Thursday, February 2, 2012

China PMI

China’s January PMI came in stronger than expected at 50.5 with New Orders at 50.4. Put that together with Q4 2011 GDP that also surprised on the upside and you’d be right in concluding that China is holding up well in face of the turbulence in Europe and slower global growth.

We’re at the optimistic end of the forecast range for China GDP growth this year: consensus is about 8% while we are at 8.5%. The trajectory for the year is that growth will most likely dip below 8% in the current quarter, but be staging a recovery by year-end as Europe returns to fragile growth and as the easing in monetary conditions we expect to see in the next few months starts to impact.

Key to that view is how the inflation unfolds over the next few months. Inflation has already fallen sharply from a peak of 6.5% to 4.1% as at December. We expect it to fall further as the year progresses.

The authorities are taking a cautious approach to easing which has thus far been limited to one reduction in the reserve ratio requirement and, more recently, a number of open market operations. That caution is entirely appropriate. As we have said before, the biggest risk to long term prosperity in the emerging markets is any lack of commitment to keep inflation in check.

Part of the answer to the growth and inflation outlook is to disentangle cycle from structure. That’s easier said than done. While the cycle is clearly turning down on the back of prior tightenings in monetary policy, China is also facing structural challenges as it rebalances its economy away from a reliance on exports to domestic demand. As that occurs, potential growth is also lower.

So where does that leave the risks to our view? Conventional wisdom tells you that if growth surprises on the downside, so too will inflation which will allow a greater degree of monetary accommodation. My primary concern is that growth surprises on the downside and inflation surprises on the upside. Don’t ya love structural change.