The New Risk From China: Deflation

Could China, the driver of global inflation in commodities such as crude oil and iron ore, be looking at domestic deflation in 2006?

Deflation effectively took Japan out of the global economy for more than a decade, slowing global growth and increasing global economic volatility. Serious deflation in China has the potential to be a lot more dangerous. At its least damaging, it would flood the world's markets with even cheaper Chinese goods. At the worst it could stall the Chinese economy, a major driver of global growth, and even send the country into one of its periods of instability.

All that from a change in prices? You betcha.

A Chinese economic think tank at the country's top economic agency, the National Development and Reform Commission, raised the red flag on deflation on Jan. 12. Since then, Chinese officials have repeatedly gone out of their way to pooh-pooh the danger. So much effort spent on denial, of course, means that it's a problem that the communist regime takes seriously.

The Urban Advantage

I know I would if I were in their shoes. Deflation in the domestic Chinese economy would pressure companies to cut wages to keep up with falling prices. That, of course, would depress demand. Chinese consumers would have less money for purchases, which would depress prices further, which would lead to further wage cuts. Once a deflationary cycle like that gets started, it can be terribly hard to reverse. Just ask the Japanese, who are now emerging from years of deflation and no economic growth.

China wouldn't survive a bout of deflation anywhere nearly as well as Japan. Japan is an amazingly cohesive society; China, even in the midst of an economic boom, is deeply fissured. Deflation would strike hardest at precisely those in the countryside who have been left behind in the current boom. The richest 10% of Chinese control 45% of the country's wealth, according to Chinese government figures, and the poorest 10% hold about 1%.