A Year of Not Worrying About Inflation

? We expect CPI inflation to average 2.0% and 3.6%， respectively， in 2012 and 2013? We think of inflation as a three-year cycle; 2012 will be the bottom

? We expect another RRR cut before end-2011， and five more cuts in 2012

One of our non-consensus

calls for 2012 is very low CPI inflation in China. We expect CPI inflation to drop sharply in H1， before rising above 4% y/y again in Q3-2013. We forecast average inflation at 2.0% in 2012 and 3.6% in 2013 (see Chart 1). Here are the foundations of our view:

1. We believe that China has been on a three-year inflation cycle for the past decade， largely driven by policymaking dynamics. We see no reason for this to have changed.

2. Weaker external demand will exacerbate downward price pressures for most of 2012.

3. Food is key to China’s CPI cycle. We expect 2012 to be characterised by both strong supply growth and more restrained demand growth (due to slower overall household income growth).

4. With monetary policy still in transition， overall demand should bottom out only in Q1-2012; this should set us up for a turnaround in Q2 and a stronger H2. We look for 6% q/q annualised GDP growth in Q1-2011， rising to 12% in Q4. PMI readings are also likely to remain below 50 in Q1.

5. Barring a sudden demand shock from Europe， we do not expect a quick turnaround in policy， and monetary policy easing should continue to be gradual. Given that prices take time to react to recovering demand， we do not expect CPI inflation to begin rising in y/y terms until mid-2012.

6. Actual consumer price inflation may well be higher than official CPI inflation， but we still believe official inflation is an accurate portrayal of the trend.

The recurring three-year inflation cycle

Chart 1 provides a straightforward illustration of the three-year inflation cycle. Since 1999， China has had three inflation cycles: April 1999 to April 2002; May 2002 to around September 2005; and July 2006 to July 2009. These cycles have two factors in common:

1. Each one lasts about three years.

2. Inflation rises in the first two years and declines in the third year.

This is not a coincidence. We believe the three-year cycle reflects how the economy and policy makers work. Generally speaking， after a year of ris-ing inflation， policy makers become worried about the risk of an inflationary spiral and start to tighten credit. Suppliers of goods will also increase capacity after having enjoyed improving profits for some time. These reactions lead to a decline in inflation after a year or so.

We expect China’s three-year inflation cycles to continue， given that there is little evidence of big structural changes in the economy or significant changes in the policy-making apparatus. This suggests that CPI inflation will fall in H1-2012， to around 1.3% y/y by July， according to our forecasts (after rising for two years from August 2009 to a peak of 6.5% in July 2011). We expect y/y inflation to bottom out in H2-2012， and rise above 4% again in Q3-2013.

A benign food inflation outlook for 2012

Food is a key driver of China’s CPI inflation. Chart 2 shows the breakdown of contributions to CPI inflation into food and non-food sub-categories (on a weighted basis). Since 1999， food has been responsible for over 70% of overall CPI inflation， on average， despite accounting for only 31% of the basket.

Chart 3 shows our estimates of the composition of the CPI food basket. Meats (MT) are the most consumed foods in China， accounting for about 22% of the food basket. Pork (PO) is the most important meat， accounting for about 9.7% of the food basket(and 2.9% of the total CPI basket). Non-pork (NP) meats together account for about 12.2% of the food basket. The next most important food categories are fresh vegetables (VE) and grains (GR)， accounting for 9.7% and 9.0% of the food basket， respectively. They are followed by aquatic products (AQ)， fresh fruits(FR)， edible oils (ED) and eggs (EG)， with respective food basket weightings of 7.7%， 6.0%， 3.7% and 2.9%.‘Other foods’ (OT)， those not included in the abovementioned categories， together account for 39.3% of the food basket.

Chart 4 shows how each type of food has affected overall food inflation since 2006. As one can see， meats (especially pork) and ‘other foods’ have dominated. Fresh vegetables and fruit were also important drivers of food inflation from March 2009 to November 2010， but their supply fluctuates， so their effects are less persistent. Grain inflation has been rising since 2010， but given that the floor for grain prices is largely controlled by the government and grain stocks seem sufficient at the moment， we see little inflation risk here.

Pork prices have started falling， as we show in Chart 5. The profitability of pig farming has improved considerably， with the pig-to-feedstuff ratio (a measure of profitability) having recovered to above 7.0 as of November 2011 from a low of 4.9 in June 2010， according to the Ministry of Agriculture (MoA); see Chart 6. Pig stocks are rising as a result of this improved profitability. According to MoA data， the number of sows

rebounded to more than 48.8mn in October 2011 from a low of 45.8mn in August 2010， which suggests more pig supply down the road.

We expect pork inflation to drop sharply. Chart 7 shows historical pork inflation and our forecasts for 2012-13. We look for an 11% y/y price decline by July 2012. As a result， the weighted contribution of pork inflation to overall CPI inflation should drop from 1.7ppt in June 2011 to -0.3ppt by July 2012.

Chart 8 shows our forecasts for overall food inflation in 2012-13. We expect it to fall from 8.8% y/y in November 2011 to around 3.3% by September 2012. Food inflation should start to pick up gradually in H2-2012 after policy easing in H1， and accelerate further to above 10% y/y in Q4-2013.

Non-food inflation forecasts for 2012-13

We show our forecasts for y/y nonfood inflation in Chart 9. We expect it to decline further to around 0.2% by July 2012 from 2.2% in November 2011， and stay close to zero for the remainder of 2012 before gradually recovering towards 1.9% by end-2013. Us versus consensus

Inflation will not become a concern again for the State Council until 2013， in our view. We believe this is the lesson of the three-year inflation cycle. The current market consensus forecasts for average CPI inflation are 3.75% for 2012 and 4.25% for 2013， according to a Bloomberg survey of 12 economists.

Our more benign CPI inflation forecasts (average of 2.0% for 2012 and 3.6% for 2013) suggest that Beijing will have quite a lot of room to manoeuvre on monetary policy in 2012. The transition to monetary loosening has begun， but it will be a gradual process. After a first cut in the required reserve ratio(RRR) on 1 December， we expect another cut before the year-end， as a preemptive move to offset the negative impact on market sentiment of the 1 January release of the December PMI(which we expect to fall further below 50). We expect another five RRR cuts in 2012.