Dissecting Chinese inflation

Consumer price inflation in China is surprisingly low at 1.5% yoy in October. Although higher than previous months, it is much lower than median inflation in developed and other emerging countries (see Chart 1). Many observers fear that with the Purchase Price Index (PPI), which measures the price of industrial inputs, rising by 17.1% yoy, it is only a matter of time before CPI inflation rises also in China, increasing pressure on prices globally.¹

Figure 1. Inflation in China and rest of the world (yoy)

Source: Refinitiv and EFGAM calculations.

It is therefore important to understand why Chinese CPI inflation is low and to assess the risk that it will soon follow the surge in the PPI.

Falling food prices cool inflation
Looking at the main price indices published by the National Statistical Office of China (NBS), the rise in fuel prices stands out (+31% yoy), a pace similar to that in developed countries (see Chart 2). In contrast, food prices have been falling for some time and in October they were 2.4% lower than a year before. Core inflation, excluding food and energy, has risen of late but remains contained at 1.3% yoy.

Figure 2. China inflation breakdown (yoy)

Refinitiv and EFGAM calculations.

Although the NBS does not publish the weights of the individual components of the CPI basket, it is possible to calculate the weight of food starting from the headline and food price inflation rates. It indicates that the weight of food has fallen to about 20% of the total from about 33% in 2016.

Within the food basket, pork is the most important item with a weight of about 13%, equal to about 2.5% of the total CPI. The price of pork has recently been volatile due to the African Swine Fever epidemic that hit Chinese hog farms between 2018 and 2020, leading to the mass culling of pigs. Prices surged by 135 yoy in February 2020 before moderating. Pork price inflation turned negative at the end of 2020 and in October it was -44% yoy, reducing overall inflation by 1.1 percentage points.

Pork prices are 8.5% higher than before the African Swine Fever epidemic. Assuming a complete normalization over the next few months, they will have a disinflationary impact also in 2022, albeit lower than this year. It is therefore likely that food prices will continue to dampen Chinese inflation.

The CPI is little affected by the PPI
The service sector, which represent 37% of the CPI basket, is also unlikely to exert upward pressure on Chinese inflation. The CPI basket includes mainly public services, such as transport, communications, health and education, or other items heavily influenced by local governments, like rents. The prices of services in China are therefore little affected by commodity price shocks and over the years have moved in line with the inflation targets set by the central government.

The remaining 63% of the CPI basket is made up of goods, including food (20%), energy (3%) and manufactured goods (40%). Of the latter, 10% is alcohol and tobacco, and 30% durable consumer goods. Many observers fear that the sharp rise in the price of industrial input prices will trickle down to consumer prices, pushing inflation much higher.

However, in the period since 2000, the transmission of shocks from industrial input prices to the producer prices of consumer goods has been small (see Chart 3). Furthermore, CPI goods inflation, including durable goods, has been little affected by changes in the prices of industrial inputs and only to a limited extent by changes in the producer prices of consumer goods.

Figure 3. China price formation chain (yoy)

Source: Refinitiv and EFGAM calculations.

Chinese CPI inflation is little influenced by commodity price shocks, unless they stem from domestic, food-related issues. Rather, CPI inflation is anchored by the stable inflation of the price of public services and by the low PPI inflation of manufactured consumer goods.

One explanation is the influence of the government on the pricing strategy of state-owned enterprises and on the readiness of private entrepreneurs to adjust prices in line with the government’s macroeconomic objectives.

The producer prices of consumer goods in China are also relevant to developed market inflation because 65% of Chinese exports are consumer goods (see Chart 4). From a US consumer perspective, the renminbi exchange rate also matters. In October, the Chinese producer prices of consumer goods expressed in US dollars were up 5.4% yoy, a little lower than the peak reached in June. Furthermore, while the renminbi remains strong, its rate of appreciation continued to moderate in the first half of November.

Figure 4. China export prices and G7 CPI (yoy)

Source: Refinitiv and EFGAM calculations.

Conclusions
Surprisingly low CPI inflation in China largely reflects the normalisation of meat prices following the African Swine Fever outbreak between 2018 and 2020. Furthermore, the importance of state-owned enterprises in all major sectors incentivises pricing strategies aligned with the government's macroeconomic objectives. This explains the limited influence of the recent surge in commodity prices on CPI inflation in China, as opposed to what has happened in the rest of the world.

For developed countries, it is also important to note the recent moderation in Chinese producer prices of consumer goods expressed in US dollars. Unless the latter suddenly surge or the renminbi exchange rate rises sharply, China is unlikely to export much inflation to developed markets in 2022.

¹ The National Statistical Office of China also publishes a Producer Price Index which measures prices of manufactured and industrial goods at the end of the production process.