At a time of slowing economic growth and massive corporate debts, a deflationary spiral would be China’s worst nightmare. And the risk is mounting. The producer price index (PPI) has been in negative territory for 39 consecutive months, since February 2012. The growth of China’s consumer price index (CPI), though still positive, has also been falling steadily, from 6.5% in July 2011 to 1.2% in May. If past experience is any indication, China’s CPI will turn negative very soon.
In China’s last protracted bout of deflation, from 1998 to 2002, persistent declines in prices were the result of monetary and fiscal tightening that began in 1993, compounded by the lack of exit mechanisms for failed enterprises, Project Syndicate reported.
After peaking at 24% in 1994, inflation began to decline in 1995. But the GDP growth soon began deteriorating rapidly. In an effort to revive growth in a difficult global environment and buffer exports against the impact of the Asian financial crisis, the Chinese government loosened monetary and fiscal policy beginning in November 1997.
But it was too little too late. By 1998, when CPI inflation began to fall, producer prices had already been declining for eight months, and remained negative for a total of 51 months, with CPI growth beginning to recover after 39 months.
An obvious lesson is that the government should have switched to loosening earlier, and more forcefully. But this experience also underscores the impotence of monetary policy in a deflationary environment, owing to the unwillingness of banks to lend and of enterprises to borrow. The fact that loss-making enterprises were allowed to churn out cheap products, eroding the profitability of high-quality enterprises (and thus their incentive to invest), prolonged the deflation.
Return to Rapid Growth
Nonetheless, China eventually managed to rid itself of deflation and return to rapid economic growth. For starters, a decline in investment during the deflationary period–together with firm closures, mergers, and acquisitions–reduced overcapacity, clearing the way for investment to rebound strongly in 2002. At the same time, expansionary fiscal policy increased effective demand, while the government, backed by its strong public-finance position, was able to tackle nonperforming loans effectively, thereby increasing commercial banks’ willingness to lend and firms’ ability to borrow.
Moreover, housing-market reforms and the development of a mortgage-loan market in the late 1990s fueled rapid growth in real-estate investment, which reached an annual rate of over 20% in 2000.
The problem with the emergence of these new growth engines is that it enabled China’s leaders to delay important structural reforms. As a result, China now faces many of the same challenges it faced in the late 1990s–beginning with overcapacity.
Eliminating Overcapacity
At this point, the authorities could eliminate overcapacity through firm closures, mergers and acquisitions, and other structural measures. They could also seek to eliminate excess capacity by using expansionary monetary and fiscal policies to stimulate effective demand. In theory, the long-term solution would be to pursue structural adjustments that would improve the allocation of resources.
Complicating this effort is the fact that, unlike in 1997-2002, China cannot absorb overcapacity by stimulating real-estate investment and exports. And no one knows whether the much-discussed “innovative industries” can have the impact that real-estate investment and exports did–not least because there is so much excess capacity in the traditional industries.
China must do what it takes to avoid falling into the debt-deflation trap. At the same time, however, China’s leadership must continue to pursue its agenda of structural reform and adjustment, even if it may have an adverse impact on growth in the short run.
