China is in the middle of its third major deflationary episode in the past three decades. The country’s global footprint is now so large that uncertainty over the timing of its exit from the current episode is one of the most important questions in the global economy today. Prior episodes offer some useful guidance on the best way forward.
China’s first modern deflation was a spillover from the traumas of the Asian Financial Crisis period of the late 1990s. The second resulted from the excesses of the Global Financial Crisis stimulus era. The current episode is also a hangover – weak consumer confidence coming out of the economic and psychological shock of the zero-COVID era, and the multi-year contraction of China’s property market.
The first episode ended as three forces came together to supercharge Chinese growth. Entry into the WTO gave China a powerful external driver. Internally, efforts to clean up financial and corporate balance sheets after the 1990s bad loan episode intersected with an urbanisation drive that was hitting warp speed. And third, China’s fixed exchange rate turned from a deflationary to a reflationary force, with the US dollar weakening on a broad front in the mid-2000s, handing China a real effective depreciation.
The second episode ended with a combination of demand and supply-side policy measures working in tandem. Supply-side reform took out obsolete capacity in heavily indebted sectors such as coal mining, steel and aluminium, reinstating profitability and righting a dangerous trajectory in balance sheets. Excess housing stock was cleared by loosening macroprudential restrictions. On this occasion, the Chinese yuan appreciated in real terms, making exit more difficult.
To achieve a durable exit from the current deflationary cycle, despite the many and varied headwinds, it is important that the lessons of history are heeded.
The key lesson is that procuring an exit from sustained deflationary pressure requires something dramatic. Muddling through is a dangerous strategy. The passive approach ignores the pro-cyclical instincts of the average economic decision-maker and the role of confidence in the asset price cycle. In the current instance, the traditional medicine for an economy dealing with a real estate bust — turning outwards for growth — is particularly fraught, given the protectionist fervour sweeping the West.
A common thread in all previous deflationary episodes is that balance sheet issues were central to the contraction, and that the resolution of balance sheet issues were a key element of the circuit breaker. It is here that policymakers could usefully focus their attention. It is local government debt (broadly defined) and housing developers that are the major balance sheet problems today.
The local government problem requires a definitive reform of vertical fiscal imbalance. A bold and complementary step would be to enact a substantial one-off transfer of liabilities to the central government. The Third Plenum lacked specificity on how the fiscal apparatus and public balance sheet would be reformed, although the problem of local government finances has been acknowledged in numerous official statements on the economy in recent years.
In real estate, policy efforts to date have contributed to slowing, but not stemming, the tide of contraction. The new idea introduced earlier in 2024 — that state entities will purchase property on-market — is novel and is thus consistent with the need for something truly out of the box to stem the decline.
Ultimately, reflation hangs on a broader thaw in consumer confidence. While households remain reluctant to spend, policy multipliers will be blunted.
China’s deflation is occurring in parallel with an inflation shock in the West, driving a very large gap in cost competitiveness. Unsurprisingly, China’s share of world exports has increased under these circumstances. The areas where Chinese exports are growing the fastest — green power and transport — are psychologically challenging for nations whose self-identity is wrapped up in their traditional pillar industries.
But claims of an unprecedented net export surge are off base. China’s current account narrowed to just 0.25% of world GDP in 2023 (the year it passed Japan as the top auto exporter) having peaked 15 years ago at 0.65% of world GDP and a 2020s high of 0.40% in 2022.
In addition to the local government and housing policies advocated above, what else should China do to break the deflationary circuit?
A second round of supply-side reforms for legacy industry (including those upstream of real estate like steel, glass and cement) would help.
Should supply-side reform also be applied to the new growth engines of solar, wind power, EVs and batteries? No. Darwinian competition in the domestic market will do its work in time, and the world needs China to continue leveraging scale in these sectors to drive the cost of green tech lower.
An unapologetically expansive fiscal policy package aimed at households could also be considered. This idea is now a consensus position among private economists in China.
Letting the Chinese yuan find its own level would also help – when your price level is falling, your currency is too strong. The Chinese Government may not have the appetite for this measure, however, given the likely international backlash, and the unknowns associated with relinquishing control at a time of pent-up depreciation pressure.
Republished from East Asia Forum of September 22, 2024.
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