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China's Pivotal Role in the Global Inflation Cycle

China’s recent moves to stimulate domestic demand have also lifted the global inflation cycle. What does it mean and will it last?

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A little more than a year ago, the global economy faced intense disinflationary pressures. Declining commodity prices and the slowdown in China’s economic growth fed fears of global recession. At the same time, producer prices in China, a key gauge of inflation, fell by a yearly rate of nearly 6%, and the country’s move to allow its currency to depreciate against the dollar only added to worries over deepening disinflation.

Fundamentally, the economy is still facing issues of overinvestment and excess capacity, which policymakers are trying to resolve gradually.

Today, that all seems like a distant memory. China has played a pivotal role recently in driving up the global inflation cycle, a cyclical recovery that has both lifted China’s own inflation rate and transmitted it globally.

Debt Indulgence

To be sure, the recovery in China has been driven by yet another round of debt indulgence. China’s debt has grown by $4.5 trillion over the past 12 months, more than growth in debt for the U.S. ($2.2 trillion), Japan ($870 billion) and the euro area ($550 billion) combined over the same period.

The bulk of this debt creation in China has been directed toward infrastructure and property markets, once again feeding domestic demand, which has lifted global commodity prices and China’s commodity-related producer price segments. Higher commodity prices and demand have also begun to translate, albeit modestly, into growth for the non-commodity segments of the producer price index.

Outside China, the rise in commodity prices is pushing headline inflation higher in developed markets, too. Given China’s dominant role in the global manufacturing supply chain, the dissipating disinflationary pressures in China’s producer prices should transmit more generally into tradeables (core goods) inflation. Recall that, while core services inflation had been holding up well in developed markets, the core goods component was the significant drag on core inflation.

Our China economics team estimates that producer price inflation will rise further over the next four months. This recovery has happened alongside rising imbalances. Concerns about asset bubbles have already led policymakers to dial back on the provision of stimulus—tightening property-market-related measures, providing window guidance to banks to tighten credit to households and allowing interbank rates to creep up. To assess the potential for any overshoot in the cyclical recovery, the key indicator to watch in this context will be property sales. 

When Stimulus Fades

Fundamentally, the economy is still facing issues of overinvestment and excess capacity, which policymakers are trying to resolve gradually. These factors point toward a bias that disinflationary pressures will reassert themselves once the effects of the stimulus fade.

Currently, the 15 economies that account for 55% of global GDP still have inflation rates that are below their central banks’ targets and comfort zones. While we do see the scope for upside surprises in inflation in the near term, the lingering issues of balance-sheet recession in developed markets, wide output gaps in emerging markets, excluding China, and, most importantly, the excess capacity overhang in China mean that the uptick in inflation should be gradual. 

Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (Oct 30, 2016) series. Ask your Morgan Stanley representative or Financial Advisor for the latest coverage on China and its growth outlook. Plus, more Ideas.