The Debt-Deflation Trap Facing China

At a time of slowing economic development and massive corporate debts, the deflationary spiral would be China’s worst nightmare. In addition, the risk is actually mounting. The producer price index (PPI) has been in negative territory for 39 consecutive several weeks, since February 2012.

The development of China’s consumer price index (CPI), though still positive, has also been falling steadily, from 6.5 percent in July 2011 to 1.2 percent within May 2015. If experience is actually any indication, China’s CPI will turn negative very soon.

In China’s last protracted bout of deflation, from 98 to 2002, persistent diminishes in prices were the result of monetary and fiscal tightening that began in Michael went bonkers, compounded by the lack of exit mechanisms for failed enterprises. After peaking at 24 percent in 1994, inflation started to decline in 1995. Nevertheless, GDP growth soon began deteriorating rapidly. In an effort to revive growth in a difficult global environment and buffer exports against the effect of the Asian financial crisis, the Chinese government loosened monetary as well as fiscal policy beginning in The fall of 1997.

However, it was too little, too late. By 1998, when CPI inflation began to fall, producer costs had already been declining for eight months, and remained negative for a total of 51 months, with CPI growth beginning to recover after 39 months.

An obvious lesson would be that the government should have switched to loosening earlier, and more powerfully. However, this experience also underscores the impotence of economic policy in a deflationary environment, owing to the unwillingness of banks to lend and of businesses to borrow. The fact that loss-making enterprises had been allowed to churn out cheap products, eroding the profitability associated with high-quality enterprises (and thus their incentive to invest), prolonged the deflation.

Nonetheless, The far east eventually managed to rid itself of deflation and return to rapid economic growth. For starters, a decline in investment throughout the deflationary period — together with firm closures, mergers, as well as acquisitions — reduced overcapacity, clearing the way in which for investment to rebound strongly in 2002. At the same time, expansionary fiscal policy increased effective demand, while the government, supported by its strong public-finance placement, was able to tackle nonperforming loans successfully, thereby increasing commercial banks’ willingness to lend, and firms’ ability to borrow.

Moreover, housing market reforms and the development of a mortgage-loan market within the late 1990s fuelled rapid growth in real estate investment, which arrived at an annual rate of over 20 percent in 2000. As a result, real estate development became the most important contributor to economic growth, even as exports boomed following China’s accession to the WTO.

The trouble with the emergence of these new growth engines is that it enabled China’s leaders to delay important structural reforms. As a result, The far east now faces many of the same challenges it faced in the late 1990s — beginning with overcapacity.

After 15 years of rapid growth in real estate development, this is not surprising. But that doesn’t make it any less risky. Actually, allowing overcapacity to continue putting downward pressure on prices, China’s economic growth will not secure at a rate consistent with its potential. Instead, the economy will end up in a vicious spiral of debt deflation.

At this point, the government bodies could eliminate overcapacity through firm closures, mergers and acquisitions, and other architectural measures. They could also aim to eliminate excess capacity by utilizing expansionary monetary and fiscal policies to stimulate effective need. In theory, the long-term solution would be to pursue structural adjustments that will improve the allocation of sources. However, that would be painful and slow. Striking a balance between your short- and long-term approaches will end up being a major challenge for China’s leadership.

Complicating this effort is the fact that, unlike in 1997–2002, China can’t absorb overcapacity by stimulating real estate investment and exports. And no one understands whether the much-discussed ‘innovative industries’ can have the impact that real estate investment and exports do — not least because there is so much extra capacity in the traditional industries.

China must do whatever it takes to avoid falling into the debt-deflation trap. Fortunately, China still has room to invest in growth-enhancing facilities and innovative industries. Policies to expand social security and improve the provision of community goods could support these efforts, boosting domestic consumption by allowing households to reduce their preventive savings.

Nevertheless, at the same time China’s leadership must continue to pursue it’s agenda of structural change and adjustment, even if it might have an adverse impact on development in the short run. China simply cannot afford to continue to kick the actual reform can down the road.

Mark Twain once purportedly said, ‘History doesn’t repeat itself, but it does rhyme’. China should brace by itself for a period of deflation, which may be even more protracted than the last one. However, with the right approach — and a bit of best of luck — China can make sure that, this time around, it recovers more self-sufficiently than in the past.

Can China beat deflation? is actually republished with permission from Eastern Asia Forum