China: Close to deflation? Asia Pacific Economic Outlook, Q1 2015

While China continues to implement short-term fixes to the economic slowdown, it has so far failed to implement major reforms aimed at shifting the structure of the economy.

State of the economy

Chinese economic activity continued to grow at a relatively modest pace in November. The government reports that industrial production was up 7.2 percent from a year earlier, slower than expected and slower than in October. Retail sales were up 11.7 percent from a year earlier, and investment in fixed assets was up 15.8 percent from a year earlier. The latter figure is relatively slow compared with recent years. However, the government also reported that credit creation accelerated considerably in November, likely due to the government’s injection of liquidity into the system. Aggregate financing was 1.15 trillion Chinese yuan, compared with 663 billion yuan in October. New local currency loans were 853 billion yuan in November, up from 548 billion yuan in October. These are big gains and could bode well for a pickup in investment. Of course, China has been beset with too much investment. Thus acceleration in investment, while possibly helping short-term growth, could exacerbate the problems of excess capacity, empty apartment buildings, and poorly performing loans. Rather, China needs acceleration in consumer spending. While the relatively poor industrial production numbers suggest weakness, the loan data suggest promise for a rebound. On the other hand, Markit reported that its purchasing managers’ index for manufacturing slipped into negative territory in December, suggesting that the massive industrial side of China’s economy continues to struggle.1

Of course, China has been beset with too much investment. Thus acceleration in investment, while possibly helping short-term growth, could exacerbate the problems of excess capacity, empty apartment buildings, and poorly performing loans.

Meanwhile, producer price deflation has accelerated, and consumer price inflation continues to decelerate in China. In November, producer prices continued, and accelerated, their 33-month consecutive decline, falling 0.5 percent from the prior month and 2.7 percent from a year earlier. This decline reflects declining energy and other commodity prices, weak domestic demand, and continued excess capacity in many industries. Consumer prices fell 0.2 percent in November from October and were up only 1.4 percent from a year earlier. The latter figure was the lowest since November 2009. This decline, too, reflects the impact of declining energy prices and weak domestic demand. It is also an indication that the central bank might engage in looser monetary policy without fear of stoking inflation. Some analysts are starting to discuss the possibility that China could get dangerously close to deflation. Others, including I, believe that a fear of deflation is not yet warranted. The drop in energy prices will actually boost consumer spending power, thus offering a stimulus to the economy that will help to alleviate deflationary pressures. The bigger risk now is a collapse of property prices given the massive excess supply of unoccupied homes following the speculative frenzy of property construction.

Policy responses

China’s government is taking a number of steps to stabilize growth while not allowing too much credit creation. The government will accelerate spending on infrastructure projects this year to prevent economic growth from dipping below 7.0 percent. The problem with this policy is that it fails to attack the imbalance in the Chinese economy. China already spends excessively on investment and inadequately on consumer spending. Efforts to reverse this have not yet seen success, hence the decision to boost public investment. In response to the government’s announcement, the Australian dollar increased in value. Australia’s currency is heavily influenced by China’s perceived demand for Australia’s iron ore and other commodities. Indeed, the price of iron ore rose as well. The increased spending on infrastructure will come from central and regional governments, state-run companies, and the private sector. Much of it will be financed by debt, which is a concern given that China’s economy has accumulated a large amount of debt. While China continues to implement short-term fixes to the economic slowdown, it has so far failed to implement major reforms aimed at shifting the structure of the economy.

In an effort to boost banks’ lending ability and hopefully stem economic deceleration, the Chinese government has broadened the definition of a bank deposit. Banks are required to hold cash reserves equivalent to 25 percent of bank deposits. Rather than reducing the required reserve ratio, the government has simply changed the definition of deposits and waived the requirement for reserves for certain types of deposits. The end result will be the release of $800 billion in funds that banks will now be able to use for lending.

Also, it has been reported that the People’s Bank of China is injecting another 400 billion yuan into the financial system to boost liquidity.2 In addition, it is also reported that the government has instructed banks to lend more, and that rules regarding loan-to-deposit ratios will not be strictly enforced. These actions follow a recent cut in benchmark interest rates. The supply of credit has decelerated lately, and the government is intent on reversing that trend in order to prevent a further decline in growth. Yet many analysts suggest that the weakness in credit growth stems not from inadequate supply of loanable funds but rather from weak demand for loans on the part of businesses facing excess capacity. Indeed, Moody’s, the bond rating agency, said that it expects an increase in loan defaults on the part of state-run enterprises, largely because of excess capacity.3 It has also been reported that a good deal of credit extension is merely for the purpose of rolling over existing loans rather than investing in new projects.

Globalizing China

China’s offer of a large currency swap with Russia is just one of several instances in which China has provided funding to troubled emerging markets—other countries include Argentina and Venezuela. Why is China doing this? First, these loans and swaps help to promote the use of the renminbi as an international currency, one of China’s long-term goals. Second, they give China leverage with these countries. While emerging countries can go to the International Monetary Fund for financing, such help usually comes with conditions involving economic reforms. China, on the other hand, is probably not setting such conditions. Rather, it is looking to boost its influence with these countries and set favorable terms for access to these countries’ resources. In the case of Russia and Venezuela, that would be energy. In the case of Argentina, it would be food. Indeed, it is reported that China’s considerable loans to Venezuela are paid back in oil, while loans to Argentina are paid back in agricultural commodities.