19 December 2016

Asian deflation - Steel trap

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The Economist

Producer prices perk up in Asia


Besides being dirty and dangerous, making steel in China has been a good way to burn through money over the past few years. But in recent months, the fires from the country’s blast-furnaces have started to emit the warm glow of profits. Steel prices have risen by nearly 50 per cent this year. Production, which fell in 2015 for the first time in decades, is also up. Smelters are set for a strong recovery after losing $10bn last year. And it is not just the steelmakers who will be pleased. Asia’s central bankers can also take some comfort in the rising prices: they suggest that the threat of deflation might be receding.

Once seen in Asia as a peculiarly Japanese phenomenon, deflation spread throughout the region’s factories in the past half-decade. The prices that consumers see in shops have on the whole continued to increase, albeit more gently than before. But the prices that companies charge for goods as they leave their factories’ gates have dipped lower and lower. Virtually all big Asian economies, including South Korea, India, the Philippines, Taiwan and Thailand, have experienced prolonged bouts of falling producer prices.

China, the biggest economy and the centre of the deflationary spiral, recorded 54 consecutive months of declines. It broke that gloomy run at last in September, when prices increased by 0.1 per cent from a year earlier, thanks to rebounds in the steel and coal industries. Elsewhere in Asia, producer prices are now also rising, or at least falling more gradually than before (see chart).

This turnaround should be cause for relief. Deflation is often a symptom of economic torpor. For companies, falling prices cut into revenues and make it harder to repay debts, which are fixed in nominal terms. As companies sour on future prospects, they also pare back their investment—a potentially vicious circle. In its outlook for 2016, the Asian Development Bank (ADB) called producer-price deflation the “new spoiler” for the region. This is one forecast it would be glad to get wrong.

Still, no one is about to declare victory yet. A couple of years ago, producer prices also appeared to be edging up, when they were battered by a renewed slowdown in China’s industrial sector. The ebbing of deflation now is partly thanks to a much lower base of comparison. Oil at $50 a barrel is still relatively cheap by the standards of the past decade, but it is two-thirds higher than the lows of January.

More promisingly, the rise in producer prices does point to vigour in the Chinese economy. A big jump in property sales ignited demand for steel, with iron ore and coal rallying alongside it. Some of the excitement is clearly speculative, with investors punting on commodities as they have in the past. Official orders to curb excess capacity in the coal industry also proved rather too effective, and led to supply shortages. The government has now shifted gears, instructing miners to increase coal production ahead of the winter, when demand for heating spikes.

Whatever the future course of prices, Asia’s half-decade of deflation has already yielded valuable lessons. It is clear that prices around the region are closely linked. Prices for commodities are, of course, global, explaining some of the similarity in inflation trends but not all of it. Researchers at the Hong Kong Institute for Monetary Research calculated that the correlation between Chinese producer prices and those of most Asian economies is very high, at about 0.7-0.9 (with 1 being a perfect correlation). A research paper for the Federal Reserve Bank of Dallas argued that the integration of the supply chain in Asia might explain the tight relationship: inflation rates are more similar in countries that trade more with each other.

Asia’s long battle with falling factory prices should also affect the way that policymakers think about inflation. It is common to dwell on consumer prices, not least because of their impact on just about everyone’s pocketbook. But for consumers, deflation is not necessarily bad. If, for instance, technological innovation leads to lower prices, this can create more, not less, prosperity. An ADB study examined nearly 150 years of deflationary episodes and came to a sobering conclusion. Although in many cases, consumer-price deflation has not caused a growth slowdown, producer-price deflation does indeed tend to be a big drag on investment. The message for central bankers is simple: keep a close eye on those Chinese steel mills, and hope their good fortune lasts.

© 2016 The Economist Newspaper Limited. All rights reserved.
From The Economist, published under license. The original article, can be found at http://www.economist.com/news/finance-and-economics/21709351-producer-prices-perk-up-asia-steel-trap

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