Morgan Stanley predicts moderate inflation in China in 2010

Although China's headline inflation indicators such as the year-on-year consumer price index (CPI) and production price index (PPI) are likely to rise early in 2010, analysts at Morgan Stanley believe the actual inflation rate will remain moderate in 2010 as a whole, with the average CPI inflation at around 2.5%.

Inflation is expected to rise rapidly in the first two quarters this year as the lag effects of strong M2 [broad money] growth in late 2009 are only partly offset by exports, which will remain weak. In the third quarter, inflation will start to moderate as a projected pick-up in export growth will be offset by a moderation in M2 growth.

But the analysts believe that many market participants may substantially overestimate the risk of inflation this year, as they base their predictions on the strong growth of monetary aggregates in late 2009, or extrapolate from the rising inflation trends in the first quarter of 2010.

And that, they argue, can be exploited with a long/short investment strategy in the first half of the year. As a help for the market to more accurately track inflation rates in China, Morgan Stanley has launched a new weekly research publication that will make use of detailed high-frequency price data from various sources to project next month's CPI and PPI.

Morgan Stanley outlines a few reasons why it would be a mistake to make high inflation predictions simply based on the strong growth of monetary aggregates. First, the bank's analysts believe that the true underlying monetary expansion is being overstated by the strong growth rate of M2, which in September expanded at the fastest pace since 1997-- up 29% from a year earlier.

They argue that the strong M2 growth fails to take into account the change in M2 caused by the shift in asset allocation by households between cash and stocks, and says M2 in China is "too broad" to be representative of people's purchasing power when compared to international standards.

M2 in China comprises household deposits at banks, which are made up of long-term savings as opposed to money for spending purposes. Yet, in recent years, an increasing number of households have been devoting part of their bank deposits to equity investments, resulting in an unstable long-term savings component in M2. As a result, the change in M2 doesn't necessarily reflect the change in money supply for spending purposes, making any implications drawn from the strong headline M2 growth misleading.

Secondly, Morgan Stanley also expects a tepid recovery in Chinese exports in 2010 and based on past experiences, a significant decline in Chinese export growth should suggest a meaningful deflationary impact on the economy. The analysts suggest weak exports will remain a strong headwind that will contain inflationary pressures. A repeat of the situation in 2000-2001, when China saw high money growth but low inflation, is likely, they say.

However, Morgan Stanley acknowledges that as many market participants remain vigilant about serious inflation down the road, there might be a 'disconnect' this year between the actual inflation rate -- and China's policy stance -- and strong inflationary expectations. And that will give rise to one of the investment themes in 2010, namely going long companies or sectors with pricing power and going short those with high risk of a margin squeeze resulting from cost pressures. The analysts think this investment strategy will remain in play until at least mid-year, when the Chinese authorities will be getting closer to tighten monetary policy.

The China Inflation Tracker (CIT), Morgan Stanley's new weekly research product which aims to provide updates of the bank's latest forecasts of CPI and PPI inflation, has been launched in response to this intensifying fear of inflation among some market participants.

As part of this product, the bank has created two indices, one for edible agricultural products and one for industrial products, to help track the underlying food CPI and PPI inflation. They are constructed by aggregating the price indices of a basket of specific product sub-categories, such as edible oil and fruit for the edible products index and construction materials for the industrial products index. The indices will be updated weekly.

Morgan Stanley's most updated forecast for December 2009 CPI, after factoring in the weekly price inflation of edible agricultural products and producer products released by the Ministry of Commerce last week, is +1.4% year-on-year. According to the Ministry of Commerce data, food CPI softened to +3.7% year-on-year from +4.4% the previous week, due to weaker prices for all products in the basket, except for meat, eggs and aquatic products.