The divergence of producer price inflation and property price inflation (inflation dichotomy) will be increasingly apparent in China as economic reforms deepen next year.

The bulk of disinflationary forces will primarily come from the industrial sector due to severe production overcapacity. According to a survey conducted by the Development Research Center under the State Council, the average capacity utilization rate of the 3,545 enterprises surveyed was only 72 percent, down 0.7 percentage point from a year ago despite the central government’s efforts to cut down overcapacity.

About 68 percent of responding enterprises project it would take at least three years to absorb excessive production capacity.

Overcapacity is usually a characteristic of centrally planned economies. Before the global financial crisis erupted in 2008, the problem of overcapacity was not apparent as the global economy was much healthier and demand for Chinese goods was much stronger.

However, as global demand waned, China’s export growth to the United States, the European Union and Japan had fallen from 14.4 percent, 34.8 percent and 11.3 percent in 2007 respectively to 8.5 percent, -6.2 percent and 2.3 percent in 2012 respectively. Export growth has remained slow this year, advancing around 8.0 percent. To make matters worse, massive stimulus introduced in 2008 and 2009 has probably encouraged companies to expand capacity even as demand was falling. 

In October, the State Council named sectors that must urgently deal with overcapacity. They include cement, electrolytic aluminum, sheet glass, shipping and steel. New projects are forbidden, projects under construction should be reappraised, illegal capacity should be removed, outmoded capacity should be eliminated in an orderly way. Ultimately, the removal of excess capacity should ease some of the disinflationary bias. However, the actual execution will likely be met with tremendous challenges. Moreover, the root causes of overcapacity are multi-faceted. They involve the taxation system, environmental protection system, the financial system and the pricing mechanism for resource products. Overcapacity problems will be with us for a long time.

Reform of pricing

The National Development and Reform Commission (NDRC) had already initiated the reform of the pricing mechanism of water, electricity and coal to improve resource allocation and reduce wastage. The estimated initial impact is upward pressure on prices, which would inevitably jack up the production costs of the industrial sector. Without strong demand to counter this, industrial profits growth would begin to fall. Industrial enterprises’ profit growth fell to 15.1 percent in October from 18.4 percent in September and growth on a year-to-date basis has been very moderate.

Using another measurement, total profits of industrial enterprises with annual revenues of more than 20 million yuan (US$3.3 million) also slowed to 6.0 percent, from 7.5 percent in September. These trends will likely trigger price cutting to boost sales which will exacerbate disinflationary forces. That’s why disinflationary forces are here to stay in 2014.

Disinflation is already quite apparent in the Producer Price Index, but has yet to pass through to nonfood components of the Consumer Price Index.

The deteriorating operating environment and thinning margins of the industrial enterprises force them to venture into property investment. Some companies are deriving more and more revenues from property investment. For instance, Hong Kong-listed Kingboard Chemical now has a substantial property development business (4.9 percent of total revenues in 2012; 0.7 percent in 2011). Listed garment maker Luen Thai has injected their land into a property  joint venture to develop residential property.

Companies’ participation in the property market has created additional investment demand. Unlike production prices, property prices will mount further. This may partially explain the broken relationship between GDP growth and property prices.

Other fundamental forces are at work as well. Housing inventories has probably reduced in Tier-1 cities such as Shanghai, Beijing, Guangzhou and Shenzhen. Enormous pent-up demand for property began to mount in 2010 when administrative measures were introduced right after the marriage boom 2008-2009 — marriage cases surged more than 10 percent for two consecutive years. The average number of marriage cases during 2008-2011 was 12.1 million, compared with 8.6 million in the preceding four years. It’s not hard to see why prices go up when demand exceeds supply.

That is why administrative measures nationwide in the past three years had not managed to bring price down in a meaningful manner. They only managed to slow down the pace of ascent. Shanghai tightened its local home purchase restrictions further. Divorced or widowed non-local residents with children are regarded as single persons, and are not eligible to purchase homes in several districts of Shanghai including Jing’an, Changning, and Pudong. More and more local governments in Tier-2 cities such as Wuhan, Nanchang, Shenyang and Xiamen are introducing further measures to tackle rising property prices on the heels of tier one cities.

These measures include raising the down payment for second home purchases, raising the requirements for non-local households’ home purchases in the city, raising land supply targets in 2014, and enhancing construction of local social housing.

Against this backdrop, the inflation expectations of general households will remain high next year. The mentality of “buying property sooner before prices start rising again” will likely prevail.

Yuan’s appreciation

In recent years there is a strong positive correlation between the yuan’s appreciation in one year and property price increase in the next year. The yuan’s appreciation helps with China’s rebalancing. As people’s purchasing power increase, it generates tremendous wealth effects which are possibly spilling over to the property sector.

The motivation of keeping the yuan’s appreciation on course is obviously related to the ultimate goal of internationalizing the yuan. The Chinese government had done a great job of fortifying a solid foundation in the past few years by winning the support of many foreign governments. China needs to build up the credibility of the currency by maintaining a mild appreciation expectation bias of the currency for a long while more. From this angle, as long as households believe the yuan will continue to appreciate, property prices will mount north.

The phenomenon of “inflation dichotomy” will soon be manifested. We anticipate that disinflationary or even deflationary forces in the industrial sector would accelerate in 2014 as China’s overcapacity problem remains unresolved. Meanwhile, property prices would continue marching north. It will be very challenging for the central bank to formulate a policy response against contradicting price signals.

Judging from the stance of current monetary policy, it is fairly apparent that the central bank is quite concerned about consumer price inflation, otherwise it should have cut interest rates this year. It means that as long as producer deflation does not spillover to the consumer sector and as long as the magnitude of property price ascent is reasonable, we expect the central bank to keep the status quo on monetary policy.