China in deflation, and how to reflate it at all costs19 June, 2012, 14:06. Posted by Zarathustra
Evidence of China’s worse-than-expected slowdown has been piling up in the recent months. Perhaps it is still hard for many to believe this, but China is already on its way towards deflation, just like what we have started talking about earlier this year.
We have already highlighted a couple of structural issues that is deflationary, and why some of inflationary structural factors such as demographics are not relevant. In short, the over-investment over the past many years, and particularly in the years after the financial crisis, has created massive over-capacity across the economy that no one is really able to quantify. We have already got over-building in the real estate sector which resulted in massive number of empty apartments and empty shopping malls (see a few of the massive empty shopping malls here). We are also aware of the over-capacity and inventory build-up in various sectors like coal and steel. We have also just learnt that steel industry profits have fallen by 96.7% in the first four months of the year compared to the same period a year ago as demand falls and inventory build-up force producers to cut prices (demand is so weak that some producers are forced to sell pigs instead). Many of these are pointing to deflation, not inflation. Not to mention the actual CPI figures which are already in negative territory on a month-on-month basis. In short, deflation is already here for China, even though it only looks pretty mild at the moment.
Source: National Bureau of Statistics
We have already noted, on the other hand, that the Chinese government has already started their attempt to reflate the economy with some of the measures look downright desperate. For instance, we don’t really get the point of encouraging private sector investment in previously banned industries could be of any help as far as GDP growth is concerned, not to mention that the private sector is clearly deleveraging, thus we don’t see why the private sector would be really keen. Monetary policy in the forms of interest rate cuts and reduction of reserve requirement ratio, while should work in “normal” time, may not work now as debt deflation means the demand for loans going forward will be weak. Stimulating consumption is not an easy task as it has been shown time and again that you really can’t force people to spend.
We do know that with a paper currency that the country has control over its issuance (that is if the PBOC ends the soft peg with the US dollar to allow for maximum independence of monetary policy on one hand while opening the capital account on the other), the government cannot run out of money. And as long as the government is willing to throw as much money into the money as necessary, it is at least theoretically possible for the government generate growth as it wishes (in local currency terms), never mind the negative impact on the currency, which has been falling against the US dollar, and will continue to depreciate if massive stimulus is on the table. We also know that in an environment of debt deflation, it is rather hard to generate inflation simply by creating money by the central bank (of course, one might argue that no central banks who are facing deleveraging have ever printed large enough amount of money to create enough inflation after the financial crisis).
Throwing as much money as necessary for the sake of maintaining economic growth is not always politically possible elsewhere in the planet (think about the lunatics of the Republican Party in the United States). For China, this is how the government can throw as much money as possible into the problem, assuming that no one is going to oppose it.
1. Force banks to lend
We have talked about this absurd option for a long time, and it seems like they are up to their old tricks once more. But lend to whom?
2. Local governments and state-owned enterprises to borrow
As the private sector deleverages, there are only policy-driven entities that can take up the slack, and that means local governments and state-owned companies. Because banks are also largely state-owned in China, the combined result would actually be similar to US government increases spending to stimulate the economy while increase borrowing. Again, because the government cannot theoretically run out of money, the government can, at least theoretically, throw as much money as necessary.
3. Build more pointless stuff
Just invest in whatever. Ten more Burj Khalifa, twenty more New York city replica, whatever. Just build something, so suppliers get paid and their overcapacity is now used, while the workers get paid to consume.
4. Bad debts? Where?
Just pretend there’s none, ok? Hide them somewhere.
5. Problem solved
The last time the Chinese government did it, the size of the package was RMB4 trillion. In reality, net new loans to non-financial companies in 2009 alone amounted to more than RMB7 trillion, and another RMB4.8 trillion or so was lent in 2010 to non-financial companies, not to mention that money supply has already been doubled. Of course, we have no idea what these figures would look like without the stimulus, or we can’t be sure about the actual lending that is directly associated with the stimulus, but the actual amount of money being thrown at the economy was probably closer to RMB8 trillion, rather than RMB4 trillion.
In the eyes of the world excluding China, the RMB4 trillion stimulus on paper (or the RMB8 trillion stimulus in substance) appears to be the phenomenal success. Not only did it well surpass that 8% growth target, but also almost as if China saved the world economy. Within China, the stimulus has been largely regarded as a mistake. Perhaps this is why the consensus currently believes that the coming stimulus will not be of the size of RMB4 trillion, because the last stimulus is now regarded as unnecessarily large.
This is mainly because of inflation that followed the massive fiscal and monetary stimulus, and because of the real estate bubble which makes new homes largely unaffordable to average workers. Worse still, in the eyes of average Chinese, the money being thrown into the problem benefit none other than real estate developers and corrupt officials, who are the winners for inflation and booming real estate prices. Indeed, as said previously, these corrupt elites who rule China are most concerned not about inflation, but lack of inflation. Without massive fiscal and monetary stimulus which enabled some of the most outrageous investment projects, corrupt officials and connected businessmen would have no chance to pocket huge amount of money in the process, and without inflation and persistently low interest rates, not only would these investment projects be impossible, it would also mean that corrupt elites of China could not have hoped to put money into the real estate market can pocket even more money.
China currently has a massive amount of debt in private sector as well as the public sector. It is in the government’s interest to inflate the debt away. However, the problem of the Chinese economy has grown even larger over the past few years when the economy was on steroid. With debt deflation in sight, even more money has to be thrown into the problem for the sake of maintaining GDP growth and to generate sufficient level of inflation to make debt servicing easier (and for corrupt elites to pocket more money). Also consider the huge risks from Europe which could turn out to be disastrous. In that scenario, the kind of money necessary to reflate the Chinese economy will not be RMB4 trillion. It will probably be closer to RMB10 trillion (on paper).
But then, if the previous RMB4 trillion stimulus was regarded as a mistake, will it make sense to try an RMB10 trillion one?