Here's what spooked China

‘Are you ready?’ Picture: 20th Century Fox

China’s markets continued their decline on Monday, this time spooked by data indicating that Chinese companies will continue to see profit margins thin, and that there will be continued downward pressure on the yuan.

In other words we’re talking about deflation here, people.

The number to watch is China’s producer-price index (PPI), which monitors wholesale prices for companies. It came at -5.9%, holding stable from November, but still looking grim and missing expectations of -5.8%.

This is also the 48th consecutive negative PPI read.

Consider this an important, underlying factor in the volatility we saw in markets last week.

That’s when China’s markets crashed twice and, unlike on Monday, took the world down with them. What made last week’s malady so contagious was the downward pressure on the Chinese yuan. The People’s Bank of China triggered a big global sell-off when it devalued the currency by 0.25% on Thursday.

PPI matters to the currency because as long as China’s companies are suffering from overcapacity, the government has the impetus to allow the yuan to weaken. Chinese companies having trouble selling products could use a weaker yuan to sell goods overseas.

On Monday, the government set the yuan higher, but the PPI read showed market participants that companies are still weak and the problems that would force the country to devalue the yuan are still very real.

“Inflation is not the decisive factor in determining the exchange rate, but it is an important factor,” wrote Bloomberg economist Tom Orlik in a note following the PPI print.

YUAN/USD ChartGoogle FinanceA year in the yuan/USD

“In the current environment, sustained low inflation is an additional reason to expect more depreciation heading further in 2016.”

He also said that the data indicated that overcapacity may be a bigger problem than we thought. The government has indicated that it’s looking into tackling this issue — which is specifically hitting old economic growth drivers like manufacturing and construction — but we haven’t seen concrete plans yet.

Meanwhile, those old growth drivers — which make up 43% of China’s economy — are growing at a mere 1.2%.

Another factor driving lower PPI is China’s corporate debt. Struggling companies are using revenue to pay down interest rather than grow and invest.

Societe Generale analyst Wei Yao put this issue perfectly in a note last year when she wrote: “China’s debt problem lies with the corporate sector, and so PPI deflation can cause more damage to debt dynamics than CPI deflation. The cure should be capacity consolidation and debt restructuring, rather than another stimulus package targeted to boost investment demand.”

To review: PPI deflation isn’t just bad for Chinese companies, it also means there will be continued downward pressure on the yuan. If there’s continued downward pressure on the yuan, there’s a higher risk for volatility in not just China’s markets, but markets all over the world.

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