Inflation and Why China Needs it but Doesn’t Have Any

February 10, 2015
By Knowledge Leaders Team in Markets
The latest Chinese CPI and PPI readings were released today and showed the lowest year-over-year change in CPI since 2009 and yet another negative PPI reading (chart 1). As such, weak Chinese inflation statistics are nothing new, but the continued weakness is no doubt putting pressure on the cash flows of debt financed capital investments that need above all high nominal growth levels to stay in the positive. This may give us a hint as to why the PBOC has cut rates recently. 
Indeed, as charts 2-4 below show, fixed asset investment continues to grow at a healthy clip of about 15% annually, with construction and gross fixed capital formation reaching new heights as a percent of GDP. Meanwhile, RMB bank loans have quadrupled since 2006 (chart 5). Needless to say, there has not been a lot of rebalancing taking place in the Chinese economy. As capital stocks and the commensurate debt levels continue to grow, but increasingly accompanied by lower and lower real growth, what China needs is higher inflation, but it’s not getting it. 
Whether China keeps the yuan at the current fixing or not, this is an incredible incentive for China to devalue. Of course there may be equally large incentives for China to maintain strong yuan, not least of which is to promote local currency trade settlement and financial stability, but the prospect should not be written off completely. 

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