Reverse engineering China's dependably stable Consumer Price Index

Behind the facade

Reverse engineering China's dependably stable Consumer Price Index


The latest release of China’s Consumer Price Index (CPI) for October showed a 1.6% year-on-year rise in prices, meaning inflation on the mainland had, by official metrics, held steady since the previous month. The announcement tracked with analysts’ expectations and, coming amid a litany of more dire economic indicators, led to a minor boost for financial markets. As a key indicator of the Chinese economy, CPI does provide valuable insight into China’s underlying rate of inflation.  But for investors and analysts on the outside looking in, the backstage mathematics involved in its calculation remain a troubling source of uncertainty.

One key source of this wariness is the weightings for each category of goods in the consumer basket the government measures the prices of in order to calculate the official CPI. China’s National Bureau of Statistics (NBS) does not make these weightings public, leading analysts to question whether the indicator is in fact representative of price changes in the Chinese economy, or if it can be manipulated to produce satisfactory inflation figures.

However, a number of institutions, including Morgan Stanley and ANZ Bank, have used inflation data together with urban and rural household surveys of household expenditures conducted every five years to reverse-engineer the weights used by the NBS. In fact, even students at the affiliate high school of Renmin University in Beijing have worked to crack the calculations (mathematically inclined readers can read said students' study in pdf form here). That in turn allows for more open debate about whether the weightings are fair and thus whether official inflation figures are worthy of the market's trust. 

Food & shelter

As shown above, the NBS assumes that 17.2% of household expenditure is spent on housing – a seemingly low percentage given that the OECD average is 25%. As Bloomberg's Thomas Orlick explains in his guide to economic indicators, the NBS refers only to the mortgage interest rate in order to calculate the price of housing. Said figure is a virtually static number that does not really take into account the price of buying a house—which according to the NBS 70-city index rose approximately 120% between 2006 and 2010. All this suggests that housing is severely underweighted in the calculation of China's overall inflation rate.

Food expenditures, set at 31.8% of household consumption, is the largest piece of the pie. This is ostensibly due to the fact that many households in China are poor, and so have to spend a higher proportion of income on food. However the proportion of income spent on food should gradually fall as the Chinese economy and household income grow (see: Engel's law). Chen Xingdong, chief economist with BNP Paribas Asia, estimated that 25 to 30% would be an “appropriate” proportion of household expenditure on food for the CPI in China today. Yet despite the weighting of food looking set to fall as income rises, Chen predicts that food is still likely to have a bigger impact on the CPI in the future as non-food prices are expected to fall in coming years. Given that food is the most volatile category in China's CPI basket, this could suggest inflation will become less stable.

As for the contribution of the other categories towards Chinese inflation, the price rises of healthcare, household facilities, transport, and communications have in the past consistently undershot the overall inflation rate. Orlick notes that this is due mainly to increases in manufacturing productivity and government-regulated prices. But as the cost of factor inputs increases and the government deregulates prices or increases taxes, these categories will contribute more to inflation and cannot be relied upon to tie down the price rises in the other categories.

Compare & contrast

With the official weights in hand, it is also possible to illustrate the impact that they have on the inflation rate by applying those of other developing countries. The chart below shows the weightings employed by the Indian government in the calculation of India’s CPI*

Housing expenditure in India accounts for 19.26% of household consumption, and food expenditure makes up 47.58%. When applied to China’s price indices, China’s year-on-year inflation rate for 2013 becomes 3.22%. That is much higher than the 2.61% produced using the official Chinese weights.

Clearly, household spending patterns—among many other factors—differ between China and India, and it would be a stretch to claim that the above proves China’s CPI is understated. It does, however, show how the inflation rate can be manipulated by altering the weights used for CPI. The above also assumes that the price indexes for each category of goods in the CPI are accurate. While it is known that up to 50,000 people survey the price of goods and services at 373,000 outlets across 500 cities and 31 provinces to obtain the foundational data for China's CPI, exactly what happens to the data at the NBS before the announcement of the final figures is not disclosed.

Due to the lack of other inflation indicators, financial markets continue to use and make decisions based on the CPI. But they should do so cautiously.  

*Note: the following changes were made to CPI data for comparison

In order to make an accurate comparison with that of China, the following changes have been made to India's CPI weightings. "Pan, tobacco and intoxicants" has been moved from the food category to the tobacco, liquor and other articles category (2.13%). “Fuel and light” has been moved into the residence category. “Personal care and effects” have been moved to the healthcare and personal items category. 

Authors: Hudson Lockett, Ryan Henderson