When bad news is good news for Chinese assets

WHILE China's 2014 Gross Domestic Product growth missed the official target only marginally, its consumer price inflation (which averaged less than 2 per cent in 2014) undershot Beijing's target of 3.5 per cent significantly. China's producer prices have been stuck in deflation for almost three years now.

The property market correction, if not managed properly, could convert the Consumer Price Index disinflation into outright deflation by inflicting a systemic shock. Our research shows if Beijing doesn't continue with its policy easing bias, the property market's correction which is expected to continue this year could easily push China's economic growth down to below 7 per cent and completely wipe out Tier 1 capital in its banking system. However, those who think all this sounds bad for Chinese assets should probably think again. The key to China's market outlook is the threat of deflation and the potential systemic fallout and their policy implications.

The size of the "output gap", or the difference between actual and potential output growth, determines the rate of inflation. A positive output gap (that is, actual growth higher than potential growth) generally leads to rising inflation, while a negative output gap leads to falling inflation or even deflation.