Has debt deflation started already in China?14 May, 2012, 14:38. Posted by Zarathustra
Yes, you hear me talking about the dreaded debt deflation (in Irving Fisher’s sense) in China.
It works like this, more or less:
Banks create money by extending credits: when banks lend you money, your deposit account’s balance increases. That money created by banks extending credits would be included in the money supply calculation. Increasing debts in the economy means increasing money supply, more or less, and that would fund the economic growth and, of course, asset prices.
An asset bubble is “financed” by loans, and it all goes well when asset prices keep inflating because the debt level looks lower. It is when things that go into reverse, that what looked like a comfortable debt level suddenly appears to be problematic. Now that with over-investment in various sectors in the Chinese economy which led to over-capacity to a point that many companies are not profitable, and a real estate bubble in a process of bursting, the level of debt becomes a burden.
The recent statistics show that China’s money supply growth is slowing, loan growth is mediocre, and, occasionally, banks’ deposits are dropping. The conventional explanation for deposits falling is that money has gone else where: perhaps real estate, or perhaps the stock market, and more recently, wealth management products which offer better yields, for example. Then most reason that if deposits are leaving, banks can’t extend as much credit as they want to.
However, there is just another possibility: and important one.
With economy slowing and companies not profitable, demand for credits are slowing. Not surprisingly, too, that with real estate bubble bursting, demand for mortgages also have to slow. With demand of credit lower, it also mans that the banking system is creating money at a slower pace. Also, with asset prices falling, it could well be possible (in the future, if not already happened) that loan repayments and default are at faster rates and new loans creation. In that case, the banking system is destroying money, all else being equal (i.e. if the central bank isn’t doing anything).
Loan growth is now slow as demand is low, and deposits fall every few months. At the same time, M2 money supply drop on the month. You can argue that some money has gone to somewhere that has no way to be included in the money supply numbers. Do consider, however, the possibility that debt deflation, if not already started, will start very soon, and the banking system is just destroying money.