The fact that China is on the verge of outright deflation may prove to be more important to global economy than even U.S. Federal Reserve tapering of quantitative easing.

According to Albert Edwards of Societe Generale SA (ADR) (OTCMKTS:SCGLY) (EPA:GLE), the most decisive macro factor for all markets will be any slide into deflation in China. Certainly many see this as conceptually possible because of China’s heavy over-investment. But is this fear now turning into reality? Recent Q2 GDP data contains the surprising fact that China’s implicit GDP deflator had slowed to only 0.5% year-over-year, noticeably weaker than the CPI data.

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Albert Edwards: China’s GDP growth unusually smooth!

The Chinese data has definitely surprised investors on the downside over the past year, but perhaps what has surprised the markets most is the willingness of authorities to keep monetary policy tight as they attempt to regain control of the shadow banking system. This is something many commentators compare to the U.S. sub-prime time bomb in the mid-nineties.

Edwards said, “I am probably not the only market commentator to find the China economic data curiously stable compared to the data volatility seen in developed economies. Monthly series like retail sales, industrial production, fixed asset investment and even the official PMI tend to move in a glacial fashion on a month-to-month basis. (Recent volatility in the trade data is due to the authorities clamping down on accounting arbitrage/irregularities). Either China is the most well-managed economy in the world or the data reporting is the most well managed in the world.

He added “We all know though about the shortcomings of the official GDP data which the current Premier Li Keqiang described in 2007 as  “man-made and for reference only”. Clearly this is also a heavily smoothed series. Do we really believe real GDP slowed to 7.5% from 7.7% in Q1 and 7.9% in Q4 last year? If so, it is about as interesting as watching paint dry.” See chart below).

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Analyze nominal GDP rather than the real GDP data

One series though that does seem to have some life to it is the nominal GDP series. So whereas real GDP slowed only slightly in Q2 this year to 7.5% from (say) 8.9% in Q4 of 2011, nominal GDP growth has hit the proverbial brick wall, slowing to 8.0% in Q2 this year from 17.0% in Q4 of 2011. In Edwards’ opinion it is nominal GDP we should be watching rather than the real GDP data (see chart below).

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Albert Edwards: Conclusion

The difference between the two GDP series above gives us the implicit price deflator shown on Chart 1. As in the U.S. and the Eurozone, it is becoming apparent that China, on this data, is within a hair’s breadth of outright deflation.