Forget Inflation, China Must Worry About Deflation: Pro

Investors are focusing on the wrong inflation numbers in China, says Hong Kong-based investment banker Sean Darby. While the consumer prices are widely considered the headline inflation gauge, the Chief Global Equity Strategist at Jefferies say producer prices give a clearer picture of the economy, and those are pointing to a "deflationary" environment.

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Producer prices in the world's most populous nation fell 0.7 percent in April from a year earlier, after dipping 0.3 percent in March and staying flat in February, and are on track to be "deflationary" on an annualized basis, Darby wrote in a report this week. He argues that producer prices, rather than consumer prices, are a better indicator of what's happening in the real economy.

"The market has been looking at the consumer price index (CPI), which tells you about things like food prices, energy, services etc. But the producer price index (PPI) is a harder, more edgy indicator because it tells you about corporate margins, ability of the manufacturers to raise prices and so on," he told CNBC on Tuesday. That indicator is saying that "companies don't have any capacity to raise prices and the pricing environment is tough."

While China's consumer priceseased in recent months, falling to 3.4 percent in April from a year earlier, and dipping to 3.6 percent and 3.2 percent in March and February respectively, the positive figures indicate an inflationary environment.

With headline inflation now under the central bank's 2012 target of 4 percent target, Darby says officials will be looking at other economic indicators like PPI, electricity generation, factory capacity and railway and freight rates, which point to a weak picture.

"I think perhaps policy makers are now comfortable with the CPI and I really doubt that that's the only tool they are using to gauge the economy," Darby said. "The fact is there is still weakness in corporate profits and we may be looking at a hard landing in corporate profits rather than a soft landing in the economy."

As such, Darby believes central bankers need to be more aggressive with easing measures, and slash interest rates as well, on top of cutting the reserve requirement ratios (RRR) for banks.

Barclays Capital's China Economist Huang Yiping agrees that slashing interest rates is a better way to create demand than reducing RRR, but he disagrees that the authorities should be overly concerned about the PPI.

"I don't think the government is or should be worrying about deflation too much," Huang said. "Generally stabilizing CPI and falling PPI (and commodity prices) mean that the authorities have more room to ease on fiscal and monetary policies if they wish to. CPI may also going down, following PPI. This is consistent with our expectation. But is 3.4 percent worrisome for CPI on the downside? Probably not."

A cut in RRR will boost liquidity in the system but may not do anything to create real demand, which is ultimately needed to support growth, Huang said. Increasing investment projects or cutting rates might be better ways to grow the economy, he added.

By CNBC’s Jean Chua.