The Threat of Deflation

Disinflation Wor- ries 2015 arrived in global expectation for deflation.

The world economy seems to be in its worst shape in two years， with the Euro Zone， North America and emerging markets releasing weakening numbers， oil price almost falling off the cliff and the danger of Ruble collapse rising. According to a Bloomberg Global Poll of international investors， the danger of deflation is rising. As many as 38 percent of those surveyed described the global economy as worsening， more than double the number of the last poll in July and the most since September 2012， when Europe was mired in recession.

In contrast， the situation of China looks not bad at all.

However， recent readings of PPI， CPI， PMI， export， investment， consumption spending， value-added of industry， or any of the big-time measures of economy， say otherwise.

As a matter of fact， the market has been little anxious since October last year when the central government decided to up the ante on railway infrastructure investment and started to promote the “one belt， one road” initiative. “Chinas Marshall Plan” became keywords of the month.

Then the Peoples Bank of China said in November 21 that it would lower its one-year benchmark lending rate by 40 basis points to 5.6 percent and cut its one-year benchmark deposit rate by 25 basis points， effective November 22. On December 11， the central bank increased the annual new loan target to 10 trillion yuan （$1.62 trillion） for 2014， up from what Chinese media have said was a previous target of 9.5 trillion yuan. The Central Economic Work Conference concluded on December 10 saw top leaders and senior officials sketching out the governments guiding economic policies and priorities for the next year. According to conference statement， the country will strive to keep economic “growth and policies steady” in 2015 and adapt to the “new normal” of slower speed but higher quality.

However， infrastructure investment and loan raise seem to have failed in giving enough push that Chinas lagging economic growth need. And just in time， the prospect of deflation looms again.

Falling of the Prices

Deflation is classed as when consumer prices turn negative with the theory being that buyers would hold off from making purchases in the hope of further falls. This raises the fear of a prolonged deflationary spiral with the slump becoming so entrenched that it impacts growth and does little for the potential of wage increases.

When people think of a large Asian country on the brink of deflation， they probably have Japan in mind. But China， the biggest of them all， is skirting close to outright falls in prices across a wide swathe of the economy.

Inflation data published earlier provides the latest evidence of Chinas descent towards deflation. According to the National Bureau of Statistics， the official Producer Price Inflation fell to 2.7% in last November， from 2.2% in October and below the market consensus of 2.4%.

On the consumer side， perhaps even more worrying， the official Consumer Price Inflation in last November eased to 1.4%， a five-year low， from 1.6% in October and the lowest reading since December 2009. Warm weather and adequate supplies pushed food prices down 0.4 percent month-on-month. The cost of items in the CPI basket other than food slid 0.1 percent from October， the first drop in three months， as global oil prices weakened.

The financial markets took the hint. The Shanghai Composite Index reversed earlier losses and is closing 2.9% higher. In Hong Kong， the Hang Seng China Enterprises Index rose 0.3% and the Hang Seng Index gained 0.2%.

The official Purchasing ManagersIndex eased to an eight-month low of 50.3 in November， the National Bureau of Statistics said， still indicating a modest expansion in activity but below forecasts for 50.6 and Octobers 50.8.

“You think theres a problem in the Euro Zone？ Theres a far bigger problem in China，” says Albert Edwards， strategist at Société Générale. He believes that investors are slowly waking up to the idea that the Chinese have a “major deflation problem” and its transition into a more consumer-led economy wont be a smooth one.

However， optimists say， despite the apparent weakness in prices， deflation is simply not a big concern for China at present， and China is unlikely to stumble into the kind of stubborn deflationary spiral that has dogged neighbouring Japan for two decades and is dominating the policy debate in Europe. Growth， for now at least， remains above 7 percent a year， making it an important engine of global demand.

“It is not a deflation unless CPI sees negative growth three to six months in a roll，” said Lu Zhengwei， Chief economist of China Industrial Bank， in last November. “Chinas CPI growth is slowing down but still positive. From this point of view， China is not in deflation.”

Hua Min， Director of World Economy Research Center of Fudan University， also said that other than the fact that the CPI is not in downward spiral， there are at least two reasons for the market to believe that China is not in deflation. First， it doesnt constitute a deflation with a constant fall of asset prices， and the market hasnt seen any considerable drop in that item yet， real estate and stock market included. Second， both money and credit supply of China appear to be quite sufficient at the moment.

Nevertheless， in a possible sign of rising concerns about deflation， the central bank finally decided to cut interest rates in November for the first time since 2012.

“Its a clear indication of how heavy the deflation pressure of China can be in these days，” said Fran？ois Perrin， head of China equities at BNP Paribas Investment Partners.

Eswar Prasad， economics professor at Cornell University， said that disinflation and weak demand growth in China could have adverse spillover effects on other countries grappling with even more severe versions of these two problems.

