight items to obtain the rate of inflation. This estimated inflation has closely tracked official inflation in recent years, suggesting that we can safely use our estimated weights of the CPI components to undertake further analysis of inflation trends (Exhibits 2 & 3). Exhibit 2: CPI Weights Exhibit 3: CPI (estimated vs official) Food 33.8% Residence 15.0% Education, culture & recreation 13.6% Transport & communications 12.5% Clothing 9.6% Health care & medical services 7.2% Household facilities & articles 5.3% Tobacco & liquor 3.0% Total 100.0% Source: China Statistical Yearbook, Macrobond, Hang Seng Bank Source: China Statistical Yearbook, Macrobond, Hang Seng Bank Reasons for weak underlying inflation 1. Slowing food price inflation Food prices account for about one-third of the overall CPI. With food price inflation slowing from a peak of 14.8% in July 2011 to just 2.7% in July this year (Exhibit 4), the headline inflation reading has also been falling. August/September 2015 3
In July, pork prices surged 16.7%, the highest monthly increase in the annual rate since January 2012, and contributed 0.48 percentage points to the overall inflation rate of 1.6%. Some commentators have expressed concerns that rising pork prices may increase upward pressure on headline inflation down the road. Our view, however, is that the effect of pork prices should not be overstated. First, pork constitutes less than 3% of the CPI basket. Second, though down by a 4.9% annual rate in the first six months of the year, pork production has remained at a relatively high level overall (Exhibit 5). Our calculations suggest that, even if the pork price boom has just begun and pork prices soar as they did in 2011 when pork price inflation rose as high as 57.1%, the overall rate of inflation would still only run at 2.8% if we assume that non-pork price inflation remains unchanged. Exhibit 4: CPI & Food Price Inflation Exhibit 5: Pork Production (12-month moving average) 14,500 14,000 13,500 '000 tons 13,000 12,500 12,000 11,500 Source: Wind, Hang Seng Bank 2. Energy price fall If we exclude food prices, the inflation rate has remained on a downward trend, suggesting that there have been some other causes for recent weak underlying inflation (Exhibit 6). Declines in world crude oil prices have clearly helped hold down inflation in many economies, including the Mainland. The price of Brent crude has been falling since the middle of 2014 and its annual pace of decline has reached about 50% (Exhibit 7). As such, the Mainland s transport and communications price inflation, accounting for 12.5% of the CPI, has also fallen from around zero into negative territory (Exhibit 8). August/September 2015 4
The effect of world oil prices on Mainland inflation may have been smaller than some observers might have expected because retail energy prices are set by the state. Although the National Development and Reform Commission (NDRC) has lowered refined oil prices relatively frequently over the past year or so, the sales tax on refined oil has also been raised several times during the same period. Overall, retail energy prices on the Mainland have fallen by less than 25% over the past year, compared with the 50% drop in the price of Brent crude (Exhibit 9). Exhibit 6: CPI vs CPI Excluding Food Exhibit 7: Brent Crude Oil Price Exhibit 8: Transport & Communications Price Inflation Exhibit 9: Retail Energy Prices (rebased 2014Jun=100) 105 100 95 90 Index 85 80 75 70 65 60 2014-06 2014-09 2014-12 2015-03 2015-06 LPG Petrol Source: Wind, Hang Seng Bank August/September 2015 5
