China's eased deflationary pressure cannot mask the unbalanced growth model favoring manufacturing sectors

The start of the Chinese economy in 2024 is being clouded by the market concerns about deflationary pressure. However, the February data seems encouraging in this regard, as the year-over-year CPI finally turned to positive territory (0.7%) and, more importantly, the core CPI (excl. food and energy) rose to 1.2% YoY.

Indeed, the interpretation of the data is complicated by seasonal and base effects. The adjusted CPI, accounting for the two factors, actually further declined from -0.02% MoM in January 2024 to -0.04% MoM in February 2024 (Chart 1). But this was largely caused by the food price decline. If we assume the current core CPI momentum to persist, the core CPI will rise to 1.6% for the whole year. Additionally, if the food price is to correct its decline in 2023, the headline CPI will rise to 0.6% for 2024, which could ultimately ease some deflationary concerns among market observers.

However, our focus should not stop at the headline figures but delve into deeper sectoral breakdown.

Chart 1 reveals a noteworthy surge in the service component, while the goods component still experienced a further decline. It suggests that China’s eased core deflation is largely due to service activities rebound, while the existing manufacturing imbalance, characterized by weaker manufacturing demand than supply, continues to persist. This aligns with the acceleration in China’s industrial value added, rising from 3.6% in 2022 to 4.6% in 2023.

Similar evidence can be gleaned from the PPI data (Chart 2). Our seasonally and holiday-adjusted month-over-month PPI, which comprises more good component than CPI, remained in negative territory, even though it increased in February.

The message conveyed by the sectoral breakdown is clear. It is likely that China will step out of a negative CPI growth in 2024 if food price can stabilize. However, the gap between supply and domestic manufacturing demand is bound to continue, which does not bode well for overcapacity issue and deflationary pressures down the road.

All in all, the market's attention should go beyond reading the headline inflation figures towards the increasingly unbalanced growth model of the Chinese economy, which is deflationary in the manufacturing sectors.

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