Jim Jubak at TheStreet.Com is writing The New Risk From China: Deflation .
Could China, the driver of global inflation in commodities such as crude oil and iron ore, be looking at domestic deflation in 2006?
Deflation effectively took Japan out of the global economy for more than a decade, slowing global growth and increasing global economic volatility. Serious deflation in China has the potential to be a lot more dangerous. At its least damaging, it would flood the world’s markets with even cheaper Chinese goods. At the worst it could stall the Chinese economy, a major driver of global growth, and even send the country into one of its periods of instability.
All that from a change in prices? You betcha.
A Chinese economic think tank at the country’s top economic agency, the National Development and Reform Commission, raised the red flag on deflation on Jan. 12. Since then, Chinese officials have repeatedly gone out of their way to pooh-pooh the danger. So much effort spent on denial, of course, means that it’s a problem that the communist regime takes seriously.
Deflation in the domestic Chinese economy would pressure companies to cut wages to keep up with falling prices. That, of course, would depress demand. Chinese consumers would have less money for purchases, which would depress prices further, which would lead to further wage cuts. Once a deflationary cycle like that gets started, it can be terribly hard to reverse. Just ask the Japanese, who are now emerging from years of deflation and no economic growth.
China wouldn’t survive a bout of deflation anywhere nearly as well as Japan. Japan is an amazingly cohesive society; China, even in the midst of an economic boom, is deeply fissured. Deflation would strike hardest at precisely those in the countryside who have been left behind in the current boom. The richest 10% of Chinese control 45% of the country’s wealth, according to Chinese government figures, and the poorest 10% hold about 1%.
About 250 million people in the country still earn less than $1 a day — the official definition of poverty in China — and 700 million live on less than $2 a day. Incomes among rural Chinese have actually declined in the last four years, the World Bank reports.
This rural 70% of China’s population has an average income of just $318 a year. If benefits like superior schools and medical care are included in the calculation, the average urban income is a huge seven times greater than the average rural income, the Chinese Academy of Social Sciences has calculated.
Rising income inequality has led to a rising tide of protest. There were, officially, 87,000 public disturbances in 2005, up 6% from 74,000 disturbances in 2004, according to the Ministry of Public Security. (And you know that if that’s the official number, the actual level of protest is much higher.)
All this, mind you, while the economy is booming and deflation is just a story told to scare naughty economists at bedtime. How did China get into this mess?
Start with an economy built around export growth and feed it with lots and lots of cheap money. And then ignore any signals that the rudimentary, somewhat free market might be sending you about overinvestment or overcapacity.
China’s GDP grew 9.9% last year, according to Chinese government figures. That’s after 10.1% growth in 2004 and 10% in 2003.
On the other hand, China has achieved this kind of growth only through massive overinvestment in the export sector. Even after a yearlong campaign to rein in investment in fixed assets — you know, things like steel mills and aluminum foundries — investments like these grew by 25.7% in 2005.
The result has been massive overcapacity in fixed assets. Look at coke producers — capacity of 242 million tons exceeded demand in 2005 by 100 million tons. Or steelmakers — capacity exceeded demand by 120 million tons. Production capacity in China’s auto industry now exceeds annual sales in China by 2 million vehicles. The government has identified 10 sectors — including aluminum, autos, cement, coke, steel and textiles — with capacity problems.
Of course, this excess capacity hasn’t ended plans to add even more capacity in these sectors. About 120 million tons of new coke capacity is under construction. New steel mills with capacity of 70 million tons are being built.
Companies can raise money to build clearly unnecessary and unprofitable factories, because all too many Chinese banks continue to make loans on the basis of political connections rather than market forecasts. Put a local entrepreneur and his local political patrons from the district government in the same room with a banker, and a loan pops out.
How do you make a profit if you’re doing business in an industry with 100 million tons of spare capacity? Export, export, export — to any international market that will buy your product. And cut your prices until the buyers can’t resist. At home, cut prices and cut them again.
See how a system like this might produce both higher global prices for raw materials and lower prices for finished goods abroad and at home? You get global commodity inflation and domestic price deflation.
China hasn’t seen domestic deflation yet. But the trends are enough to worry Beijing’s economists. Consumer price inflation fell to 1.8% in 2005 from 3.9% in 2004. (Like all other Chinese statistics, regard this one with extreme skepticism.) Prices, according to the National Development and Reform Commission, could start to fall in the second half of 2006.
Watch instead the news on domestic protest. If the tide of protest keeps rising, if the repression gets more violent, you’ll have a pretty good idea that the poorest of the Chinese are feeling the bite of deflation. The big danger is that the regime will feel so much pressure to restore order before the 2008 Beijing Olympics, meant as a national showcase, that it will resort to teaching the protesters some large-scale lesson like that imposed by the tanks of the Red Army in Tiananmen Square in 1989.
Actually makes you root for inflation, doesn’t it?
Is China at risk of deflation?
Yes, for the very reasons Jim Jubak cites:
- Massive overcapacity in fixed assets
- Plans to add even more capacity in these sectors
- Too many Chinese banks continue to make loans on the basis of political connections
In China: What Next? Andy Xie also mentions the overcapacity situation in China.
Overcapacity is causing investment slowdown: I estimate that fixed investment in industries that are experiencing overcapacity contributed 40-50% of GDP growth in 2005. Without other components of the GDP accelerating, China’s economy should slow in 2006.
