UBS cuts 2014 China CPI forecast to 2.7 pct

China's consumer price index slowed from 2.5 percent year-on-year growth in January to 2 percnet year-on-year in February, hitting a 13-month low, and producer price index showed a steeper decline of 2 percent year-on-year. Besides the Chinese New Year effect, the weak inflation readings are largely attributable to lower food and commodity prices.

We cut China's 2014 CPI inflation forecast from 3.0 percent to 2.7 percent due to a weaker starting point, but do not think China face full-scale deflation. We expect PPI to stabilize and register positive month-on-month growth in H2 2014, but average -0.6% for the whole of 2014, a smaller contraction compared with 2013 (1.9%).

CPI inflation was mainly dragged down by lower food prices

While February CPI was affected by the earlier arrival of the Chinese New Year, food inflation in the January-February period was much weaker than usual. Contrary to the usual seasonal pattern around the Chinese New Year, pork prices declined by 1 percent month-on-month in January and 3 percent month-on-month in February. The drop in pork prices contributed 0.3 percentage point to 0.5 percentage point drop in headline CPI growth since December (Figure 1), while the rest mainly came from lower prices in other food items such as grain and fresh vegetables. The former has been helped by the increased share of large-scale hog farming in the past couple of years which has made the usual hog cycle very mild. The latter has been helped by good harvest and mild winter weather. Prices of non-food items, which are about 70 percent of the consumption basket, have remained stable in the past two years (Figure 2), averaging at around 1.6 percent year-on-year.

Lower commodity prices the biggest contributor to the decline in PPI

The drop in commodity (mining products) and raw material prices has directly contributed to nearly half of the 1.9 percent decline in China's PPI in the past year. Prices of other investment goods are also heavily influenced by the costs of raw materials and inputs, apart from the economic cycle which affected demand. During January-February 2014, general economic activity but especially investment activity was usually sleepy, weaker than the same period in 2013 when a prelude of strong credit growth had pushed up growth outlook and restocking activity. Consequently, raw material prices fell more steeply in the past two months. Consumer goods prices within the PPI also declined in Jan-Feb by 0.3 percent, though entirely driven by the drop in food prices.

No need to worry about full scale deflation

Should we worry about persistent decline in PPI delaying corporate investment, transmitting to CPI and cause full scale deflation in China in the coming year?

Not really.

On the producer goods front, the decline in prices of commodities and raw materials contributed the bulk to the decline in PPI, but that is arguably not malign deflation. Raw material prices will unlikely decline perpetually – to the extent some hard commodity prices may fall further due to a large increase in supply, it is good news for China as the largest consumer and a big net importer. The yuan appreciation against the US dollar has also helped to depress import prices of commodities and raw materials in the past year. In fact, the gap between overall factory gate price inflation (PPI) and input costs has stayed stable in recent months, even expanding marginally in the Jan-Feb period.

The existence of excess capacity in some sectors may have depressed and may continue to weigh on some producer goods prices. However, demand has been relatively stable and is expected to pick up, inventory levels are relatively low in most sectors (Figure 4)； and the government's effort to retire excess capacities should also help contain supply.

On the consumer price front, the food component was the main reason behind the weakening in both the CPI and PPI consumer goods inflation in recent months. Core manufacturing goods price inflation has remained stable at one to two percent.

Looking forward, the continued near double digit wage growth may put upward pressure on services and many manufacturing goods prices and prevent a full-scale deflation. In the next couple of years, prices of energy, transport and utilities will be raised steadily as part of the factor price reform, which should also help to limit the fall in PPI inflation.