The end of deflation in China will be felt around the world


At the end of last year, a group of investors decided to take the Nasdaq-listed, China-based company Qihoo 360 private. Their biggest concern whether they could get a high enough price.
They did, $9.3bn including the assumption of $1.6bn in debt. But the authorities’ sharp watch against capital outflows meant the process took far longer than originally expected. That is because according to Chinese law these investors, led by Sequoia Capital China, had to create a domestic company on the mainland to buy the Qihoo shares from foreign investors. The subsequent money transfer to those offshore holders required approval from Beijing which took far longer than expected.
It is just over a year since the renminbi’s surprise 1.9 per cent depreciation and an additional 4.3 per cent drop in value against the dollar later. Today the delicate balancing act between allowing the currency to slowly drop, yet avoiding giving rise to massive capital outflows, continues. July saw an acceleration in net capital outflows yet again, though not nearly as dire as in January or a year ago.
Meanwhile, beyond the intervention of the authorities to temper the flows, the fundamentals that partly determine the value of the Chinese currency are shifting.

Most notably, China is on the verge of changing from an economy where prices keep dropping to one in which deflation is expected to dwindle to almost nothing. That is a dramatic departure from the past 50 months, when deflation dragged down not only prices in China but in most of the world, thanks to exports of ever cheaper manufactured goods, as well as falling commodity prices.

The end of deflation “is the most positive development for China,” says Haibin Zhu, chief China economist at JPMorgan.

The consequences will be felt both in China and around the world. The deflation was especially severe in producer prices — a reflection of the perpetual oversupply in many sectors of the economy, especially those dominated by the State-owned enterprises. Thus in the most recent month, producer prices fell 1.7 per cent year on year compared to 2.6 per cent in June. But on a monthly basis, they actually rose 0.2 per cent, led by metals prices, thanks to continuing infrastructure and property investment. By the end of July, the country was already on its way to meeting its steel and coal reduction targets, according to research from ANZ. Slower industrial production and less investment is exactly what the mainland requires.

If analysts’ expectations that deflation is coming to an end are right, the real burden of debt will become lighter, providing some relief to over indebted corporates, and removing the biggest cloud over the country — the concern that the growth of debt is unsustainable and a financial crisis is inevitable. It also takes pressure off the People’s Bank of China to cut interest rates and bank reserve ratios at a time when many fear that monetary policy is too tight, yet the central bank fears lowering rates lest it spark more outflows.

“The real borrowing cost is being significantly reduced for Chinese corporates,” adds Mr Zhu.

“It was 7 per cent to 8 per cent last year but could fall to below 2 per cent in real terms.”

Moreover, after a trend for a lack of profits last year, Mr Zhu expects a far brighter profit picture for 2016.

Other forces are also helping Chinese corporates deal with their debts. Even if the central bank doesn’t lower rates, the banks are under competitive pressure from a domestic bond market that poses an increasingly attractive alternative to loans.

“Chinese bonds have outperformed US bonds in dollar terms since 2014 and China is the only country in the SDR basket whose bonds pay positive nominal and real yields,” notes Jan Dehn, head of research for Ashmore Group in London.

To be sure, inflation is always a double-edged sword. If it rises too sharply, investors could demand higher yields on securities to compensate, and the renminbi could drop, precipitating another more vicious round of capital outflows. But Japan, mired in deflation, shows the perils of that state of affairs. At the moment, Chinese households, unlike their counterparts in Japan, can generally earn positive yields on their investments in the government bond market, lending support to consumption.

This is not the artificially high growth of 2009 which drove global commodities to unsustainably high levels. And certainly, China is probably many years away from being a global safe haven.

But at least it no longer appears an imminent sink hole either.

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