China Factory Price `Sweet Spot' to Wane, Tightening Real Rates

  • March producer prices on-month to turn negative: Macquarie
  • Policy makers ready to offset downward pressures: CBA

China’s economy has received a shot in the arm from rising producer prices and the easier financial conditions they spawned.

The bad news: That boost to the global reflation outlook is poised to wane in the second half as low year-earlier numbers are removed from the equation. But there’s good news too: Chinese policy makers bent on ensuring a smooth leadership reshuffle later in the year are poised to keep the economy ticking, underpinning domestic and thereby global demand.

Economists surveyed by Bloomberg News forecast factory-gate inflation will ease back slightly to 7.5 percent in March from a year earlier and dial back to 3.8 percent in the fourth quarter as year-earlier comparisons rise. That means real interest rates for industrial companies -- as measured against the Producer Price Index that most impacts them -- are projected to tighten from minus 3.45 percent in February to positive 0.55 percent in the final quarter, assuming benchmark lending rates remain unchanged.

“The first half of 2017 is likely to be a sweet spot,” said Andrew Polk, director of China research at Medley Global Advisors LLC in Beijing. "Real financial conditions will automatically tighten due to slower PPI growth in the second half of the year, so policy will shift back into a holding pattern in order to avoid over-tightening."

Surging commodity prices from oil to iron, a weakening yuan and government stimulus helped fuel a spike in producer prices after years of deep deflation, boosting profits for industrial companies and triggering a recovery of investment.

For downstream manufacturers, it was a mixed blessing as they paid more for inputs but couldn’t always pass on their higher costs to final buyers. Purchasing managers’ reports have showed smaller firms still reporting deteriorating conditions in recent months even as life got better for medium and larger companies -- often state owned.

Producer prices will turn negative in March on a month-on-month basis for the first time since June, indicating a peak for the corporate earnings cycle, said Larry Hu, head of China economics at Macquarie Securities Ltd. in Hong Kong.

Read More: China Factory Prices May Be Peaking Just as Global Ripples Start

It’s "the turning point for reflation," Hu wrote in a research note on Monday. "We don’t particularly worry about the near term, as cement prices and power production still look robust entering April. But we expect more headwinds" in the second half.

The swing away from deflation helped fuel an 8.5 percent increase in profits at industrial enterprises last year after a fall of 2.3 percent a year earlier. It also lowered borrowing costs on corporate debts that reached 156 percent of gross domestic product last year according to Bloomberg Intelligence estimates.

Historically, China’s factory prices have swung sharply. While economists don’t anticipate a return to falling prices, they do expect gains to moderate sharply, with an annual pace of 2.1 percent seen in 2018 and 1.8 percent in 2019, according to a March survey.

The coming drag on growth from slowing producer-price gains from a year earlier is likely to be countered by policy measures as Communist Party leaders begin a twice-a-decade leadership shuffle later this year.

By setting a consumer price inflation target of about 3 percent for 2017, compared to the average of 2 percent last year, the central bank has the flexibility to keep monetary policy supportive, said Li Wei, the China and Asia economist for Commonwealth Bank of Australia in Sydney. The 12 percent growth target for M2 money supply also is above nominal growth, giving ample scope for supportive policy, he said.

“We expect Chinese policy makers to be highly risk averse in 2017, with little appetite for economic weakness,” said Li. "The political backdrop is very pro-growth in 2017."

— With assistance by Kevin Hamlin

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