3. Economic slowdown If we exclude both food and energy prices, the inflation rate has remained at only 1.7% (Exhibit 10). In our view, this relatively low rate of underlying inflation has mainly been the result of the broad economic slowdown and the previous appreciation of the RMB. Slowing economic growth on the Mainland, down from double-digit levels a few years ago to the current 7%, has resulted in slower growth in spending on goods and services, which, in turn, has led to downward pressure on overall consumer price inflation. In addition to the smaller price increases in overall food costs and the declines in energy prices discussed above, the rates of price rises in the remaining six categories making up the CPI have either been falling or remained steady (Exhibit 11). In particular, the residence expenses component has been down from an annual growth rate of 6.8% in January 2011 to 0.8% in July 2015. That said, prices of tobacco and liquor have picked up in recent months due mainly to the fact that the Central Government increased taxes on these items with effect from May 10 this year. Exhibit 10: CPI Excluding Food & Energy Exhibit 11: CPI (by components) August/September 2015 6
4. Earlier strength of RMB Until recently, the RMB had been continuing on its appreciation trend as it followed the US dollar to strengthen against other major currencies. According to the Bank of International Settlements (BIS), the RMB nominal effective exchange rate index (the value of the RMB against a basket of currencies) has jumped about 30% since the beginning of 2010, notably, strengthening by about 15% over the past year alone. A stronger RMB lowers prices of imported goods to the Mainland and, indeed, there has been a close relationship between the two in recent years (Exhibit 12). Lower prices for imported goods, in turn, leads to lower prices for consumer goods, which constitute 75% of the CPI. Again, there has been evidence that the latter has tracked closely the former over the past few years (Exhibit 13). Exhibit 12: RMB vs Prices of Imported Goods Exhibit 13: Imported Goods vs Consumer Goods Inflation outlook and monetary easing We expect modest underlying inflation pressure going forward as the above factors are likely to remain in place. World food prices have hit a six-year trough, with the United Nations Food and Agriculture Organisation (UN FAO) food price index down to its lowest level since September 2009 and down by about 20% from a year earlier (Exhibit 14). This downward trend points to limited price pressure on foodstuffs on the Mainland given the high correlation between the two variables in recent years (Exhibit 15). August/September 2015 7
Recent data indicates that the Mainland economy may continue to slow. Fixed asset investment, industrial output and retail sales all returned a weaker annual rate of growth in July. Slowing demand for goods and services also suggests that inflation is likely to remain moderate. Exhibit 14: UN FAO Food Price Index Exhibit 15: Food Price Inflation (world vs Mainland) World oil prices started to fall in the middle of 2014 and then stabilised around the end of the year. The impact of the rapid decline in oil prices should therefore drop out of CPI calculations beginning in the second half of 2015. However, as oil prices have once again begun to fall, the impact of this variable on overall consumer price inflation may persist for longer than previously expected. Having declined from about USD110 a barrel in July 2014, Brent crude stayed steady in a range of USD55-65 a barrel between February and July this year but has recently dropped to below USD43 a barrel. Our calculations show that, if Brent crude remains at USD45 a barrel, the annual rate of change in oil prices, and hence transportation prices, will remain in negative territory until this time next year (Exhibit 16). August/September 2015 8
On August 11, the PBOC changed the way it sets the daily mid-rate for the RMB from which the currency is allowed to move up to 2% in either direction by referring to the closing rate of the interbank foreign exchange market on the previous day. The RMB dropped by about 3% against the US dollar in the two days immediately following the announcement but has since stabilised following an announcement by the PBOC on August 13 that there was no basis for the RMB to continue to depreciate (Exhibit 17). In our view, the RMB depreciation is unlikely to lift prices of imported goods significantly unless there is a significant further weakening in the currency. After all, the 3% depreciation