China must not panic over deflation and reinflate a bubble

China’s current challenges are the result of misallocation of resources in its boom years; the troubles in the property sector are a symptom of this, not the cause
Competition and productivity are the main forces behind today’s deflationary pressure, and this is a positive development

Andy Xie

Published: 3:30pm, 22 Aug 2023

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Market-driven restructuring is driving China’s deflation. It leads to more efficient allocation of resources and greater purchasing power for consumers. If China can resist the reflationary pressure from those who lose out due to the deflation of property and financial bubbles, a healthier and more sustainable growth cycle is coming, which will turn China into a high-income country.

In 1997, I predicted deflation coming to China, after assessing the impact of the massive devaluation of its neighbours’ currencies. Economists usually prescribe monetary expansion, fiscal stimulus and currency depreciation when facing deflation. I thought the same then.

Chinese premier Zhu Rongji judged that, if China devalued its currency, it would trigger more devaluation by its neighbours, prolonging the damaging chaos in the region. China’s wage was so low, it was felt that the country had plenty of opportunities to improve competitiveness by becoming more efficient. With the benefit of hindsight, aren’t we glad that China wasn’t run by economists?

Misallocation of resources during China’s boom years is the cause of today’s challenges. A vast property bubble hijacked the country’s macroeconomic policy.

As it threatened to take down the country with it, policymakers danced around it again and again through multiple cycles of tightening and loosening. Speculators concluded from this policy pattern that the government would never let the bubble burst, which supercharged it in every upturn.

The monetary policy that supported the property bubble led to other bubbles. Shadow banking surged to 100 per cent of gross domestic product at its peak. It seemed that everyone was starting a venture capital or private equity fund with billions invested.

Obviously, with a 2 per cent management fee, they are doing well and have the money and now the time to advocate money printing. That is the only way for them to get their 20 per cent carried interest. If they don’t, they are still rich, but their investors will become poor.

People walk on the street in front of the large screen showing latest stock exchange data, in Shanghai on August 14. Photo: EPA-EFE

Ironically, the property market’s woes are not the main source of deflation.

Local governments in poor areas cannot spend like before. Chinese households are paying off their debts early, not doubling down in property. These do affect aggregate demand. But retail sales are holding up, though not rising like before. The service sector is still growing.

Competition and productivity are the main forces behind today’s deflationary pressure, a positive story. For example, the price war in the auto market is a major factor. For decades, global auto companies sold China-made cars at higher prices than in Europe or Japan. Without significant local competition, they were milking the market.

Now, Chinese carmakers can make similar or better cars and sell them for much less. The profit bubble in China’s auto market is bursting for German and Japanese companies. They have to join the price war to survive.

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Productivity is another major factor in auto deflation. Chinese players are innovating very fast in the electric vehicle sector. Costs are tumbling, while performance is improving.

The deflation story in the auto sector looks good from these angles. Of course, overcapacity is a factor. But competition will shake out weak players. Declining prices are part of the process.

02:01

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The price of a cup of coffee is facing downward pressure. International vendors like Starbucks have been selling a cup at the same price as in developed countries, even though China has much lower labour costs and, now, lower rent too. The absence of local competition allowed this price bubble to last for so long.

Now Chinese competitors are getting into this space. A young person could go to Italy for a few months and come back to make a cup much better than Starbucks’. That kind of deflation is obviously good.

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The rising competitiveness of the domestic tourism sector is another good deflation story. Chinese airlines have significantly improved their services and their prices are still low compared to their international competitors.

Numerous tourist attractions have enhanced their offerings enormously. Hotels in China offer better value for money than in many other countries. This is why, after the “zero Covid” policy ended, domestic tourism has recovered strongly, while outbound tourism disappointed. This kind of deflation is good for consumption growth.

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Price anomalies tend to be widespread during a big bubble. When it bursts, they pop too, causing deflation. At the peak of Japan’s bubble, a small steak went for US$100, and fruit was selling at crazy prices. Hotels were charging astronomical sums. After a big property bubble bursts, deflation is part of the normalisation process.

Economists tend to equate deflation with “Japanification”. As I argued in these columns in April, Japan’s decline was due to declining competitiveness. As the generation of entrepreneurs who built Japan’s economy retired in the late 1980s and early 1990s, their successors have behaved like bureaucrats, hanging onto what they have. They were paralysed as Japan’s neighbours peeled off its industries one by one with better tech and lower prices.

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China’s first generation of entrepreneurs are still working and hungry. Just look at the old players in the auto and machinery sectors. They are being helped by tech-savvy Gen-X managers.

Many millennials are becoming entrepreneurs, and they are hungrier. Without the distractions of property and financial bubbles, they are going into real technologies like new materials and automation.

The key to China’s future is to focus on real economic activities, not reviving bubbles. After the 1998 Asian financial crisis, South Korea and Taiwan pivoted to real tech. They have become high-income economies.

China must not revive bubbles using stimulus. Letting them go is half of the success story. Time will do the rest.

Andy Xie is an independent economist