As China was the first economy to emerge out of the COVID-19 shock, industrial production recovered at a pace not matched by demand, leading PPI inflation to a recent low of -3.7%YoY in May 2020. Base effects mean PPI inflation will almost certainly continue to rise over the next few months. In addition, China’s economic activity is robust, evidenced in the construction sector by excavator sales surging 97%YoY in January and 205%YoY in February. Moreover, the US$1.9trn stimulus announced by the Biden administration should benefit China’s industrial sectors, with a mooted huge infrastructure package offering the potential for more US-related upside.
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Figure 1. China’s PPI inflation has picked up rapidly since mid-2020 and is set to march higher into 21Q2 |
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Figure 2. Industrial inflation cycles in the US and China are highly synchronous |
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Source: CEIC and Citi Research |
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Source: CEIC and Citi Research |
Oil prices are a swing factor to monitor. China depends on imports for over 70% of its oil. Higher oil prices ripple along the production chain from upstream to downstream sectors. A 10%YoY upside surprise to oil prices could add about 1ppt to PPI inflation in China.
Also potentially adding to the inflationary pressure is China’s ambitious commitment to decarbonization. (Beijing is looking to reduce energy consumption and carbon dioxide emissions per unit of GDP by 13.5% and 18% within five years.) Capacity expansion is being curbed in traditional materials sectors and heavy industries. In this sense, as China economist Xiangrong Yu describes it, the decarbonization initiative is “supply-side reform 2.0 and will be inflationary for materials to be consumed more (e.g., copper) or produced less (e.g., steel) by China.”
Set against this, China’s growth momentum will likely peak off around mid-year, according to Yu. The budgetary deficit target is set at 3.2% of GDP this year (vs 3.6% in 2020), and the quota for special local government bonds is trimmed to RMB3.65trn (vs RMB3.75trn in 2020). Financing for local government financing vehicles (LGFVs) and government funds could be tightened as well. Credit supply will likely be front-loaded, on expectations of tighter monetary policy, and then weaken as the year draws on.
PPI inflation may print relatively high in China in coming months. But in the absence of exceptionally strong demand, especially investment, industrial inflation is unlikely to rip ahead. Thus, economist Yu sees headline PPI inflation hitting a peak around mid-year. Meanwhile, any spillover from PPI reflation to consumer prices should be limited, as the “beta” of CPI against PPI inflation is estimated at only 0.26. Overall, while industrial reflation in China may drive some volatilities, it should not unduly constrain monetary policy.
For more information on this subject, please see China Economics View: How Much of a Worry Is Industrial Inflation?
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