The New Risk From China: Deflation

And there's no doubt that growth like that has raised average incomes in China. Real disposable income in urban areas rose 9.6% in 2005. Rural incomes grew by 6.2%.

On the other hand, China has achieved this kind of growth only through massive overinvestment in the export sector. Even after a yearlong campaign to rein in investment in fixed assets -- you know, things like steel mills and aluminum foundries -- investments like these grew by 25.7% in 2005.

2 Million Cars Too Many

The result has been massive overcapacity in fixed assets. Look at coke producers -- capacity of 242 million tons exceeded demand in 2005 by 100 million tons. Or steelmakers -- capacity exceeded demand by 120 million tons. Production capacity in China's auto industry now exceeds annual sales in China by 2 million vehicles. The government has identified 10 sectors -- including aluminum, autos, cement, coke, steel and textiles -- with capacity problems.

Of course, this excess capacity hasn't ended plans to add even more capacity in these sectors. About 120 million tons of new coke capacity is under construction. New steel mills with capacity of 70 million tons are being built.

Companies can raise money to build clearly unnecessary and unprofitable factories, because all too many Chinese banks continue to make loans on the basis of political connections rather than market forecasts. Put a local entrepreneur and his local political patrons from the district government in the same room with a banker, and a loan pops out.

How do you make a profit if you're doing business in an industry with 100 million tons of spare capacity? Export, export, export -- to any international market that will buy your product. And cut your prices until the buyers can't resist. At home, cut prices and cut them again.

See how a system like this might produce both higher global prices for raw materials and lower prices for finished goods abroad and at home? You get global commodity inflation and domestic price deflation.

China hasn't seen domestic deflation yet. But the trends are enough to worry Beijing's economists. Consumer price inflation fell to 1.8% in 2005 from 3.9% in 2004. (Like all other Chinese statistics, regard this one with extreme skepticism.) Prices, according to the National Development and Reform Commission, could start to fall in the second half of 2006.