China faces the risk of a debt-deflation loop

The writer is chief Asia economist at Morgan Stanley

In 2002, Ben Bernanke, then a governor at the US Federal Reserve, gave a speech outlining the importance of keeping deflation at bay. He concluded: “Sustained deflation can be highly destructive to a modern economy and should be strongly resisted.”

Such a warning might not seem pertinent for much of the world where central banks are arguably still fighting the battle against inflation. But in China, it seems highly relevant.

Unlike other major economies, China is facing the challenge of deflation. Its gross domestic product deflator — the broadest measure of prices, taking in all goods and services of a country — is at minus 1.4 per cent and has contracted for two consecutive quarters. Consequently, China’s nominal GDP growth was just 3.5 per cent in the third quarter, much lower than the 6.4 per cent of the US.

A deflationary backdrop poses a few challenges. First, real rates after taking into account deflation will rise, increasing the burden on debtors. Second, even as debt growth slows, it will probably remain higher than nominal GDP growth. And so debt-to-GDP ratios will continue to climb. More crucially, a weaker GDP deflator negatively affects the trends in corporate revenues and profits. If deflation continues to eat into these, companies will cut wage growth, creating a vicious “loop” of even weaker aggregate demand and deflationary pressures.

These issues are particularly challenging in China’s context, considering that it is also facing elevated debt ratios and weakening demographic trends. Along with deflation, these factors combine to present a challenge to China we term the “3 Ds”.

The deflationary pressures in China stem from the deleveraging of the balance sheets of the property sector and local governments. When you consider that the combined debt on these balance sheets accounts for about 100 per cent of GDP, it is hardly a surprise that demand and price pressures are as weak as they have been.

To address the deflation challenge, policymakers need to use the full force of monetary and fiscal policies to lift aggregate demand. They are already easing both monetary and fiscal policies but we believe that the efforts deployed so far will only lead to a gradual improvement in the GDP deflator. The measures will not be adequate to lift the deflator to the 2-3 per cent range in the next two years that we think would be conducive for healthy growth in corporate revenues and profits.

We believe there are two interrelated reasons why. First, the policy response so far has been largely reactive and hesitant. In part, this reflects the fact that policymakers had been concerned about unproductive build-up of debt and had triggered the deleveraging process.

As a case in point, even though growth headwinds had started to mount from early in the second quarter this year, it was not until July that more concerted policy easing measures were introduced and even these are not sufficient to decisively arrest the growth headwinds. The challenge is that by not easing forcefully enough, it will keep the risk of a debt-deflation loop alive. Real rates will stay high and continue to weigh on aggregate demand.

Second, the growth mix remains unbalanced. China’s investment is still too high at 42 per cent of GDP. This propensity to invest or perhaps overinvest has come at the cost of diminishing returns, excess capacities and deflationary pressures. Hence, continuing to reflate the economy through investment, as China had done in the past, would probably only be a temporary fillip and could complicate inflation management over the medium term. Indeed, one could argue that the current situation is a result of past efforts, where infrastructure and real estate were boosted in a countercyclical fashion whenever exports turned weak.

The optimal policy approach now is to stimulate consumption. Specifically, policymakers could increase social welfare spending on education, healthcare and public housing, which could help unleash the country’s high household savings. For now, we see few signs that this transition is materialising. As it is, government expenditure-to-GDP ratios on social welfare have remained flat in recent years.

The risks to the inflation outlook are skewed to the downside, and the recent weakness in both the growth and inflation data suggests that the risk of a debt-deflation loop remains. A concerted shift to rebalance the economy towards consumption or a strong uplift in the global trade cycle appear to be the two key factors that could lead to a faster transition towards more healthy inflation environment.