Monday, May 16, 2011

China interest rate increases over?

The monthly China “data dump” last week contained a couple of surprises. Annual inflation slowed from 5.4% in March to 5.3% in April, but this was not as large a decline as the market was expecting. Food prices were down for the second month in a row, but non-food prices were stable.

Domestic factors that have been driving food prices higher seem to be on the wane. As a result we expect headline inflation to decline into the end of the year. This is based on the assumption that there are no further supply disruptions that would drive commodity prices higher.

The bigger surprise was in the activity data where the slowdown in most indicators was more marked than expected. In particular retail sales growth continued to decline with growth in real terms now at its lowest level in 6 years. Industrial output fell from 14.8% y/y in March to 13.4% in April – the market had been expecting a decline to 14.6%. Fixed investment spending was the only indicator to post an increase in annual growth from 25.0% to 25.4%.

The data releases were quickly followed by a further rise in the Required Reserve Ratio (RRR) to 21% (for the larger banks). However, the weakness in the activity data has me thinking the PBC may call a halt on further interest rate increases. Recall we were surprised by the very modest decline in GDP growth from Q4 2010 to Q1 2011 (9.8% to 9.7%). This was despite the evident slowdown in a number of indicators. This more recent slowdown in the activity indicators suggest the GDP slowdown has accelerated into Q2.

A halt to interest rate increases would not be the end of the inflation battle. We still expect further increases in the RRR (two or three more?) to offset the expansionary impact of purchases of foreign exchange reserves.

Furthermore, with retail sales slowing at the same time exporters remain in fine fettle (as indicated by recent trade data), further appreciation in the CNY is increasingly desirable. Exporters would then get to make their contribution to the adjustment and households would get a reprieve via higher real incomes. From a global rebalancing perspective, it is desirable for resources to shift from the tradeable to the non-tradeable sector.