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The New Risk From China: Deflation

Burdened with industrial overcapacity and corruption, it's in danger of a Japan-sized bust.
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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%.

About 250 million people in the country still earn less than $1 a day -- the official definition of poverty in China -- and 700 million live on less than $2 a day. Incomes among rural Chinese have actually declined in the last four years, the World Bank reports.

This rural 70% of China's population has an average income of just $318 a year. If benefits like superior schools and medical care are included in the calculation, the average urban income is a huge seven times greater than the average rural income, the Chinese Academy of Social Sciences has calculated.

Rising income inequality has led to a rising tide of protest. There were, officially, 87,000 public disturbances in 2005, up 6% from 74,000 disturbances in 2004, according to the Ministry of Public Security. (And you know that if that's the official number, the actual level of protest is much higher.)

That's brought the typical response from security forces: beatings of protesters and mass arrests. China will strike "hard" against rising unrest, a senior official of the ministry told the

Xinhua News Agency

this week. "For a considerable time to come, our country will be in a period of pronounced contradictions within the people, high crime rates and complex struggle against enemies," the official said.

No. 4, With a Bullet

All this, mind you, while the economy is booming and deflation is just a story told to scare naughty economists at bedtime. How did China get into this mess?

Start with an economy built around export growth and feed it with lots and lots of cheap money. And then ignore any signals that the rudimentary, somewhat free market might be sending you about overinvestment or overcapacity.

On the one hand, this works really, really well. China's GDP grew 9.9% last year, according to Chinese government figures. That's after 10.1% growth in 2004 and 10% in 2003. When the final data are in, China's economy is expected to jump over France and Britain to rank as No. 4 in the world behind the U.S., Japan and Germany.

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


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.

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?

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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