Commentary on Political Economy

Thursday 10 August 2023


China’s Deflation Danger Isn’t What You Think

Only a productivity boom, driven by market reforms, can heal the economy after an asset-price collapse.

Aug. 10, 2023 2:27 pm ET

A vendor at a vegetable stall in Shanghai, Aug. 7. PHOTO: RAUL ARIANO/BLOOMBERG NEWS

If you’re American or European, your first thought on hearing this week that China is slipping into deflation probably was, “We should be so lucky.” Undeterred, investors now are fretting about price declines in China, although probably for the wrong reasons. As with anything involving China’s economy, what’s really happening is complex.

The headline is that China’s economy experienced a 0.3% year-on-year deflation in consumer prices in July. Alarm bells are ringing because economists assume (wrongly) that consumer-price deflation signals or even causes recession. The price data on Wednesday capped off a bad few days for other statistics about China’s economy. Exports and imports fell by 14.5% and 12.4% year-on-year, respectively, in July. The conclusion would appear to be that malaise is setting in.

Set aside for now the question of how much deflation has happened and when. One oddity, as China watcher Michael Pettis observes, is that we all largely avoided a freak-out during the five months earlier this year when consumer prices were falling from one month to the next. Instead, we’re freaking out in a month when prices rose compared with the prior month, only because the year-on-year comparison happens to be negative this time.

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Which isn’t to encourage too much optimism about China’s economy, alas, because the picture is still dreadful. Consumer prices are a distraction from the far worse deflation afflicting the economy. It’s a deflation of asset prices as the country gingerly nurses its hangover after decades of debt-fueled low-quality economic growth.

This manifests in several interrelated ways. One is the decline in property prices as Beijing since 2020 has tried to crack down on speculation. This deflation is exposing the extent to which house-price inflation drove so much of China’s consumer economy. Now households are suffering a negative wealth effect and dialing back consumption as a result.

Another is growing distress at local-government financing vehicles, or LGFVs. In happier times they funded public-works projects and politically connected corporate borrowers by issuing debt backed in one form or another by land. Now they’re particularly vulnerable to asset deflation. Declining property values will hit the land-sale revenue that ultimately backstops these vehicles, while the low productivity of the projects the LGFVs funded will start to dent the ability of the funds’ own debtors to repay.

If you’re looking for a China economy risk, this is the big one. LGFVs owe debts equal to roughly 50% of gross domestic product. Only around one-fifth of the 2,892 such vehicles hold sufficient cash on hand to meet their short-term debts and make interest payments, according to an analysis by the Rhodium Group It’s all a potential financial disaster. Even if Beijing manages to organize some sort of bailout for these funds, the vehicles won’t for the foreseeable future be able to finance more sugar-rush GDP boosts such as white-elephant bridges and tunnels.

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Beijing’s best hope of managing the asset-price pain would be a supply-side revolution—a real one this time. As the West sank into the doldrums of financial panic and recession after 2008, Beijing implemented a supply-side financing stimulus, pouring credit into producers. This staved off recession, but it inflated the asset bubbles that today threaten the economy because Beijing stalled on policy reforms that would have allowed all that credit to find its most productive uses.

Beijing risks a long period of stagnation for as long as it continues to resist those reforms. The old, wasteful credit-stimulus model will have run out of steam, but there will be too few opportunities for productive private entrepreneurs to step in to provide goods and services (and, most important, jobs) to Chinese households. Too bad, then, that Xi Jinping through most of his tenure has reversed previous market reforms, not implemented new ones.

This is the true and worrying significance of the consumer-price data, which is somewhat different from what the conventional wisdom seems to think. A developing economy’s natural state should be much higher consumer-price inflation than we would tolerate in the West. As a developing country converges with the productivity of developed economies, prices and wages should converge as well.

The art is to understand when inflation is healthy in this way, versus when it’s symptomatic of immiserating errors such as currency devaluations or regulatory sclerosis. Hint: The public will tell you, via elections or riots. One thing is clear, however. If a developing country like China starts to flirt with deflation, the convergence definitely isn’t happening.

The solution must be to jump-start productivity. This isn’t what Western gadflies will tell Beijing to do. Expect more pleading for another round of monetary credit stimulus as in the post-2008 period. Mr. Xi’s test is whether he can deliver a true productivity revolution this time instead.

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