China’s nominal GDP growth in 1Q14 slowed by much more than real growth did. The GDP deflator rose by merely 0.4%, holding back the growth of corporate earnings and government revenue and also hindering smooth corporate deleveraging. While the downward pressure on inflation stemmed primarily from weak aggregate demand, the sharp appreciation of the renminbi nominal effective exchange rate (NEER) over the past two years was also a contributing factor.

Exchange rate appreciation depressed domestic prices by lowering renminbi-denominated import prices and restraining the growth of aggregate demand directly and indirectly. Our empirical analysis shows that the renminbi NEER appreciation exerts the most downward pressure on PPI, followed by the GDP deflator and then CPI, reflecting the different weights of imported goods in these price indexes.

The recent weakening of the renminbi against the dollar only slightly offset the appreciation of the renminbi NEER over the past two years. Looking forward, the euro is likely to weaken against the dollar. If the renminbi does not also weaken, its NEER may rise further, continuing to put downward pressure on China’s inflation and especially PPI. Guiding the renminbi weaker would help China better deal with the impact of changes in the dollar/euro exchange rate.