China’s disinflation – a benign environment for bonds

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China’s Producer Price Index (PPI) inflation rate continued to fall in November (2.7% year-on-year versus 3.3% in October), with an outlook for further weakness.

This data suggests that earnings growth in some upstream sectors would be squeezed. China’s CPI inflation rate fell also (2.2% year-on-year versus 2.5% in October) with core inflation stubbornly stuck below 2% year-on-year.

Beijing may be subject to many constraints on its easing effort, but inflation is not one of them. Such a macroeconomic environment is positive for bonds as we head into the new year. China’s low inflation also reflects a region-wide phenomenon, suggesting potential policy easing by the regional authorities going forward, ceteris paribus.

Exhibit 1: A disinflationary force – having risen since September 2016, Chinese Producer price inflation is now falling again

Source: CEIC, BNP Paribas Asset Management (Asia), as of December 2018

Exhibit 2: Consumer price inflation is also falling while China’s core inflation rate remains stubbornly stuck below 2% year-on-year

*Headline CPI less food & energy. Source: CEIC, BNP Paribas Asset Management (Asia), as of December 2018

The recent fall in energy prices and lower domestic commodity prices were the key factors driving China’s inflation rate lower. But this phenomenon is also reflected throughout Asia, where inflationary pressures have been subdued despite weakening regional exchange rates and soaring oil prices over the past year. Now that the oil price trend has turned, inflation in China (and in the region) is likely to continue to soften, supporting a monetary easing backdrop, especially when exchange rate volatility settles down.

China’s CPI inflation is expected to remain subdued at 2.5% YoY (versus the central bank’s 3.0% target) in 2019 due to weak demand momentum and non-food price inflation. PPI may even turn negative in 2019 if energy and local commodity prices continue to fall. The latter suggests earnings growth of some upstream sectors would be squeezed.

Beijing may be facing many constraints on its easing policies to support growth on the back of a trade war with the US. These include debt-reduction efforts, a shrinking current account surplus on the back of a weaker renminbi, and pockets of property bubble that still need to be addressed. But inflation is not an obstacle for further monetary easing.

More broadly, if China cannot generate sustained inflation, it is likely that Asia and the world would not be able to generate much inflation either; remember all the market fuss about China exporting inflation/deflation at different points in time?

It seems that sentiment on the Chinese bond market has recently turned from worrying about defaults to cheering about disinflation, as the yield on Chinese government bonds has fallen towards 3.0% from almost 5.0% a few months ago. The issue is supply. While I expect most of the funding will come from provincial government bond issuance, thus expanding the Chinese ‘municipal government’ bond market – a development that international investors have been hoping for – Beijing can also tap into its RMB 2.8 trillion-strong fiscal savings to contain the expansion in its fiscal deficit, thus the funding needs.

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Chi Lo

Senior Economist for China

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