UBS China Economic Focus-how much should we worry about deflation in China

UBS Investment Research
China Focus

25 March 2009
www.ubssecurities.com
Tao Wang
Economist
wang.tao@ubssecurities.com
+8610-5832 8922

In February, China’s consumer price index (CPI) declined 1.6% compared to a year ago, the first y/y decline in 6
years. The producer price index declined even more. Against the background of a global recession and looming
fear of global deflation, many believe that China has entered deflation. Moreover, some see a deflationary spiral
as a real danger—whereby declines in prices and demand become mutually re-enforcing—and are calling for the
central bank to lower interest rates or adopt other forms of further monetary expansion.
At the same time, almost at the complete opposite end of the spectrum, warnings have been raised about inflation
returning sooner than later. Substantial liquidity injections globally and stimulus policies in China are cited as the
main factors, and a quick return of commodity price increases is seen as the main likely trigger.
We believe that the year-on-year drop in prices in China in the first months of 2009 is mostly due to a decline in
food and other commodity prices, after strongly rising food prices led to sharp increases in CPI inflation in 2008.
Looking ahead, we believe the downward movement in food and fuel prices alone will not translate into a
deflation spiral or a long period of price decline. Nevertheless, we think core price deflation has become a rising
risk in China because of declining export demand and expected weaker growth in domestic consumption. All the
policies that are designed to stimulate demand and growth are also policies that could help fend off deflation.
While some commodity prices are expected to rebound from recent lows, we do not think global and domestic
monetary and fiscal expansion will lead to imminent inflation – not before they are translated into increased
aggregate demand exceeding supply. The main current challenge, in China and abroad, is still trying to jumpstart
ailing demand.