On the subject of China exporting deflation

Over the last decade, China's effect on US domestic prices has been a frequent topic of debate.  The "China price" contributing to cheaper goods coming into the US has been cited as both a positive and a negative over the years.  This summer, a devalue of the Chinese yuan brought panic over China's potential to export deflation to the US.  With highly active central bankers around the world and uncertainty over global rates, China's effect on global and US inflation is a concern.  Here are my views on how China may impact US inflation going into 2016.

It is important here to first explain how China can affect prices in the US.  Here are what I consider the main mechanisms whereby China impacts US inflation/deflation: 1) The impact of China's demand for goods and commodities on overall global growth, 2) The impact of currency moves on US import prices, 3) The impact of China's domestic prices, wages, and activity on export prices, and 4) The impact of China's commodity demand on the price of global commodities.

Lets start with the most impactful mechanism.  China is 13% of global GDP.  At a 7% growth rate, it will contribute 27% of the IMF’s expected 3.3% 2015 global growth.  China is the largest trading economy in the world, accounting for 12% of global trade.  It is the single largest importer of heavy machinery and capital goods, and the most important trade partner for the 3rd and 4th largest economies in the world.  China’s economic activity has a meaningful impact on most of the world’s major economies.  As China slows, the world economy slows, and global inflation slows.  The world's factories and mines were built for a China growing 10-plus percent, pushing global growth above 5 percent.  Those high growth days are over, and now there is plenty of slack in the system to last a while.  Most signs point to that slack growing.  From a purely numerical perspective, regressing China GDP and US inflation shows a statistically significant relationship, with an R-squared of .35.  That would indicate China growth explains 35% of US inflation, mostly via China’s impact on global growth and global demand.  China export prices alone only explain 15% of US inflation based on a ten-year monthly regression, so the China economic growth impact is about more than China export prices.  With Beijing lowering the growth target and headwinds slowing broad activity, expect growth to slow further, putting downward pressure on global growth and leading to a potentially deflationary impact on the US for some time.

The second most important mechanism for China’s impact on US inflation is the direction of the yuan.  The yuan has contributed to upward US price pressures for the decade leading up to 2015.  The yuan appreciating against the dollar more than 30% over the last decade has effectively raised the prices of China’s exports by the same amount.  Up to 2015, the yuan was a one-way bet, pushing consistently higher.  2015 has changed that trend.  Directly, China accounts for 16-17% of US imports.  But, indirectly the impact goes beyond that 17%, because China is a highly important stop on the global supply chain.  Moves in the yuan can have an impact in the short term as US import prices would be affected quickly by currency moves.  Numerically, China export prices adjusted for the currency changes over the last ten years explain 32% of moves in US inflation.  Most market pressures are for a depreciating yuan, which would have a deflationary impact on the US.  For my views on the yuan, see my blog post here 5 Important Things You Should Know About the Chinese Yuan.

China is a massive importer of commodities.  But, the economy’s impact on global commodity prices is not a clear-cut story.  China’s commodity consumption is concentrated on industrial and base metals, as well as other infrastructure building materials.  See China’s commodity consumption here: http://laohueconomics.com/china-commodity-consumption/ Energy commodity demand, for example, is not as meaningful as with other major economies.  China's crude oil consumption constitutes 12% of the world’s total, and natural gas only 5%, compared to 55% of the world’s total iron ore consumption.  China’s weaker commodity imports have recently had a direct impact on growth in commodity exporting countries, like Australia and Mongolia.  But the economy’s weaker commodity demand has less of an impact on the prices of US imported commodities.  The commodity import make-up between the two countries is different.  US crude oil consumption is nearly double that of China, and China's iron ore consumption is over five times that of the US. Again, it is China’s impact on growth in commodity exporters and the resulting weaker global growth that has an impact on US inflation, not necessarily a direct impact on US imported commodity prices themselves.  Add to that the fact that China’s imports by volume have not collapsed as much as prices have dropped (see trade data here http://laohueconomics.com/test/).  Global commodity prices have dropped due to global supplier production increases more than China’s lower demand.  The prospects for global commodity prices and their effects on US prices are in the hands of global commodity producers, and not merely a product of lower China demand.

China's domestic prices may have some impact on US prices, but the connection is a weak one.  China's export price growth has averaged slightly below zero for the ten years to 2015, and modestly above zero in 2015.  Efficiency gains, logistics improvements, and low wages kept export prices low on average even as commodity demand drove up materials costs.  But, surplus labor from the countryside is drying up, and wages are rising as the labor force has peaked.  The "China price" will see upward pressure even as material prices decline.  The offsetting effects will mean a muted direct impact from China's domestic prices on US inflation.  Numerically, as mentioned above, China export prices alone have a very weak link to US inflation, with an R-squared of just .15.  And, it is uncertain how the offsetting wage increases and materials costs decreases will play out going forward.

In a nutshell, up to 2015 China's decade-long currency appreciation had been inflationary, and its insatiable demand for goods and commodities from abroad fueling global growth was also inflationary.  But, those same two factors have probably reached a turning point, reversing course and reversing the impact on prices globally and within the US.  Downward pressure on the currency means a meaningful probability for lower prices exported to the US.  Lower growth targets and mounting headwinds mean slower demand for materials and goods, leading to a high probability of lower global growth, more slack, and lower prices globally and in the US.  On balance, most signs point to China contributing to deflationary pressures in the US for some time.