Eureka! The real driver of China’s GDP is in the prices

Anyone fortunate enough to have shared an office with a follower of the dismal science will know that when a eureka moment strikes, the otherwise unexcitable economist has a tendency to break down in tears of joy and exult with wild acclamations in all manner of tongues as if they have just won the Nobel Prize … “I’d like to thank my mom, my first grade math teacher, professor Ma … ad infinitum ad nauseum etc etc …”

Well, it wasn’t quite one of those moments this week at Asia Times, but it came close. It certainly made us jump out of our chairs as our ever-deeper dive into China’s GDP data threw up some spectacularly intimate relationships between China’s economic growth rates and the all-too-familiar price indicators.

If the Chinese economy is growing at 11.8% per annum in nominal terms (that’s your paycheck), while the price-adjusted real growth rate (that’s how many more Happy Meals you can afford) stood at 6.9%, the difference between the two – approximately 5% – would be the inflationary element, right?

But wait a moment. This is where the floodgates of my mind flew open. Last time I checked (April 12 to be exact), China’s first quarter CPI – short for consumer price index – was a feeble and unthreatening 1.4%. Even the core inflation measure, stripping away jumpy food and energy items, was as flat as the proverbial pancake at 2%. Where in the world is China hiding this 5% of inflation?

All of which lights up in bright red neon one BIG QUESTION: If that really is the on-the-ground magnitude of price increases hitting the economy, is China’s monetary policy way too loose? The benchmark one-year lending rate of 4.35% has remained untouched since late 2015.

We reported on April 24 that China’s agriculture-heavy primary sector sank into the worst contraction of the past 25 years, falling 1.7% in nominal output during the first quarter despite posting 3% growth in real terms. The 4.7 percentage point difference between the two rates – which can be seen as an rough approximation of the so-called GDP “deflator” – turned out to be very close to the -4.4% in the food component of the CPI inflation basket as of the end of Q1.

The first mini eureka moment arrived when we saw how closely correlated the food CPI and the primary sector’s GDP deflator has been over the past 15 years or so. This is not a single quarter event. For example, egg prices are nearly 12% cheaper in the first three months of this year from a year earlier; vegetable prices slumped 18.8%.

While that may be good news for consumers, it would turn the faces of farmers a sickly shade of green. (Not to mention making Beijing policy makers a little queasy at the prospect of swelling ranks angry country folk in this sensitive year of political transition.)

The dramatic change in the fortunes of China’s industrial economy since early 2016 – as judged by nominal growth hitting 14.2% in the latest quarter – has price recovery, or “reflation,” written all over it. And when we saw the estimated GDP deflator – again the difference between nominal and real growth rates – for the secondary economy was practically in tango with the PPI, or the producer price index, that’s when we had our second little eureka moment.

PPI is regarded as an important inflation indicator for the industrial sector, but this analysis demonstrates its usefulness as a very sensitive bellwether to the health of China’s 30 trillion yuan (US$4.4 trillion) and ballooning secondary economy, which makes up 40% of the country’s GDP.

If that logic stands, the latest pullback in the PPI to 7.6% in March from February’s 7.8% would be a reminder that the secondary economy’s growth, in nominal terms, may face some downside risk in the coming quarters. The rapidly slumping steel prices seen since late March and into early April would play into this negative narrative.

As noted in our previous article, the services tertiary sector appears to suffer the least amount of price volatility. The estimated GDP deflator for the tertiary sector was indeed less dramatic and has been picking up gently in the four most recent quarters to just below 4%.

While the services component of the CPI basket also has a similar upward trajectory, the match over a longer period between the two lines is clearly not as close as that seen in the analysis for the primary and secondary economy. Maybe we’ll stumble across a better match in the next round.