Is deflation really China’s next big export?

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Last week, China released numbers that showed growth in its consumer price index was negative for a third month running in December — recall that “deflation does not and will not exist in China” — deepening its economic miasma.

It’s pretty remarkable at a time when even Japanese inflation is running red-hot. Here’s a nice chart from mainFT’s write-up of the data on Friday:

Alphaville has written a lot about what this means for China (and whether it really is becoming the new Japan) but one benign side-effect has been that it has helped weigh a little on uncomfortably-high inflation elsewhere.

While China’s inflation rate has dipped below zero, its producer prices index and the cost of its exports have absolutely plunged, as this Bank of America chart shows.

However, BofA economists Helen Qiao and Miao Ouyang stress that the “China exporting deflation” narrative is much muddier than it might seem.

Yes, lower Chinese export prices have helped weigh on imported manufactured goods prices in the US and Europe. But in both cases the Chinese import price decline was actually smaller than the broader fall. BofA writes:

While it is hard to disentangle the effects of improving supply chains and falling import prices from China, we believe the former has likely dominated the disinflation seen in the US CPI in 2023. In Europe, the main driver for falling import prices last year was energy prices.

(Zoomable version)

Moreover, while Chinese stuff is big in both the US and Europe (respectively 16.5 per cent and 20.8 per cent of total imports), the contribution to inflation rates is smaller than you might think.

That’s because a lot of Chinese imports are intermediate and capital goods used in the production of stuff you buy in the shop (things like steel and machinery). It therefore takes time before prices on these feed into consumer price indices, and they might not do so fully.

In fact, BofA’s Qiao and Ouyang estimate that Chinese imports only make up less than 5 per cent of US goods consumption — and point out that goods only account for about 40 per cent of the US CPI basket.

What if China’s downturn worsens, deflation deepens and its export prices plunge even further? As the global economy’s dominant factory, couldn’t that turn today’s silver lining into tomorrow’s international deflationary spiral?

BofA thinks not. Partly because they think renewed infrastructure spending will help boost China’s economy this year, and partly because physical goods is just one aspect of inflation: central banks can and would adjust monetary policy in response, generating services inflation.

China can, at most, export goods deflation but not overall deflation to other countries. As long as central banks have independent monetary policies, they can set medium-term inflation targets at any level. In other words, to a modern economy with an autonomous control of its money supply and interest rates, another country would not be exporting inflation/deflation to it through trade.

This implies the goods deflation exported by China will translate into overall deflation or lower inflation for other countries only if those recipient central banks accommodate that shock. If central banks choose to fight back by setting monetary policy to generate an offsetting increase in the price of non-tradables, deflationary pressure will unlikely prevail. At the maximum, this “exports of goods deflation” can affect the relative price of goods vs. services. In other words, saying that China is exporting goods deflation is as true as saying that China is exporting services inflation.

Perhaps. A few more negative inflation prints and the China-exporting-deflation narrative will probably accelerate anyway. But for now this seems to be a pretty positive dynamic, so let’s not ruin it by overthinking things.