As many central banks around the world tighten their monetary policy to combat rising prices, China’s role in affecting global inflation has drawn market attention. A closer look shows China to be an absorber of global inflation – and in some respects even having a deflationary impact.
For those who think China adds to the world’s inflation, China’s domestic inflation must be higher than that in other countries and transmitted via export price inflation. This could also be aggravated by an appreciating renminbi exchange rate. In such circumstances, China’s export price inflation would become its trading partners’ import price inflation.
How much of China’s export price inflation passes through to importing countries’ domestic prices depends on demand elasticity. The more elastic the demand for Chinese exports, the smaller the pass-through, and vice versa.
An inherent deflationary drag
Compared with surging inflation in the US and Europe, China’s -3% consumer price index (CPI) inflation rate is quite subdued in the current cycle (Exhibit 1).
Indeed, China has an inherent deflationary drag in its economy due to excess capacity and resource misallocation problems – and the flow of structural reforms designed to overcome these1. So, from both cyclical and long-term perspectives, it is unlikely that China will export inflation to the world.
Furthermore, since late 2021, when the developed world’s inflation started to surge, the real (inflation-adjusted) renminbi exchange rate has depreciated – not appreciated – by 1.4%, so the exchange rate has not added to China’s export price inflation.
Looking back over a longer period, the renminbi’s real exchange rate has indeed appreciated, but its impact in terms of inflating China’s export prices has been only limited. The evidence for this can be seen in the deterioration of China’s terms of trade, which represent the ratio of its export prices to import prices.
Several inflationary catalysts
China’s terms of trade has declined for years, and especially sharply since the Covid-19 crisis. This suggests that the rise in its export prices has lagged the increase in its import prices.
Furthermore, US import prices from China have generally risen more slowly than its average global import prices (Exhibit 2).
The subdued rate of China’s export price growth runs counter to the view that China is exporting inflation. Granted, China has aggravated global inflationary pressures by disrupting supply chains since the pandemic in late 2019 due to its periodic production shutdowns.
However, it is far from being the only supply-chain disruptor. The Russia-Ukraine war is another major factor inflicting inflationary pressures on developed markets, especially Europe.
Arguably, China’s role as the world’s factory during the pandemic helped to stabilise global inflation – despite the periodic production interruptions due to its zero-Covid policy lockdowns – because of the dominant role of its processing trade.
When China imports raw materials, which have seen prices surge, it then processes them and exports the finished products at a smaller export price increase than its import price increase (hence the deterioration of its terms of trade).
In this sense, China is actually an absorber of global inflation, not a net contributor.
Crucially, China’s subdued export price inflation has a weak pass-through to importing countries’ domestic prices.
This is because, as research has shown, global import demand – including for Chinese manufactured goods – is elastic2. When import prices rise by 1%, demand drops by more than 1%. This imbalance in demand response makes it harder for importers to pass-through price increases stemming from the exporting country to the domestic system.
An elasticity coefficient of less than 1 means demand is inelastic; above 1 indicates that demand is elastic. Our own estimate of the import price elasticity of US demand for Chinese exports indicates a coefficient of more than 3.
Not an inflation exporter
As the largest trading nation in the world and the world’s factory, China’s inherent deflationary drag on its economy has been acting as a global inflation stabiliser since its accession to the World Trade Organization.
Despite its periodic disruption to the global supply chains since the pandemic began, China is not exporting inflation to the world.
China’s -3% CPI inflation rate is less than one-third of what the major developed economies are experiencing in this cycle. Thanks to its relatively closed capital account, this inflation differential allows China to pursue monetary policy easing while developed world central banks are tightening.
This policy divergence also implies that the RMB-USD exchange rate will face more downward pressure in the short term. From this perspective, China is having an deflationary – not inflationary – impact on the world.
1 See “Chi Time: China’s Deflation Scare Revisited”, 22 January 2014, and “Chi Time: How Worried Should We Be About China’s Rising Core Inflation?” 19 December 2017, available upon request.
2 For example see “Import Demand Elasticities Revisited”, Mahdi Ghodsi, Julia Grubler, Robert Stehrer, The Vienna Institute for International Economic Studies, Working paper 132, November 2016, and
“How Elastic is China’s Export When Facing Exchange Rate Changes”, Leiming Hong, University of Oslo, May, 2012.