The New Risk From China: Deflation

The Plan: Pry Open Wallets

The government has several alternatives to make sure that doesn't happen.

It could juice up the money supply. That would cut the value of money, sending prices upward. And cheaper money would increase demand. Of course, with China's current financial system, much of that extra money would wind up going into investments in more capacity in already money-losing industries.

It could juice up exports. That would soak up some capacity -- but it would also get China in hot water with trading partners that want China to cut its trade surplus. It would certainly increase pressure on the country to revalue the yuan, China's currency.

It could increase domestic demand. Chinese consumers simply save too much and spend too little. The Chinese savings rate was about 40% of annual gross domestic product in 2005. (For contrast, the U.S. savings rate was negative in 2005.) Result: At the end of 2005, personal savings in China totaled $1.8 trillion -- a good piece of change in an economy where total GDP was $2.3 trillion. If Chinese workers saved less and spent more -- like us -- it would soak up a lot of that excess capacity.

That last is, apparently, the solution the government has adopted. The Central Economic Work Conference held at the end of 2005 called "expansion of domestic demand" key to economic growth in 2006.

Easier said than done, especially when you look at why so many Chinese save so much and spend so little. It will take more than a propaganda campaign to get the average Chinese to spend more.

Over the last decade or more, the Chinese government has failed to put in place or has actually dismantled the kind of social programs that cut saving and encourage consumption. Chinese workers don't have retirement plans of any sort -- the government just hasn't got around to setting up meaningful plans. So even if they make just $2 a day, workers struggle to put something aside.

Same with health care. No national health insurance. No company health insurance. And the government system of free hospitals and clinics has been largely dismantled. Many of these have been privatized, and now make a profit by taking in only patients who can pay. So it's either save or do without medical care.

The Olympics Loom

And finally, there's the issue of property ownership. Chinese farmers don't own the land they farm; they lease it for, at the most, 25 to 30 years. And that lease is only good until local authorities decide they want to take the land for a factory or some other investment. Just imagine how economically secure you'd feel knowing that your land is yours only at the pleasure of some official. More reason to save.

I don't have a lot of hope that the central authorities in Beijing will be able to implement the changes needed to make the average Chinese secure enough to spend more. Historically, dynasty after dynasty, the weakness of the Chinese system has been the inability of the central government to get local officials to implement its decrees. The evidence right now is that local officials are pretty much flouting national policy on anything, from environmental rules to policies on land rights, that might cost the local elite a yuan of profit.

I don't know if we'll ever see a number that shows deflation in China. One advantage the Chinese government has over the U.S. Federal Reserve is that it controls all the data. Admitting to deflation is simply too damaging.

Watch instead the news on domestic protest. If the tide of protest keeps rising, if the repression gets more violent, you'll have a pretty good idea that the poorest of the Chinese are feeling the bite of deflation. The big danger is that the regime will feel so much pressure to restore order before the 2008 Beijing Olympics, meant as a national showcase, that it will resort to teaching the protesters some large-scale lesson like that imposed by the tanks of the Red Army in Tiananmen Square in 1989.

Actually makes you root for inflation, doesn't it?