China’s inflation soared to 2.5%y-o-y in December.

PBoC seen to remain cautious on monetary stance.

According to Barclays, CPI inflation rose slightly more than expected, to 2.5%y/y (Barclays: 2.4%, consensus: 2.3%) in December, from 2% in November. The upside surprise reflects stronger food inflation, which added 0.4pp to the 0.5pp increase in the headline, led by vegetable and pork prices.

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Non-food inflation also edged higher, contributing the remaining 0.1pp. PPI inflation was -1.9% (Barclays: -2.0%, consensus: -1.8%, Figure 3). Note that Chinese food inflation typically posts higher m/m increases in Q4, owing to the cold winter and holiday demand. This year the m/m increases were weaker than usual.

The full-year CPI inflation was 2.7% in 2012, lower than 4% target and 5.5% recorded in 2011. The relatively contained inflationary pressures, in our view, reflect 1) a pre-emptive monetary policy to keep liquidity in check, with the PBoC resisting pressures to cut the RRR since June 2012 slower economic growth, to a likely 7.7% from 9.3% in 2011, which constrains domestic demand and non-food inflation; and 3) the subdued global recovery, which has helped to keep commodity prices under control.

We forecast CPI inflation to rise to 3.2% in 2013. This is based on our baseline views that the PBoC will remain cautious in 2013 given its expectation of lower Chinese potential growth and concern about medium-term inflation and asset bubble risks. Our baseline growth-inflation mix implies no interest rate cut (or hike).

Experiences in H2 2012 confirms our view that the PBoC prefers rolling over a large stock of reverse repos rather than permanently injecting liquidity to the system, but we do not rule out the possibility of one RRR cut in Q1. Our baseline expects fiscal policy to be modestly expansionary, with an emphasis on supporting structural rebalancing rather than just new infrastructure investment projects.

Part of the PBoC’s caution on monetary easing is also likely related to the rapid expansion in non-bank financing in H2. The associated financial risks have triggered government actions, with the NDRC, MoF, PBoC, and CBRC jointly issuing a circular on 31 December to regulate local government investment vehicle financing.

Admittedly, the strong total financing provides some comfort with regard to the growth recovery. Shadow banking activities reflect a market response to financial repression, and together with bond financing they contribute to interest rate liberalisation and financial sector development.

But risks are piling up. In 2013, improved government regulation and supervision could lead to some decline in non-bank financing, which in turn would requires appropriate functioning of the formal banking system to ensure appropriate financing.