16 July 2019

China’s feedback loop for global disinflation

As financial markets brace for the US Federal Reserve’s tapering this year with an expectation that interest rates will eventually rise to keep the inflation genie in the bottle, the risk of deflation has also crept up.

This sounds contradictory, doesn’t it? And the market hasn’t discussed this tail risk much, until recently. In my view, the threat of deflation has always been there since the subprime crisis unraveled in the United States. There is no contradiction but market confusion about the drivers behind the post-crisis pricing environment.

I talked about China’s deflationary risk last year. But at the time, many dismissed it as someone crying wolf and predicted that quantitative easing would bring back global inflation. Evidence since then has shown a trend of falling inflation worldwide. Now an increasing number of analysts, including recently the International Monetary Fund, are seeing a risk of inflation undershooting central bank targets in the year (perhaps years) ahead. Deflation remains a tail risk not just for China.

China’s producer price index (PPI) has been in deflation for almost two years, pushing up the real borrowing cost to over 8 percent a year and creating a real liquidity squeeze that has only eased a little since 2012. China’s PPI deflation is worrying because it has not been able to reverse itself even when international commodity prices, as measured by the CRB commodity price index, recover (see chart). This suggests that China’s deflationary pressure is domestically rooted.

Further, due to implementation of structural reforms, China’s economic growth and, hence, demand for commodities, will be constrained in the medium term. Weak Chinese demand will translate to weak commodity prices and create a feedback loop for causing deflationary pressures around the world.

The truth behind China’s malaise is that the developed world is stuck with a balance-sheet recession adjustment, which is characterized by the twin devils of private sector deleveraging and becoming highly risk-averse. The challenge arises from the fact that after the bursting of the asset bubble, the private sector cuts spending to save enough money to reduce debt. Unless external demand comes to the rescue and/or massive fiscal stimulus is injected into the system, income flows will fall during the deleveraging process. Falling income, in turn, aggravates debt reduction effort, leading to more spending cuts and, hence, a debt-deflation spiral.

If this economic cleansing process is allowed to work itself out, economic dynamics such as relative price signals, the money multiplier in the system and economic growth will be restored albeit after a prolonged adjustment. However, since the subprime crisis, global authorities have mostly focused on short-term measures to reduce debt-service cost (through zero interest rates and quantitative easing) and socialize losses (by bailing out non-viable institutions) to support income flows. This has impeded the adjustment process, prolonging it even more.

It is impossible for both the developed and emerging worlds to export their way out of balance-sheet recession at the same time. So the onus for preventing a downward economic spiral rests with governments, which have run fiscal deficits up to levels that have become socially and politically unacceptable. Soaring fiscal deficits, in turn, feed back to the deleveraging pressure that has manifested itself in austerity measures. Inflation will not return easily under such a debt-deflation spiral.

But we do see growth returning in the developed world, don’t we? Well, yes and no. Behind the US headline GDP recovery, for example, the median income has fallen steadily since the subprime crisis broke in 2008; income of American male workers has dropped to levels below those last seen more than 40 years ago. Europe’s recession ended in 2013, but its economy is stuck at depressed post-bubble levels; over half of the young populations of Spain and Greece remain unemployed.

This is certainly not the kind of growth that can generate a lot of pricing power, or inflation. Moreover, with further austerity measures on the way, deflation remains a tail risk as none of the G3 economies have done enough deleveraging. Arguably, this kind of growth is barely enough to keep their economies from falling into outright deflation.

So much for the developed world, but what about China? Its closed capital account shielded its economy from the detrimental effects of the subprime crisis. But China has an inherent domestic deflationary bias (as seen in falling wholesale price level), thanks to excess capacity and the misallocation of resources. Its core CPI inflation has not risen above 2.5 percent since the 1997-98 Asian crisis. The new wave of structural reform, which is meant to right these wrongs, is going to generate more deflationary pressures in the medium term.

With predominant disinflation and a tail risk of deflation, the policy makers are facing the tough decision of timing the monetary tightening. As for the markets, it seems that bonds are not yet completely dead while equities are facing the conflicting forces of weak pricing power and benign liquidity.

– Contact HKEJ at [email protected]



Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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