Deflation inflicts a dual blow on an economy. It increases the burden of debt in real terms， something that China， which Standard Chartered estimates has a debt-to-GDP ratio above 250 percent， can ill afford.

Falling prices can also hold back consumption， as people delay purchases in expectation of even cheaper prices. But as China tries to shift its economy from credit-fuelled investment towards consumer-driven growth， it needs its citizens to go shopping.

In the scenario of higher spending， Chinas policy makers could do very little， at least until the prospect of out- right deflation becomes a more serious risk.

Whats Next for the Central Bank

Further easing in consumer inflation and accelerating industrial deflation in November reflect stagnation in the worlds second-largest economy， and that may push the central bank to cut banks required reserve ratios as a means of easing liquidity and stabilizing growth， market observers said.

During the Central Economic Work Conference in Beijing， analysts said that Chinas top leaders may discuss a reduction in the 2015 Consumer Price Index target to 3 percent， from 3.5 percent in 2014.

“Consumer prices may remain low， and the full-year CPI is expected to be 2 percent， much lower than the 3.5 percent target，” said Lian Ping， chief economist at Bank of Communications Co Ltd. “The CPI may continue to ease in 2015.”

Meanwhile， deepening industrial deflation is difficult to curb in the short term， experts said， because the prices of raw materials， including oil and natural gas， may remain soft around the world.

Liu Ligang， chief economist in China at Australia and New Zealand Banking Group Ltd， said： “The weak PPI means Chinese enterprises are struggling amid the economic slowdown. Their profits will drop further as their debts surge.”

The Peoples Bank of China， the central bank， cut the benchmark interest rates in November. But the cuts were asymmetric， and deposit interest rates and interbank market rates remain high.“That means the effect of the rate cuts is weak， and the central bank must cut the reserve ratio more than once to ensure that the monetary policy is effective，” Liu said. He forecast three reserve ratio rate cuts of 50 basis points each in 2015.

Strong headwinds from the property market correction， overcapacity in upstream industries and high local government debt are the main causes of the slowdown.

“Increasing deflationary pressure in China will push up real interest rates and compel more rate cuts，” said Wang Tao， chief economist in China at UBS AG.

“We expect at least two more cuts in benchmark lending rates totaling 50 basis points by the end of 2015， and we see the central bank continuing to provide sufficient liquidity to keep the money market rates low.”

“Rate cuts are key in driving down debt service burdens， improving corporate cash flow and reducing financial risk by slowing the pace of nonperforming loan formation. We do not see these measures as having a significant stimulative impact on credit and GDP growth，” she said.

Impact of Rate Cut

Then， there comes the question about the impact of rate cuts on the broader economy. Lower borrowing costs will largely benefit hulking statebacked companies， helping them to keep going even if they are not economically viable.

Rate cuts could also signal the status quo will be preserved， which “might give the market an impression that the new government once again uses credit easing to stimulate growth”， said Lu Ting， chief China economist at Bank of America Merrill Lynch.

Under President Xi Jinping and Premier Li Keqiang， China has laid out a path towards comprehensive reform designed to introduce real market forces. But there has been little to show for it. “I think the majority of policy makers still talk about reform in a positive way，” says Zhang Zhiwei， economist at Deutsche Bank. “The question is about timing and how to do it.”

Until then， Chinas economic model remains reliant on the trusted drivers of growth： credit-fuelled investment and exports. However， both are under increasing strain. Credit growth has been explosive in recent years since the financial crisis， while weak global growth means that the export engine is stalling， and driving down prices.

The worry is that China decides to take the nuclear option to fan inflation at home： currency devaluation. A sharp drop in the value of the RMB could boost exports， and help use up excess capacity； it would also offset the drag of weaker commodity prices. But raising import prices would be bad news for Chinese consumers， as would higher input costs for manufacturers.

Analysts say the chances of devaluation are still slim， but growing. “I dont think this is likely， but the weaker Chinese data gets， the greater the pressure on policy makers to go for the easy option of devaluation，” says Fred Neumann， chief Asia economist at HSBC. “Should China opt to depreciate its exchange rate， this would be a game changer.”

Such a move could prove disastrous for efforts elsewhere， notably Europe and Japan， to fight deflation. China is the worlds top exporter to the EU， meaning that a significant drop in the price of its goods would put fresh downward pressure on already very low inflation trends in the eurozone.

But the aggressive expansion of the Bank of Japans quantitative easing programme has raised the stakes. The yen has tumbled to a record low against the RMB， while South Korea has put the market on notice that it is watching the Japanese currency closely. If the BoJ sparks a regional currency war， China may not be able to remain neutral.

“If youre trying to crush a credit bubble， which the Chinese are， the last thing you need is a rapid appreciation in the exchange rate，” says SocGens Mr Edwards.