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Investment Research — General Market Conditions

10 June 2009

Flash Comment
China: Negative inflation but deflation no concern
Consumer prices in May came in broadly in line with expectations at -1.4% y/y. While headline CPI is likely to remain in negative territory for most of this year, deflation is no major threat to the Chinese economy. Our forward-looking indicators all suggest inflation will pick up. With only a modest output gap, we expect the People’s Bank of China to tighten monetary policy in H1 10 and resume the gradual appreciation of CNY at some stage. Consumer prices, May (% y/y)
Act CPI PPI -7.2 Con DB -6.9 na Last -1.5 -6.6 -1.4 -1.3 -1.3

Details Consumer prices in May came in broadly in line with expectations at -1.4% y/y (consensus: -1.3% y/y). Lower food prices and lower rent continue to be the main drivers behind the sharp decline in consumer price inflation over the past year. However, the drop in food prices has eased because of a sharp increase in vegetable prices, while meat prices continue to ease following the surge early last year. Sequentially we estimate that consumer prices in China have been increasing in recent months and hence the decline in headline year-on-year inflation is solely due to the base impact from last year.

Source: Ecowin and Danske Bank

CPI inflation to remain negative until late 2009
10 5 0 Consumer prices excl. food % y/y Consumer prices % y/y
Forecast

10 5 0 -5 -10

Assessment & Outlook Hence deflation should not be a major concern. Deflationary pressure is currently easing significantly and our forward-looking indicators suggest inflation should pick up and it cannot be completely ruled out that inflationary pressure will re-emerge next year. House prices have increased in recent months, suggesting that the decline will soon end. In addition, energy and commodity prices have increased recently and the government’s liberalisation of some administered prices (water and energy) should add somewhat to inflation looking forward. Finally, the recent extraordinarily sharp increase in money supply growth is a strong indication that inflation in China will pick up next year (see chart on next page). We expect consumer price inflation to remain in negative territory for most of this year (mainly due to the base impact from last year) and then increase substantially from early next year (see chart).

-5 -10 02 03 04 05

Producer prices

06

07

08

09

10

Source: Reuters EcoWin and Danske Markets

Food and rent are the main drivers
25 % y/y 20 15 10 5 0 -5 Clothing Transport and communication 00 01 02 03 04 05 06 07 08 09 Residential Food % y/y 25 20 15 10 5 0 -5 -10

Implications We are unlikely to see further interest rate cuts from the People’s Bank of China (PBOC). Despite the strong headwinds from the global economy, it appears that China has been able to manage a soft landing of its economy. China’s output gap has only increased modestly compared with the US and Europe (see chart on next page) and hence China will probably have to return its monetary focus on price stability before central banks in the US and Europe. For that reason we believe China will tighten monetary policy in H1 10 (possibly by reintroducing lending quotas). A modest output gap and continued need to contain inflation is our strongest argument for China at some stage resuming its gradual appreciation of CNY against USD.

-10

Source: Reuters EcoWin

Senior Analyst Flemming J. Nielsen +45 45128535 flemm@danskebank.dk

www.danskeresearch.com

Flash Comment

Meat prices continue lower
60 % y/y 40 20 0 -20 0 02 03 04 05 06 07 08 09 Fresh vegtables Grain Meat % y/y 60 40 20 0 -20 0

PMI suggests deflationary pressure is easing
70 60 50 40 30 05 06 07 08 09 << Prices charged, Markit-CLSA PMI Diffusion, 12M change Producer prices>> % y/y

10 5 0 -5 -10 -15

Source: Reuters Ecowin

Source: Reuters EcoWin and Markit

Sharp increase in money supply growth suggests inflation will pick up next year
10 8 6 4 2 15 0 -2 00 01 02 03 04 05 06 07 08 09 10 11
Source: Reuters EcoWin

Unlike US and Europe, China has only a modest output gap

% y/y

Money supply M2, 12M lag>> << Consumer prices

% y/y

30 25 20

6 % of GDP 4 2 0 -2 -4 -6

Inflation>>

% y/y

<<Output-gap

10

-8 80 85 90 95 00 05 10

25 20 15 10 5 0 -5 -10 -15 -20 -25 -30

Source: Reuters Ecowin and Danske Markets

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Flash Comment

Disclosure
This report has been prepared by Danske Research, which is part of Danske Markets, a division of Danske Bank. Danske Bank is under supervision by the Danish Financial Supervisory Authority. The author of this report is Flemming J. Nielsen, Senior Analyst. Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high quality research based on research objectivity and independence. These procedures are documented in the Danske Bank Research Policy. Employees within the Danske Bank Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and to the Compliance Officer. Danske Bank Research departments are organised independently from and do not report to other Danske Bank business areas. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or dept capital transactions. Danske Bank research reports are prepared in accordance with the Danish Society of Investment Professionals’ Ethical rules and the Recommendations of the Danish Securities Dealers Associations. Financial models and/or methodology used in this report Calculations and presentations in this report are based on standard econometric tools and methodology. Documentation can be obtained from the above named authors upon request. Risk warning Major risks connected with recommendations or opinions in this report, including a sensitivity analysis of relevant assumptions, are stated throughout the text. First date of publication Please see the front page of this research report.

Disclaimer
This publication has been prepared by Danske Markets for information purposes only. It has been prepared independently, solely from publicly available information and does not take into account the views of Danske Bank’s internal credit department. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no li-ability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. The Equity and Corporate Bonds analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for retail customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S. Danske Bank A/S is authorized by the Danish Financial Supervisory Authority and subject to limited regulation by the Financial Services Authority (UK). Details on the extent of our regulation by the Financial Services Authority are available from us on request. Copyright © Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.

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