Inflation's bite won't spoil China's recovery

A new fruit brand known as “settlement apples” has caught on in China over the last few weeks.

The apples, which are popping up on social media in Chinese financial circles, have come from a wealthy commodity investor who made a colossally bad futures bet that food price inflation would surge as China reopened. But apple prices have stayed low and the trader had to close out the long positions and take physical delivery of more than 1,000 tonnes of apples purchased through the Zhengzhou Commodity Exchange.

He resorted to selling many of these fruits through an e-commerce platform with jiao ge guo, a phrase he coined meaning “settlement apples”, printed on their packages. 

The story underscores how post-pandemic inflation is taking a different path in China. Runaway price increases swept across Western countries when they reopened after lifting restrictions. But in China, which made a sharp U-turn on its Zero-Covid policies late last year, both supply and demand factors are pointing to inflationary pressures staying low. Amid a reshuffling of other administrative posts, China on March 12 announced that Yi Gang would remain as central bank governor, signalling stability and continuity of the country’s monetary policy. In our base-case scenario, we expect China’s 2023 inflation to stay below the official target of three per cent, allowing the authorities to maintain relatively accommodative policy.

Industrial inflation still soft

In the West, supply-chain disruptions contributed significantly to rising costs last year, but China has moved beyond these with both domestic and global supply networks back to normal. The country’s Producer Price Index is still in a deflationary stage, and we expect it to rise less than 1.5 per cent for the year.

In addition, global commodities such as copper, crude oil and iron ore are trading well below their 2022 peaks, easing pressure on input costs. And, unlike the ultra-tight labour markets in Europe and North America, China’s jobs market is only seeing the very beginning of a recovery and is far from overheating.

Consumer price increases yet to bite 

On the demand side, China didn’t dish out the massive stimulus checks which spurred spending in countries like the US during the pandemic. Chinese consumer spending is recovering but is considered still not strong enough to fuel significant inflation.

Looking into the key components of China’s Consumer Price Index (CPI), we see limited room for increases this year across many areas. House prices, which account for 17 per cent of the CPI basket, will probably remain stable because the property market is still recovering from a major shock. Major cities have seen a tentative strengthening in prices, but broader enthusiasm for home purchases has not fully returned, while rent hikes, if any, will likely be effectively capped by the loss of household income stemming from the pandemic years.

Inflation in non-housing services, which represent 30 per cent of the basket, may be more substantial, with demand rising back toward its long-term trend. Still, there is a gap between actual consumption of services and its trend level, which will take time to close. The slow recovery of China’s job market means there is no trace yet of the wage pressures that have pushed up services costs in some developed markets. With unemployment still above trend in China, wage increases won’t be the source of upside shock to services inflation in the near term.

Then of course there’s food. Food and energy items, which together account for 28 per cent of the basket, may see modest inflation. Pork prices, the biggest food component, are trending down as supply pressures moderate. Prices of other fresh produce such as vegetables will remain stable as mobility restrictions imposed during Covid lockdowns are lifted and supply chains return to normal.

Investor takeaways

Mild inflation is expected to help Chinese policymakers to avoid tightening monetary conditions in the near term, as a soft recovery continues.

Nevertheless, investors should watch out for inflation risks in areas such as housing and pork prices. Inflation may accelerate if recovery in the property market exceeds expectations, or if pork prices enter a new upcycle in the second half of this year. 

Those “settlement apples” taste sweet according to many buyers, but they show why bets on inflation surging in China are likely to turn bad for a while yet.