China: Will Inflation Information Lead to Easing or Squeezing?

Monetary and fiscal policies seem to be changing in China. The country’s central bank, the People’s Bank of China (PBoC), and their main banking regulator, the China Banking Regulatory Commission (CBRC), have made some gradual but noticeable shifts over the past two months. Our initial expectation was that they would keep monetary policy stance on the “tighter” side, but in recent weeks they seem to have taken their foot off the tightening pedal by prioritizing short-term growth.

The current easing effort isn’t as broad as earlier easing programs, such as what we saw in 2009. It’s aimed more at specific segments of the economy. For example, the PBoC cut reserve requirements by 50 basis points for banks that have certain exposures to rural economy and small firms and for finance companies, leasing, and auto-finance companies. These will positively impact about 18% of the deposit system. Reports confirmed that cuts were extended to a few other joint-stock banks as well. Consistent net liquidity injections into the system through open market operations since May are helping banks that fund a relatively large part of their assets from non-deposit sources. The CBRC also eased the calculation norms for loans and deposits for banks (loans are capped at 75% of deposits) to create room for banks to extend loans relative to their deposit base. This will also enable the smaller banks to bring some of their off-balance sheet exposures back on to their balance sheet.

Other economic data has been modestly positive in recent weeks. China’s official manufacturing PMI (purchasing managers’ index) was at 51 for June; that its highest level in 2014. HSBC’s Services PMI indicator also printed a 2014 high of 53.1, indicating improving growth prospects. Exports seem to be recovering, with the growth rate for each of the last three months (i.e., April, May, and June) turning positive. All this has helped stabilize growth expectations. Previously, we were looking at GDP growth perhaps dipping below 7%, but we now get a sense that they’ll be able to keep growth at or above that number. On the equity market side of things, earnings expectations for fiscal years 2014 and 2015 have been adjusted from 12% at the start of the year to 7% now. These numbers reflect the underlying economic environment much better.

A factor that has helped Chinese monetary policy authorities in easing their policy stance is reasonably benign inflation. Consumer prices rose at 2.3% year-over-year in June 2014. Since the start of the year, they’ve increased by just 0.7% (annualized 1.4%), implying that headline consumer price inflation remains well within the government’s target of 3.5%. At the producer price level, prices are still contracting. They contracted at a pace of -1.1% year-over-year in June, making it the 28th consecutive month of contraction, a period that started in March 2012. Property prices, which were rising rapidly last year and were a key area of concern, are cooling off. In May, only 15 out of 70 cities reported an increase in new residential home prices. Compare that against December 2013, and you’ll see it’s down meaningfully from 65 out of 70 at that time.

Looking ahead, unless inflation rears its head higher in coming weeks, China will keep fine-tuning its monetary policy to help the economy maintain a stable pace of growth, while simultaneously pursuing their goal of increasing the share of consumption as compared to investment in their economic pie.

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