Spending more on infrastructure won’t reverse the trend: The infrastructure areas that can justify more investment account for 4% of total investment, I believe. Spending more there won’t reverse the trend.
Stimulating property again could lead to another wave of bad debts: Giving property a second wind is a popular proposal for stimulating the economy. Cutting mortgage rates could boost sentiment. However, it would mostly encourage more speculation. The industry is already swollen and highly speculative.
Is Deflation Bad?
The idea that deflation is necessarily bad is where the rest of Jubak’s analysis falls apart.
Jubak states “Deflation would strike hardest at precisely those in the countryside who have been left behind in the current boom. The richest 10% of Chinese control 45% of the country’s wealth, according to Chinese government figures, and the poorest 10% hold about 1%.”
For starters I fail to see how the percentage of wealth control is all that relevant in and of itself. I will get to the reason for that statement in just a bit, but first let’s show without a doubt the inequality problem is actually worse in the US.
According to Wealth inequality: data and models, published by Federal Reserve Bank of Chicago and University of Minnesota on August 17, 2005, US wealth is highly concentrated and very unequally distributed. The top 1% hold one third, and the richest 5% hold more than half of total wealth. At the other extreme, a significant fraction of the population holds little or no wealth at all. It seems the concentration of wealth is the United States is even greater than that in China.
Would deflation “strike hardest at precisely those in the countryside who have been left behind in the current boom”? To answer that question let’s first address the question at the very heart of the matter. Who does deflation hurt the worst? The answer to the latter question is easy: those heavily in debt and those dependent on forever rising property values. Having answered the critical question, let’s see how China fares in deflation vs. how the US would fare.
Risk of deflation – China
Is deflation going to hurt farmers left in the countryside in China? I think not. What debts do they have? Furthermore they would welcome lower prices on goods they buy now. Down the road they certainly would welcome lower property prices in the cities. I doubt demand or prices paid for their produce would drop much from here. People do have to eat. In practice most of China’s private citizens would benefit, as their savings rate is enormous. Deflation would primarily hurt businesses sitting on malinvestments financed with debt. Deflation benefits savers. Let’s also not forget China is a real growth story over the long haul. The problem for now is that China is too heavily dependent on overburdened and debt ridden US consumers. Lacking sufficient internal demand there is simply nowhere for excess Chinese capacity to go.
Risk of deflation – United States
Now let’s turn to the US. Deflation in the US would help the cash rich at the expanse of those in debt or whose wealth is mostly or especially in assets like houses. Who would deflation hurt the most? Unfortunately the answer is the masses: those struggling from paycheck to paycheck and especially those who are upside down on a house mortgage and heavily in debt on their SUV or credit cards. Hopefully it is readily apparent that the US consumer, deep in debt with a negative savings rates is actually at far greater “lifestyle risk”, relatively speaking, than someone from China. There is also no going back to the rural farm option. Thus it’s not wealth distribution per se that determines who is most at risk, but rather the debt distribution and savings rates that will determine who fares worst. Looking further down the road, there is every liklihood of continued global wage arbitrage putting pressures on US wages, and with an economy pretty much tied to a property bubble with little pent up internal demand for anything, with baby boomers wanting to retire, and with rising medical and pension problems, the picture looks worse (relatively speaking) for the US. Indeed the standard of living in the US may be poised for its first decline since the great depression. It will be a rude awakening if and when it happens.
Free Market Comparison China vs. US
Jubak writes of a ‘rudimentary free market’ in China.
Heinz Blasnik, a friend of mine living in Austria had this response when I Emailed him the article:
I think there is FAR MORE economic liberty in China than in the West. This is confirmed by just about anyone who has ever been there. There is for instance simply NO welfare state at all. When you go into business, you can expect to be able to do as you please without state interference, aside from the occasional corrupt local bureaucrat on the take (and those live dangerously).
A good friend of mine is Chinese. He regularly travels between Austria and China and also confirms this view. His father was actually a big party apparatchik in Mao’s time. While there’s still a large and inefficient state sector (state owned companies living on subsidies), all the rest is a free-for-all in wheeling and dealing that we only know from the history books.
Misconceptions About China
- The idea that capitalism is stronger in the US than China is for the most part a myth or at least highly overrated.
- Wealth inequality is excessive in China. While that might be true, it is worse in the US.
- The idea that deflation would be ‘bad’ for China is misguided. There would be winners and losers in China but because of the high savings rate in China vs the negative savings rate in the US, because of serious overleverage to housing in the US, and because of enormous consumer debt levels in the US, a serious bout of deflation would be far worse for the US than China.
- Deflation whether here or elsewhere would be bad for some people (those heavily in debt and or those dependent on property and asset bubbles), but generally good for everyone else.
- Stoking the fires of inflation to keep global reflation alive would only put off the overcapacity problems while making matters worse down the road.
- Malinvestments in the housing, autos, and retail sectors seems most at risk in the US. In China, the property, aluminum, autos, cement, steel and textiles sectors appear to be most at risk.
- A global slowdown has begun and the popping of various property bubbles is at the heart of it.
- The downside risks are greatest in countries with the most consumer debt, the US and UK. Fighting the bust can only make matters worse.
- All in all, it’s not a pretty picture especially with Bernanke at the helm.
Mike Shedlock / Mish/