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Amid deflation fears, keep an eye on inflation

By Yi Xianrong (China Daily)
Updated: 2008-12-24 07:41

China's producer price index (PPI) rose 2 percent in November over the same period last year, according to the National Bureau of Statistics. The index had been dropping for three consecutive months, and the November figure was more than 4 percentage points lower than the October figure of 6.6 percent, a historic low following the 1.9 percent increase in April 2006.

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Statistics released later showed an increase of the November consumer price index (CPI) by 2.4 percent over the same period last year, a drop of 1.6 percentage points from the October figure.

Despite anticipating such falls, the market was surprised by their large margins. Based on these figures, some people would hold that the economic difficulties that China has to confront would be worse than anticipated. They would argue the country will soon have to be up against double pressures of fighting both economic downturn and deflation. But it is too early now to draw any conclusion.

First, let's take a look at the PPI. Generally speaking, the PPI is regarded as a preceding indicator of the CPI. If the PPI drops, a likely drop of the CPI follows. However, in the past few years, China's PPI rose quickly, but the pattern in the rise did not transfer to the CPI. Some have argued that China's price transfer mechanism is not unblocked.

If the price transfer mechanism is regarded as not unobstructed when the PPI rises, we have good reasons to doubt the mechanism will work well when prices drop.

However, the rapid PPI drop means market demand is greatly shrinking, production reducing, the gap between demand and supply further widening. The situation deteriorates when supply exceeds demand. All these demonstrate the severity of China's current economic situation.

We should not underestimate the transfer of a rapid PPI drop to the CPI and its impact on the latter, because we are now facing a greatly changed economic situation and environment.

Yet, the rapid PPI drop may be a result of price cuts in the international commodity markets. For example, the international oil price was as high as $147 per barrel in July, but now it is only about $40. As international oil prices fluctuate, so do the prices of other raw or primary products in the international markets.

Two reasons account for the rapid decrease of the prices for international bulk commodities. First, the world economy stepped into a recession after the shock of the US subprime crisis, forcing a rapid decline in demand for many goods. Second, the exchange rate of the US dollar reversed dramatically, turning from rapid depreciation against other currencies before July to rapid appreciation. As the dollar is the major settlement currency in the international market, the rapid fluctuation of its rate will inevitably result in great changes of the pricing system of the international commodity markets.

In addition, prices for many financialized bulk commodities fluctuate radically due to the de-leveraging of the international financial market and the decrease in investment demand. Price drops for bulk commodities will reduce China's import-oriented inflation, and these drops will also result in the overall PPI decrease.

The CPI also has witnessed a rapid decline for several months in a row. The CPI drops mainly result from the fall of food and housing prices. The drop in food prices indicates that the macro-economic policies the government has adopted to support agricultural production, to increase supply as well as to control the rapid rise of prices have played their part to a certain degree.

However, we should take note of the main reasons for the last round of rapid price rises. These include domestic price reform, rapid price rise of international bulk commodities and excess global liquidity (including excess liquidity in China). Of course, the latter two factors have changed. Global liquidity has gone from being in excess to being insufficient, aggravating price drops.

For example, the tight monetary polices adopted since 2007 have shown their impact on price accumulation. Therefore the current CPI drop is also predictable.

However, we should not jump to a conclusion that China will experience deflation in 2009. For, although the current economic situation may last several more months, China's economy may rebound in the next three to five months. This could happen because of the implementation of the latest government stimulus package and increase in investment projects. By that time, the prices will show a new trend. This will also be the case with the monetary policy. With a loosening monetary policy and a historically low interest rate, market liquidity may become excess again.

When excess liquidity emerges in the market, both asset prices and the commodity prices will rise.

Such circumstances could lead to the pressure of inflation, rather than deflation, in the future. This is why the central bank points out in its third quarter report that the monetary policy should help prevent deflation in the short term but inflation in the long run. This assertion is very reasonable.

Of course, the CPI drop also creates a favorable condition to boost economic growth. This will not only bring benefits to people's daily life, but also create opportunities to undertake the reform of the pricing system.

For example, this is a very good opportunity to rationalize the prices of agricultural products, crude oil, as well as mineral resources.

With a reversal of the macro-economic policies, chances for a continued drop of the CPI have been reduced. On the other hand, a CPI drop creates not only favorable conditions to boost economic growth, but also a very good opportunity to reform the pricing system of many key elements.

The author is a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences.