Deflation is something that has rarely occurred during recent years amidst massive quantitative easing by major central banks around the world. However, as recent official data show that China's inflation is falling rapidly, that may place some sectors under deflationary pressure soon. The much milder inflationary pressure is providing the central government bigger room for policy loosening.

China's Consumer Price Index (CPI) rose 2.2 percent year-on-year (YoY) in June, further down from the increase of 3 percent in May and 3.4 percent in April, according to the National Bureau of Statistics. The milder inflationary pressure was mainly due to the significant month-on-month (MoM) declines in fuel and food prices. During the month, food prices increased by 3.8 percent after rising 6.4 percent in May. On a MoM basis, food prices actually dropped 1.6 percent with the prices of pork, fresh vegetables and fresh fruits all falling.

As the effects of overseas economic turmoil continue to spread and the property market correction in China further manifests going forward, the country may see inflation softening further or even face deflationary pressure at least on the producer side in the near term.

Meanwhile, the Producer Ex-Factory Price Index (PEFPI) considerably decreased 2.1 percent in June after dropping 1.4 percent in on the back of the significant correction in commodity prices and huge de-stocking pressure in the manufacturing sector. The Producer Purchasing Price Index (PPPI) saw an even sharper decline of 2.5 percent, compared to the 1.6 percent decrease in the previous month. The significant decline of producer prices actually reflects the noticeable slowdown in the global economy as well as the capacity shrinkage and de-stocking processes in the domestic manufacturing industries.

As global demand remains weak while de-stocking pressure still exists in some commodity sectors like coal, industrial prices are likely to slump further in the third quarter of 2012.

The CPI is also expected to see further slowdown thanks to the seasonal increase in supply as well as consecutive drops in fuel and input costs in the short term. The year-on-year growth of CPI may mitigate to a trough level below 2 percent around July before it slowly rises in the fourth quarter this year.

The consecutive decline of inflation will provide further room for policy loosening. However, the mild and gradual policy adjustments by the central government can hardly reverse the slowdown trend in country's economic growth this year.

The author is Executive Director at BOCI Securities. The opinions expressed here are entirely his own.

(HK Edition 07/24/2012 page2)