Inflation and growth in China

Pre-pandemic inflation landscape

Before the detection of Covid in December 2019, median global inflation was fluctuating around 2% per annum (see Table 1). In developed markets the argument could be made that it was too low, running much closer to 1%. In fact, developed market median inflation only rose above the broadly adopted 2% inflation objective six times between 2016 and 2020, a stark contrast to the situation today. In emerging markets, median inflation was close to 3% year-on-year (YoY) before Covid, but the distribution of inflation rates within this group of countries was much wider than among developed countries.

Table 1 – Inflation heatmap (CPI % chg. year-on-year) ¹

Source: Refinitiv and EFGAM calculations.

Inflation in China

Inflation in China has taken a different path to most other economies over the course of the pandemic. Headline inflation began 2019 below the People’s Bank of China’s (PBOC) 3% target at 1.7%. Throughout the year, it rose as African swine fever caused widespread culling of the pig population, leading to a 123.1% YoY increase in the price of pork in January 2020. Pork is the most important item in the food index, which has a weight of around 20% in China’s CPI. Food inflation was 20.6% YoY in January 2020, contributing around 4.1% to the 5.4% YoY headline inflation. Following this peak, prices began to normalise as the pork crisis eased. Large base effects led to negative YoY pork inflation from September 2020. Headline CPI inflation dropped as a result (see Chart 1).

The impact of energy inflation on headline CPI over the same period has been weak. Core inflation has rarely strayed far from non-food inflation, which represents core inflation with the addition of energy. This indicates that removing food from the index, headline inflation can mostly be explained by changes in the prices of services and manufactured goods. This could explain why inflation in China has been so contained since the normalisation of food prices.

Chart 1 – Inflation in China (CPI % chg. year-on-year)

Source: Refinitiv and EFGAM calculations.

The Chinese CPI basket for services is largely made up of public services such as transport. These services have a pricing strategy influenced by provincial governments’ desire to achieve the inflation targets set by the central government. This makes services prices relatively insensitive to external commodity shocks. The same can be said of manufactured goods, with state and private-owned businesses also adjusting prices in line with the government’s economic objectives.²

Economic growth in China

Covid had a meaningful impact on economic activity in China, with GDP growing just 2.2% YoY in 2020, its lowest pace of expansion in ten years (see Chart 2). Despite a strong, investment-led recovery with 8.1% YoY growth in 2021, momentum was lost towards the end of the year. GDP grew 4.0% YoY in Q4 2021, its lowest growth rate since Q2 2020. This loss of momentum coincided with downward revisions to growth projections for 2022. The IMF had projected Chinese growth to be 5.6% in October. This was updated to 4.8% in January.³

Chart 2 – Chinese GDP (% chg. year-on-year)

Source: Refinitiv, IMF and EFGAM calculations.

The downward revision to GDP growth projections reflects some of the key issues facing the Chinese economy. Tightening of fiscal policy (see Chart 3) emphasised a shift in focus from recovery to deleveraging and a reduction in public investment. Deleveraging efforts were aimed at reducing financial risk, particularly in the real estate sector. They have also led to higher financing costs, lowering activity and investment in Chinese real estate which accounts for 25% of China’s gross value added.⁴ While deleveraging was deemed necessary, it has weighed on growth. 

Chart 3 – Chinese real estate loans (% chg. year-on-year) and government primary balance (% GDP)

Source: Refinitiv and EFGAM calculations.

Easing policy in China

In an effort to boost activity, the Chinese government has pivoted on several contractionary policies. Chinese banks increased loans to the private sector, reaching a record high of CNY 3.98 trillion in January 2022. In the same month, the M2 grew by 9.8% YoY, the strongest expansion since February 2021, and the PBOC lowered a range of policy rates. There have also been commitments from China’s State Council’s Financial Stability and Development committee to relax regulation of large tech companies, provide support for the real-estate sector and wider economy, and ensure stock market stability.

With President Xi expected to secure a third term in power during the Communist Party’s 20th National Congress towards the end of 2022, growth and stability will be two of his top priorities this year. Nonetheless, the outlook for China’s economy is currently highly uncertain due to Russia’s invasion of Ukraine and a new wave of Covid. In the spirit of stability, China’s zero-Covid policy is likely to remain in place as stated in the 2022 Government Work Report (GWR).⁵ There may be room for some flexibility within this policy, however, as some factories have been allowed to remain open in ‘bubbles’ during China’s latest lockdown. This highlights the shift in focus to sustaining economic growth.

The same strategy seems to be in place in response to Russia’s invasion of Ukraine. The 2022 GWR set the lowest growth target in three decades at 5.5% and President Xi will be keen to avoid becoming too involved in a situation which could worsen the growth outlook. China has been warned about sanctions from the US if it were to support Russia with economic or military aid. As such, China has remained neutral while emphasising its commitment to de-escalation.

To summarise, while President Xi is targeting stability this year, there has been some room for flexibility within policies which promote growth. The easing of fiscal and monetary policy may bring inflation closer to the PBOC 3% target. It is important to note that this flexibility may not have been feasible if Chinese inflation was susceptible to commodity price increases like many economies across the globe and was already suffering the same spikes in inflation as a result.

¹ The inflation heatmap is colour coded to be blue when inflation is below the inflation target, white when it is in line with the target and red when it is above the target.
² Dissecting Chinese inflation, GianLuigi Mandruzzato, Macro Flash Note, November 2021
³ World Economic Outlook Update, IMF, January 2022
⁴ http://go.pardot.com/e/931253/-January-2022-Analysis-EAP-pdf/hksd/38140682?h=uPY6qjT7IaJa5X2qqFM2A86ASBkqmbnzzpA3VTm5J7A
⁵ http://go.pardot.com/e/931253/S622c96d7c6d09c94e48a68ff-html/hksh/38140682?h=uPY6qjT7IaJa5X2qqFM2A86ASBkqmbnzzpA3VTm5J7A