in the RMB is small when compared with its 15% gain over the past year. We expect the underlying inflation trend to remain weak on the Mainland in the months ahead. Our projection is that inflation will reach 1.5% for 2015 up slightly from the 1.3% recorded for the first seven months of the year, but far below the 3% target set by the Central Government. Modest inflationary pressures should give the PBOC flexibility to engage in further easing of policies to stimulate the economy. We forecast that the PBOC may lower the RRR by 150 basis points and benchmark interest rates one to two more times before the end of the year. Exhibit 16: Oil Price Inflation (assuming USD45/barrel) Exhibit 17: Renminbi Mid-rate & Spot Rates August/September 2015 9
China Economic Monitor Statistics August 2015 GDP Industrial output Fixed asset investment Retail sales Nominal Real Real Nominal Nominal Foreign trade Consumer prices Exports Imports Trade balance Food Non-food RMB bn yoy (%) yoy (%) ytd (%) yoy (%) yoy (%) yoy (%) USD bn yoy (%) yoy (%) yoy (%) 2010 40,151 10.4 15.7 24.5 18.4 31.3 38.7 183.1 3.3 7.2 1.4 2011 47,310 9.3 13.9 23.8 17.1 20.3 24.9 155.1 5.4 11.8 2.7 2012 51,947 7.7 10.0 20.6 14.3 7.9 4.3 231.1 2.6 4.9 1.6 2013 58,802 7.7 9.7 19.6 13.1 7.9 7.3 259.7 2.6 4.7 1.6 2014 63,614 7.3 8.3 15.7 12.0 6.1 0.4 382.5 2.0 3.1 1.5 2015F NA 7.0 6.5 12.0 10.5 3.0-10.0 653.0 1.5 2.5 1.0 Q4 2013 18,208 7.7 10.0 19.6 13.5 7.4 7.2 90.5 2.9 5.5 1.6 Q1 2014 12,821 7.4 8.7 17.6 12.0-3.4 1.6 16.7 2.3 3.5 1.7 Q2 14,083 7.5 8.9 17.3 12.3 5.0 1.6 86.0 2.2 3.4 1.7 Q3 15,086 7.3 8.0 16.1 11.9 13.0 1.2 128.0 2.0 3.0 1.5 Q4 21,656 7.3 7.6 15.7 11.7 8.5-1.6 149.5 1.5 2.6 1.0 Q1 2015 14,067 7.0 6.4 13.5 10.6 4.7-17.6 123.7 1.2 1.9 0.8 Q2 15,620 7.0 6.3 11.4 10.2-2.2-13.6 139.5 1.4 2.1 1.0 Mar 2015 NA NA 5.6 13.5 10.2-15.0-12.7 3.1 1.4 2.3 0.9 Apr NA NA 5.9 12.0 10.0-6.4-16.2 34.1 1.5 2.7 0.9 May NA NA 6.1 11.4 10.1-2.5-17.6 58.9 1.2 1.6 1.0 Jun NA NA 6.8 11.4 10.6 2.8-6.1 46.5 1.4 1.9 1.2 Jul NA NA 6.0 11.2 10.5-8.3-8.1 43.0 1.6 2.7 1.1 YTD 29,687 7.0 6.3 11.2 10.4-0.8-14.6 306.3 1.3 2.1 0.9 Deposits (domestic currency) Loans (domestic currency) New loans Lending rate 1-year Money supply (M2) Forex reserves Foreign direct investment CNY per USD (period end) Total social financing RMB bn yoy (%) RMB bn yoy (%) RMB bn % yoy (%) USD bn ytd (%) RMB bn 2010 71,823 20.2 47,920 19.9 7,950 5.8 19.7 2,847 17.4 6.5897 14,019 2011 80,940 13.5 54,790 15.8 7,470 6.6 13.6 3,181 9.7 6.2940 12,829 2012 91,740 13.3 62,990 15.0 8,200 6.0 13.8 3,312-3.7 6.2303 15,760 2013 104,380 13.8 71,900 14.1 8,890 6.0 13.6 3,820 5.3 6.0543 17,290 2014 113,860 9.1 81,680 13.6 9,780 5.6 12.2 3,840 1.7 6.2055 16,460 2015F 122,969 8.0 91,680 12.2 10,000 4.6 12.0 3,800 2.0 6.50 17,000 Q4 2013 104,380 13.8 71,900 14.1 1,613 6.0 13.6 3,820 5.3 6.0543 3,322 Q1 2014 109,100 11.4 74,910 13.9 3,010 6.0 12.1 3,948 5.5 6.2171 5,600 Q2 113,610 12.6 77,630 14.0 2,726 6.0 14.7 3,993 2.2 6.2031 4,920 Q3 112,660 9.3 79,580 13.2 1,945 6.0 12.9 3,888-1.4 6.1394 2,280 Q4 113,860 9.1 81,680 13.6 2,098 5.6 12.2 3,843 1.7 6.2055 3,503 Q1 2015 124,887 10.1 85,907 14.0 3,671 5.4 11.6 3,730 10.6 6.1997 4,644 Q2 131,829 10.7 88,795 13.4 2,880 4.9 11.8 3,694 8.0 6.2010 4,125 Mar 2015 124,887 10.1 85,907 14.0 1,180 5.4 11.6 3,730 10.6 6.1997 1,241 Apr 125,758 9.7 86,615 14.1 708 5.4 10.1 3,748 10.5 6.2032 1,056 May 128,990 10.9 87,520 14.0 901 5.1 10.8 3,711 10.1 6.1976 1,236 Jun 131,829 10.7 88,795 13.4 1,271 4.9 11.8 3,694 8.0 6.2010 1,833 Jul 134,000 13.4 90,273 15.5 1,480 4.9 13.3 3,651 7.7 6.2097 719 YTD 134,000 13.4 90,273 15.5 8,030 4.6 13.3 3,651 7.7 6.3790 9,488 NA: not available; (A)= actual; (F)= HASE forecast; yoy= year-on-year; ytd= year-to-date Source: State Statistical Bureau, China Statistical Yearbook, Macrobond, CEIC, Bloomberg, Hang Seng Bank August/September 2015 10
GDP Growth Consumer Price Inflation Urban Fixed Asset Investment Retail Sales Loan & Deposit Money Supply (M2) Benchmark Interest Rates Exports & Imports August/September 2015 11
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