Deepening deflation

Price declines in most sectors of the economy and in most regions of
the country indicate continued high levels of oversupply in the
economy.

Chinese consumer prices continued to fall in August, and a closer look
at the government's CPI figures indicates that the problem of deflation
may be even more worrisome than many analysts have acknowledged.
Variations in the CPI trend across the country point to bottlenecks
caused by heavy investment spending in certain areas, notably the
western regions and Shanghai, but the general trend is still one of
continued price declines in all but a handful of sectors.

Earlier this year, expectations rose that China's deflation problem
might be coming to an end, as the CPI remained flat year-onyear in
February after three consecutive months in negative territory. Official
projections around this time were for full-year CPI inflation of 1-2
per cent in 2002. The February blip might be the result of the
different timing of the Spring Festival holiday period over the past
two years. Another possible reason was that it was a statistical
anomaly, supported partly by higher prices for food and energy.

Whatever the reason, since then consumer prices have fallen in each
successive month on a year-on-year basis, with seasonal fluctuations in
food prices no longer offsetting industrial deflation in certain
months. The August 2002 figures, in fact, show a slight decline of 0.4
per cent in food prices from August 2001 – a trend that may intensify
next year as China's agricultural markets are further liberalised.

The real drivers of CPI movements in recent years have been continued
rises in the price of regulated services (particularly healthcare,
housing rental and public utilities) and countervailing declines in the
price of manufactured goods. While these broad trends remained
unchanged in August from most of the past year, more detailed figures
from the National Bureau of Statistics show a number of significant
shifts at the regional and sectoral level.

The Chinese economy is still far from fully integrated, and CPI trends
have varied widely from province to province. At one extreme, seven of
the country's 31 provinces (including minority autonomous regions and
directly-administered cities) showed rising consumer prices in August,
despite the national trend of deflation. The CPI index for Qinghai rose
by a startling 3.4 per cent year-on-year, while prices rose by 0.7 per
cent in Shanghai and 0.5 per cent in Tibet. Given the weak pricing
power of Chinese producers generally, these anomalous figures seem to
indicate localised areas of shortage, possibly in the labour and
property markets, in regions targeted for high-priority state
investment. Qinghai and Tibet are among the most sparsely populated
regions of the country, and rising prices there are a likely
consequence of heavy infrastructure spending connected with Beijing's
'Go West' programme. Likewise, Shanghai has continued to receive
preferential allocations of credit from China's state-owned banks,
particularly for infrastructure development in Pudong New Area.

At the other extreme, some provinces showed CPI deflation rates well
above the nationwide average: prices fell by 1.9 per cent in Shanxi and
by 1.2 per cent in Anhui, Guangxi, Sichuan, Chongqing, Shaanxi and
Xinjiang. Some of these figures may represent severe distress in
particular product markets ?for example, coal in Shanxi and cotton in
Xinjiang (provinces that might otherwise have been expected to
experience price pressures generated by 'Go West' projects).

Technological progress

The bureau's breakdown of CPI trends by product category is equally
revealing. The sharpest price fall was a 16.4 per cent yearon- year
decline in communications equipment, highlighting the impact of
technological progress in this sector. In other areas, however, price
declines point to a worsening of overcapacity, even in markets where
Chinese goods are internationally competitive. Textile prices fell 2.6
per cent year-on-year, which seems to confirm earlier indications of
haphazard capacity expansion in the sector, such as a sharp rise in
imports of textile machinery. This is happening several years before
Beijing's trading partners will open their markets to apparel imports
under the terms of China's WTO entry.

There are also signs of distress in the home appliance market,
particularly for producers of television sets. Prices of 'durable
consumer goods for entertainment purposes and their repair services'
fell by 9.2 per cent year-on-year, indicating continued oversupply. The
television set industry is certainly benefiting from foreign
investment, especially by Hitachi, which has partnered with a Chinese
firm to produce for the Japanese market. However, the shift to digital
transmission format for high-definition television promises to make
China's entire manufacturing plant obsolete within a few years
?suggesting that this sector may face employment pressure towards the
middle of this decade.