China’s deflationary tsunami is brewing – MacroBusiness


Pantheon with the note. It’s only just begun.

Regional PMIs for July were rather pessimistic, indicating weaker domestic and global demand. But a more positive aspect was the continued easing of supply chain issues, unlike past lockdown reopening cycles in China. Lower demand no doubt helps on that front. But whatever the driver, a key source of global inflationary pressures is fading.

Japanese and Korean manufacturing PMI supplier delivery times improved in July, and although China saw a slight deterioration, it is still the best reading since March 2021. The improvement for Japan is particularly encouraging , marking the first sustained rally in nearly a year, as shown in our chart below.

Improved logistics in China, aimed at mitigating zero-Covid costs, likely explains part of the overall improvement. The largest factories now operate in a “closed loop” system, allowing production to continue and meet export orders, even when restrictions are tightened. Strenuous efforts have also been made to facilitate the rapid return of production and distribution in the latest wave of Covid. But the fall in demand also clearly plays a role, in a more mixed benefit for the global economy.

Weak demand is increasingly evident in Korean exports, a reliable leading indicator of global trade, as well as domestic data from Europe and the United States. We can also see it in the drop in shipping costs, shown in our graph above. The price of cargo shipments from Asia to the rest of the world has fallen since the start of the year and is generally around 50-75% of the peak seen in 2021. Given the delay in building new vessels, it is highly unlikely to reflect an aggressive supply response.

Supply chain issues are increasingly a thing of the past, reducing or removing a major source of inflationary pressure. At the same time, falling commodity prices mean lower input costs for manufacturers. Japan is an exception, for now, as recent yen weakness is impacting imported inputs, but Korea, and especially China, are experiencing lower input inflation. We expect this to trickle down to customers, both domestic and global, as lower demand means lower pricing power.

Taiwan crisis risks throwing sand in the gears

A risk to improving supply chain and inflation, however, is the deteriorating situation in Taiwan. We’ll leave the political and military commentary to others, but the economic consequences seem inevitable. In response to President Pelosi’s visit, China has imposed trade measures on Taiwan, although apparently for other reasons.

A ban on the import of certain fish and fruits from Taiwan will have little global impact. But China’s embargo on sand exports across the strait potentially carries higher risks. The biggest casualty is expected to be domestic growth in Taiwan, with higher prices and likely shortages in the construction industry. Some of the fallout on Chinese industry is
possible, accordingly. But silica and quartz sands are also a key input for the production of semiconductors.

But while China held a dominant position in Taiwanese sand imports, with reports suggesting a share as high as 75% a decade ago, that share apparently collapsed to 1.9% in the first half of 2022. increasing share of domestic supply. Taiwan has instead turned to imports from Australia and elsewhere, despite higher shipping costs. Disruption to the semiconductor industry should therefore be manageable, especially given rising inventories and reports of a supply glut.

Chinese military exercises, planned in Taiwanese territorial waters after Ms. Pelosi’s visit, will also be disruptive. Taiwan has already announced that it is planning alternative cargo flight routes with Japan and the Philippines. Shipping will also be affected. But that should be less noticeable globally, as drilling is currently only scheduled for four days, August 4-7. We expect to see a one-time impact on regional trade and production data for August, but this should be repaired in September.

China’s economic retaliation so far seems manageable, from a global perspective. But a further escalation is possible. The bulk of Chinese imports from Taiwan are machinery and electrical equipment, the ban of which seems unlikely given the damage it would cause to Chinese industry. If nationalist fervor forces such a move, we would expect more material damage to regional supply chains.

Tensions over Taiwan also appear likely to affect broader negotiations between China and the United States, and must now mean that the chances of a reduction in US tariffs on Chinese goods are slim. On the contrary, trade frictions between the two economies are expected to intensify in the coming months. Supply chain watchers can’t relax yet.

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