1.
While many regional economies reported new multi-year high CPI numbers lately, China will likely buck the trend by reporting a potentially lower CPI reading for May as compared with April (see CPI inflation likely begins to trend down while PPI continues to rise—a preview of the May data, China Views, June 6). Yet the Chinese equity markets seem to take little comfort from this expectation, which should have been building since early May when prices of daily food produce began to seasonally subside. What is the market worried about?
2.
Clearly, rising energy prices are weighing on investors’ minds. In particular, China’s energy price controls and increasingly frequent reports of energy shortages have led investors to wonder whether the underlying inflation pressures have truly begun to trend down even if the officially-reported headline numbers begin to soften. More importantly, such price controls are clearly neither efficient nor sustainable, and therefore, it begs the question of who is bearing the costs of the price controls, when they will (have to) be scrubbed, and what will then happen to headline inflation and growth.
3.
Although these are important issues, we believe the key to assess China’s inflation outlook remains to be how successful the central bank is in controlling broad money supply growth. It is here we see some positive signs emerging: the growth rate of broad money supply, as measured by our preferred M3 proxy, seems to have peaked last October, and have been gradually trending down (see Exhibit 1). If the central bank can keep money supply growth from rebounding, CPI inflation would likely also have peaked and would begin to trend down towards 5%-6% later this year.
4.
In our view, the main reason that China’s CPI inflation trend may differ from that of the region is because the People’s Bank of China has tightened monetary policy earlier and more aggressively. The authorities became more concerned about inflation after headline CPI broke 6% in 4Q2007, and they began to tighten domestic bank credits more forcefully. After putting bank lending on a tight leash for 6 months, there are increasing signs suggesting that the tightening has gradually become binding on the margin, leading to tighter liquidity in the market, rising “curb market” interest rates, and stress on corporate cash flows in a few sectors.