Chinese Profitability Rising on Pivot to Domestic Consumers

Steady consumer price inflation and a consistent fall in prices for producers could make Chinese companies more profitable as the nation pivots from export-driven to a domestic demand-focused economy.

Chinese firms have seen their cost of raw materials fall every month for the last 32 months. Producer prices fell 2.2% in October, nearly the highest rate of price declines in 2014 although nowhere near the -3.8% decline in prices seen in 2012. 

Steady consumer price inflation and a consistent fall in prices for producers could make Chinese companies more profitable as the nation pivots from export-driven to a domestic demand-focused economy.

Chinese firms have seen their cost of raw materials fall every month for the last 32 months. Producer prices fell 2.2% in October, nearly the highest rate of price declines in 2014 although nowhere near the -3.8% decline in prices seen in 2012. 

Constant deflation has been attributed to greater production efficiencies in Chinese factories and lower transaction costs thanks to improved financial infrastructure. However, the leading cause of price declines is a continual oversupply of energy thanks to China’s massive expansion of coal burning plants and the growing supply of oil and natural gas nationwide. Liquefied petroleum gas saw the steepest price decline in 2014, with prices sinking 4.2%. Gasoline on its own fell 2.9% and diesel fell 1.2%. The only energy cost to buck the trend is liquefied natural gas, which rose 3.9% in October.  This trend is opposite the U.S. where an abundance of domestic energy production has caused natural gas prices to sink.

Weakening Consumer Prices

Despite declines in production costs, those savings have not found their way to Chinese consumers, who have seen inflation for as long as Asia’s largest economy has been keeping records. However, the rate of consumer price inflation is slowing. In October, the Chinese CPI rose just 1.6%, the second month in a row below 2%. That 2% level has held in China since 2012, when the CPI saw radical disinflation as the Chinese PPI went from positive to negative.

While overall prices are growing in China, consumers are spending less of their income on food. Most food prices fell in October, according to the National Bureau of Statistics of China.  Only flour (0.2%), soy products (0.2%), potatoes (0.3%), beef (0.2%), peanut oil (0.1%), and cutlassfish (0.1%) saw price gains. Other meat products such as pork (-0.6%) and chicken (-0.2%) are falling in prices, which is likely freeing Chinese consumers’ income for other discretionary products.

Falling Employment, Domestic Pivot

Most economists believe that it is too early to tell whether Chinese companies will earn sustainably higher margins in domestic markets thanks to the widening gap between producer and consumer prices. However, decelerating GDP growth in China linked to a slump in the European Union and moribund growth in the United States is proving to be less of a concern for analysts, who increasingly see a Chinese crash as unlikely.

However, optimism is wearing thin as China’s employment index continues to weaken as the labor market contracts. In July 2014, China’s non-manufacturing employment index fell below 50, indicating a contraction of service jobs in the nation of over 1.3 billion people. The non-manufacturing PMI remained above 50, at 53.8, in October, while the Employment index fell for the third month in a row to 48.9.

Pessimists have cited this decline as an indication that deflation in the European Union, China’s biggest trading partner, is bleeding into the Asian economy. To help shore up China’s economic growth, many believe that the nation will need to focus on stirring up domestic demand, which the Chinese Communist Party has largely failed to do since 2008.

More optimistic analysts believe domestic demand will inevitably rise thanks to cheaper production costs and the need for businesses to court Chinese consumers. Some say the fall in prices and rising margins may encourage higher incomes for workers and greater domestic spending, enabling a virtuous cycle that helps Chinese companies grow without reliance on foreign markets for goods.