Investment Research — General Market Conditions

10 June 2009

Flash Comment
China: Negative inflation but deflation no concern
„ Consumer prices in May came in broadly in line with expectations at -1.4% y/y.

„ While headline CPI is likely to remain in negative territory for most of this year, deflation
is no major threat to the Chinese economy. Our forward-looking indicators all suggest Consumer prices, May (% y/y)
inflation will pick up. Act Con DB Last
„ With only a modest output gap, we expect the People’s Bank of China to tighten monetary CPI -1.4 -1.3 -1.3 -1.5
policy in H1 10 and resume the gradual appreciation of CNY at some stage. PPI -7.2 -6.9 na -6.6

Source: Ecowin and Danske Bank

Details
Consumer prices in May came in broadly in line with expectations at -1.4% y/y (consensus:
-1.3% y/y). Lower food prices and lower rent continue to be the main drivers behind the sharp
decline in consumer price inflation over the past year. However, the drop in food prices has CPI inflation to remain negative until
eased because of a sharp increase in vegetable prices, while meat prices continue to ease late 2009
following the surge early last year. Sequentially we estimate that consumer prices in China % y/y % y/y
10 Consumer prices 10
have been increasing in recent months and hence the decline in headline year-on-year inflation
Forecast
is solely due to the base impact from last year. 5 5

0 0
Consumer prices excl. food
-5 -5
Assessment & Outlook Producer prices

Hence deflation should not be a major concern. Deflationary pressure is currently easing -10 -10
02 03 04 05 06 07 08 09 10
significantly and our forward-looking indicators suggest inflation should pick up and it cannot
be completely ruled out that inflationary pressure will re-emerge next year. Source: Reuters EcoWin and Danske Markets

House prices have increased in recent months, suggesting that the decline will soon end. In
addition, energy and commodity prices have increased recently and the government’s
liberalisation of some administered prices (water and energy) should add somewhat to inflation
looking forward. Finally, the recent extraordinarily sharp increase in money supply growth is a Food and rent are the main drivers
strong indication that inflation in China will pick up next year (see chart on next page). 25 % y/y 25
% y/y
20 20
We expect consumer price inflation to remain in negative territory for most of this year Food
15 15
(mainly due to the base impact from last year) and then increase substantially from early next
10 10
year (see chart). Residential
5 5
0 0
Clothing
-5 -5
Transport and communication
Implications -10 -10
00 01 02 03 04 05 06 07 08 09
We are unlikely to see further interest rate cuts from the People’s Bank of China (PBOC).
Despite the strong headwinds from the global economy, it appears that China has been able to Source: Reuters EcoWin
manage a soft landing of its economy. China’s output gap has only increased modestly
compared with the US and Europe (see chart on next page) and hence China will probably
have to return its monetary focus on price stability before central banks in the US and Europe.
For that reason we believe China will tighten monetary policy in H1 10 (possibly by
reintroducing lending quotas). A modest output gap and continued need to contain inflation is
our strongest argument for China at some stage resuming its gradual appreciation of CNY
against USD.

Senior Analyst
Flemming J. Nielsen
+45 45128535
flemm@danskebank.dk

www.danskeresearch.com
Flash Comment

Meat prices continue lower PMI suggests deflationary pressure is easing

60 % y/y % y/y 60 70
Diffusion, 12M change % y/y
10
Meat Producer prices>>
40 Grain 40 60 5

20 20 0
50

0 0 -5
<< Prices charged, Markit-CLSA PMI
40
-10
-20 Fresh vegtables -20
0 0 30 -15
02 03 04 05 06 07 08 09 05 06 07 08 09

Source: Reuters Ecowin Source: Reuters EcoWin and Markit

Sharp increase in money supply growth suggests inflation will Unlike US and Europe, China has only a modest output gap
pick up next year
10 30 6 % of GDP Inflation>> 25
% y/y Money supply M2, 12M lag>> % y/y % y/y
20
8 4
15
25 2 10
6 << Consumer prices
5
0 0
4 20
-2 -5
2 -10
15 -4 -15
0 <<Output-gap -20
-6
-25
-2 10 -8 -30
00 01 02 03 04 05 06 07 08 09 10 11 80 85 90 95 00 05 10

Source: Reuters EcoWin Source: Reuters Ecowin and Danske Markets

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Flash Comment

Disclosure
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Danske Bank is under supervision by the Danish Financial Supervisory Authority. The author of this report is
Flemming J. Nielsen, Senior Analyst.

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Financial models and/or methodology used in this report

Calculations and presentations in this report are based on standard econometric tools and methodology.
Documentation can be obtained from the above named authors upon request.

Risk warning
Major risks connected with recommendations or opinions in this report, including a sensitivity analysis of
relevant assumptions, are stated throughout the text.

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