China – the case for a floor
My latest video, discussing the lessening of deflationary pressure, whether that can continue, and what the implications are for markets.
As judged by the change in the GDP deflator, China's deflation lessened in Q3 last year. Given changes in CPI and PPI since then, Q4 GDP data to be released on January 19th will likely show that the easing of deflation pressure persisted into the end of last year. And leading indicators for Q126 are pointing to continuation in the early part of this year.
It is tough to attribute this stabilisation to an improvement in cyclical momentum. Through 2025 there had been some signs that the collapse in construction was bottoming out, but the data in Q4 showed renewed weakness. FAI numbers have been terrible. The recent improvement in CPI has been driven by food prices, which aren't related to the economic cycle.
However, there are some domestic drivers that should be helping to address deflation. The demand:time deposit ratio has stabilised, there's been a rise in PBC lending to the financial sector, and China is once again starting to see capital inflows. China's price level is also benefiting from global factors: the stability in commodity prices, and, perhaps, the weakening of the USD.
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There are also structural reasons to think that deflation in China is likely to be a cyclical phenomenon rather than a hard-to-shake Japanese-style funk. There aren't signs of a balance sheet recession in China, and unlike other economies that have suffered serious deflation – Japan most notably, but also Hong Kong after the Asian financial crisis, or Taiwan following China's entry to the WTO – China isn't an expensive economy where a period of deflation is necessary to regain competitiveness.
That China is cheap is partly because the rise in real interest rates that many observers worry about hasn't led to real exchange rate appreciation. Instead, the CNY is cheaper than any time since 2013.
So, while the cycle in China remains weak, there are still reasons to think there is enough of a shift in nominal momentum to affect markets. As an example, my simple reaction function for the PBC has been signalling over the last 6M that for the first time since 2022, the probability of further monetary easing has been falling. It is this change is in turn now providing some support for the currency.
With the cycle still so weak, I doubt the CNY can move much – and indeed, as long as deflation persists, I doubt the PBC would want the currency to appreciate more. My long-standing view has been that real cyclical improvement in China's economy and markets is unlikely while the property market remains in crisis. There is a scenario, however, in which pressure for CNY appreciation helps stabilise the domestic economy and thus becomes self-reinforcing. By intervening to slow down appreciation, the PBC would boost domestic money supply and so try to engineer more domestic reflation.