November 30, 2014 3:59 pm
China: Fear of a deflationary spiral
Josh Noble and Gabriel Wildau
Falling prices for manufacturers plagued by overcapacity present a problem for Beijing’s policy makers
The 600,000-square-metre China Commodity City in Yiwu city, often referred to as “Walmart on steroids”, is one of the world’s largest wholesale markets.
But as the holiday season approaches, Guo Wei, factory manager at China Zhongsheng Crafts Co, which makes plastic Christmas trees for export to the US, the UK, Australia and Japan, is struggling to cope. For some products, the company is even selling below cost.
“Sales revenue is holding up OK, but when it comes to prices, customers want them lower and lower. They all say the economy isn’t good,” said Ms Guo. “Some of our own products aren’t profitable any more but we still make them to keep our customers happy.”
For over a decade, China has faced accusations of exporting deflation. In 2002, Haruhiko Kuroda – then a Japanese finance ministry official, now head of the Bank of Japan – warned in the Financial Times that China’s entry into the World Trade Organisation would add a “powerful deflationary force” to the global economy.
The central government has pledged to stop measuring officials’ performance mainly based on GDP, but this change will take years to trickle down to lower levels of government.
Overcapacity is not just a local problem: sinking prices for Chinese-made goods affect costs globally. Before the financial crisis, that helped drive a consumer boom in the west. But now excess supply risks worsening the problem of falling prices in developed economies.
Eswar Prasad, economics professor at Cornell University, says: “Disinflation and weak demand growth in China could have adverse spillover effects on other countries grappling with even more severe versions of these two problems.”
Deflation inflicts a dual blow on an economy. It increases the burden of debt in real terms, something that China, which Standard Chartered estimates has a debt-to-GDP ratio above 250 per cent, can ill afford.
Falling prices can also hold back consumption, as people delay purchases in expectation of even cheaper prices. But as China tries to shift its economy from credit-fuelled investment towards consumer-driven growth, it needs its citizens to go shopping.
In the scenario of higher spending, China’s policy makers could do very little, at least until the prospect of outright deflation becomes a more serious risk.
“Cheaper commodities benefit consuming countries which drive global demand,” says Fred Neumann, chief Asia economist at HSBC.
Rate cuts could also signal the status quo will be preserved, which “might give the market an impression that the new government once again uses credit easing to stimulate growth”, said Lu Ting, chief China economist at Bank of America Merrill Lynch.
Under President Xi Jinping and Premier Li Keqiang, China has laid out a path towards comprehensive reform designed to introduce real market forces. But there has been little to show for it. “I think the majority in policy circles still talk about reform in a positive way,” says Zhang Zhiwei, economist at Deutsche Bank. “The question is about timing and how to do it.”
Until then, China’s economic model remains reliant on the trusted drivers of growth – credit-fuelled investment and exports. However, both are under increasing strain. Credit growth has been explosive in recent years since the financial crisis, while weak global growth means that the export engine is stalling, and driving down prices.
The worry is that China decides to take the nuclear option to fan inflation at home: currency devaluation. A sharp drop in the value of the renminbi could boost exports, and help use up excess capacity; it would also offset the drag of weaker commodity prices. But raising import prices would be bad news for Chinese consumers, as would higher input costs for manufacturers.
Analysts say the chances of a devaluation are still slim, but growing. “I don’t think this is likely, but the weaker Chinese data gets, the greater the pressure on policy makers to go for the easy option of devaluation,” says Mr Neumann. “Should China opt to depreciate its exchange rate, this would be a game changer.”
Such a move could prove disastrous for efforts elsewhere, notably Europe and Japan, to fight deflation. China is the world’s top exporter to the EU, meaning that a significant drop in the price of its goods would put fresh downward pressure on already very low inflation trends in the eurozone.
But the aggressive expansion of the BoJ’s quantitative easing programme has raised the stakes. The yen has tumbled to a record low against the renminbi, while South Korea has put the market on notice that it is watching the Japanese currency closely. If the BoJ sparks a regional currency war, China may not be able to remain neutral.
“If you’re trying to crush a credit bubble, which the Chinese are, the last thing you need is a rapid appreciation in the exchange rate,” says SocGen’s Mr Edwards. “Economically, China doesn’t have a lot of choice. It’s just an inevitability, and Japan is the straw that broke the camel’s back.”
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But these measures remain piecemeal, and are in many ways simply experiments at the margins of the economy.