Deflating Chinese Inflation Concerns

(By Fisher Investments) China announces Q2 GDP on Friday, but it's safe to say no one expects much. Premier Wen Jiabao said Sunday "downward pressure" on the economy "is still relatively big," and the OECD and IMF issued new warnings of slowing Chinese growth. Meanwhile, many interpret last week's rate cut—the second in as many months—and June's inflation slowdown as evidence the long-feared hard landing may be here. However, in our view, these developments seem in keeping with two recent trends in Chinese policymaking: officials' aim to goose growth in this election year and their longer-term path toward economic liberalization.

We've frequently written of how the political cycle impacts growth in China's command economy. In the year before the "election" (a catchall for China's undemocratic leadership selection process), officials use available throttles to tame inflation so they can accelerate growth—lowering the likelihood of civil unrest—during the planned transition without risking runaway price increases. Slower growth in the year or so before the election typically results and, true to form, growth and inflation have slowed since 2011 began. Thus, last autumn, policymakers launched apparent efforts to boost bank lending—their primary means of loosening monetary policy.

However, measures like lower bank reserve requirements didn't immediately flow through to the broader economy. Banks did lend more, but primarily to large, state-owned companies. China's large, state-owned banks prefer lending to them because of the government's implicit guarantee—they're less risky investments than smaller, privately held enterprises. But small businesses contribute mightily to China's emerging economy—and if banks don't lend to them, they can't much invest in new equipment, software, product development, facilities, employees and the like.

China's struggles with small-business lending have been well-documented in recent months, and it's likely been an extra drag on growth. Officials have introduced pilot reforms in one city to liberalize the banking system in an effort to improve small-business lending, but the program's in its infancy, and progress is slow-going—and it's likely some time before the program's implemented nationally. Efforts to build a corporate bond market will require a similarly long time horizon. These are important, encouraging steps, but not immediate growth boosters.

Hence, Chinese growth slowed a bit further in Q1, and more recent data have been mixed. But the 18^th Communist Party Congress—the "election venue"—is approaching this autumn, and both Wen and the State Council have pledged to boost growth quickly. Hence, officials announced a rash of fiscal stimulus measures recently, including a cash for clunkers program, subsidies for energy-saving appliances and near-term infrastructure projects. Tax cuts to stimulate spending are in the offing. They made monetary moves, too, delaying the deadline to comply with Basel III bank capital requirements, lowering risk weightings for small-business loans and again cutting banks' reserve requirement. And now, the two rate cuts, combined with an official mandate for banks to increase lending—as the state-run Xhinhua news agency put it—"highlight China stabilizing economic growth."

Wen has suggested further stimulus is in the offing, saying, "We must take further steps to increase the strength of pre-emptive fine-tuning." In our view, this should put to rest fears June's inflation reading—a 29-month low in headline inflation and falling producer prices—heralds the onset of troublesome deflation. Rather, it likely means officials have ample room for maneuver—both for more stimulus and for liberalizing protected sectors of the economy, like energy markets. The government maintains artificially low energy prices—in fact, recent cuts are likely one reason inflation's so low. Officials have long planned to introduce a more market-oriented system, which likely brings higher prices over time. Chinese people may find this concept far more tolerable while fuel prices and inflation are low.

Thus, whether or not China's Q2 GDP growth ends up slower, a hard landing remains highly unlikely. Recent stimulus may take a while longer to impact economic growth. And even if the growth rate slows, the actual value added to global GDP likely remains firm—just as it increased even as growth slowed last year. Overall and on average, evidence suggests China's still chugging—and remember, stocks move in advance of the economy, not after.