Whether China economy has a risk of inflation/deflation is debatable. The inflation camp cites the fact that banks in China have printed large amount of money and channeled the liquidity into the market at a record pace especially during the first half of 2009 (See Graph from Chinatells). Such a scale of money supply will take effect in pushing up the price of everything sooner or later, maybe not now, but definitely in the forseeable future. In addition, it seems that the CPI/PPI are already starting to react towards a positive direction (See Graph from Chinatells). On top of such headline figure, the housing market in Beijing and Shanghai is already showing a sign of frenze and bubbles. Based on the theory of Monetarists, inflation is a money phenomenon and with excessive supply of money, the headline reading will go up sooner or later, with the velocity of money circulated in the society ticking up.
Life would be easy if it is that simple. There are a few points to argue against the above conclusion. First the M2 growth looks high on the headline number, but it does not necessarily mean the supply of money for investment/speculation is growing at the same pace. In fact, due to the risk averse nature during economic downturn, large amounts of that money growth go into household and corporate saving, which are basically dormant in the form of bank deposit. In addition, given the nature of China economy as the world’s biggest manufacturer and leading exporter, the export growth (a proxy of output gap) plays an important role in terms of inflation development. It is observed that every time there is a decrease in export growth, deflation comes hand in hand as there are excessive supply of products which keep the domestic price low. In the last ten years China has experienced three times of deflation: 98/99 around Asia Financial Crisis, 00/01 after the burst of Tech bubble, and 08/09 after the financial crisis. All deflations come with a severe downturn in export growth. Therefore unless there is good reason to believe that China’s export will rebound strongly in 2010, which is highly dependent on the economic performance of USA and EU, the headline CPI is unlikely to go beyond any big number following above logic.