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Why China poses the next great risk for a deflationary world

F-22Raptor

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China is trapped. The Communist authorities have discovered, like the Japanese in the early 1990s and the US in the inter-war years, that they cannot deflate a credit bubble safely.

A year of tight money from the People’s Bank and a $250-billion crackdown on shadow banking have together pushed the Chinese economy close to a debt-deflation crisis.

The surprise cut in the Reserve Requirement Ratio — the main policy tool — comes in the nick of time. Factory gate deflation has reached 3.3%. The official gauge of manufacturing fell below the “boom-bust” line to 49.8 in January.

Haibin Zhu from JP Morgan says the 50 point cut in the RRR cut from 20% to 19.5% injects roughly $100-billion into the system.

This will not itself change anything. The average one-year borrowing cost for Chinese companies has risen from zero to 5% in real terms over the last three years as a result of falling inflation. UBS said the debt-servicing burden for these firms has doubled from 7.5% to 15% of GDP.

Yet the cut marks an inflexion point. There will undoubtedly be a long series of cuts before China sweats out its hangover from a $26 trillion credit boom. Debt has risen from 100% to 250% of GDP in eight years. By comparison, Japan’s credit growth in the cycle preceding its Lost Decade was 50% of GDP.

The People’s Bank may have to cut all the way to zero in the end — a $4 trillion reserve of emergency oxygen — but to do that is to play the last card.

The trigger was an amber warning sign in the jobs market. The employment component of the manufacturing survey contracted for the 15th month. Premier Li Keqiang targets jobs — not growth — and the labour market is looking faintly ominous for the first time.

Unemployment is supposed to be 4.1%, a make-believe figure. A joint study by the International Monetary Fund and the International Labour Federation said it is really 6.3%, high enough to cause sleepless nights for a one-party regime dependent on ever-rising prosperity to replace the lost elan of revolutionary Maoism.

Whether or not you call it a hard-landing, China is struggling. Home prices fell 4.3% in December. New floor space started has slumped 30% on a three-month basis. This packs a macro-economic punch.

A study by Jun Nie and Guangye Cao for the U.S. Federal Reserve said that since 1998 property investment in China has risen from 4% to 15% of GDP, the same level as in Spain at the peak of the “burbuja” — the country’s house price bubble. The inventory overhang has risen to 18 months compared to 5.8 in the US.

The property slump is turning into a fiscal squeeze since land sales make up 25% of local government money. Zhiwei Zhang from Deutsche Bank says land revenues crashed 21% in the fourth quarter of last year. “The decline of fiscal revenue is the top risk in China and will lead to a sharp slowdown,” he said.

The IMF says China’s fiscal deficit is nearly 10% of GDP once land sales are stripped out and all spending included, far higher than generally supposed. It warned two years ago that Beijing was running out of room and could ultimately face “a severe credit crunch.”

The gears are shifting across the Chinese policy spectrum. Shanghai Securities News reports that 14 Chinese provinces are preparing a $2.4 trillion blitz on infrastructure to combat the downturn.

How much of this is new money remains to be seen but there is no doubt that Beijing is blinking. It may be right to do so — given the choice of poisons — yet such a course stores up even greater problems for the future. The China Development Research Council, Li Keqiang’s brain-trust, has been shouting from the rooftops that the country must take its post-debt punishment “as soon possible”.

China is not alone in facing this dilemma as deflation spreads and beggar-thy-neighbour currency wars become the norm. Fifteen central banks have eased monetary policy so far this year.

Denmark’s National Bank has cut rates three times in two weeks to minus of 0.5% to defend its euro-peg, the latest casualty of the European Central Bank’s euros 1.1 trillion quantitative easing. The Swiss central bank has been blown away.

Asia is already in a currency cauldron, eerily like the onset of the 1998 crisis. The Japanese yen has fallen by half against the Chinese yuan since Abenomics burst upon the Pacific Rim. Japanese exporters pocketed the windfall gains of devaluation at first to boost margins. Now they are cutting prices to gain export share, exporting deflation.

China’s yuan is loosely pegged to a rocketing US dollar. Its trade-weighted exchange rate has jumped by 10% since July. This is eroding the wafer-thin profit margins of Chinese companies and tightening monetary conditions into the downturn.

David Woo from Bank of America says Beijing may be forced to join the currency wars to defend itself, even though this variant of the “Prisoner’s Dilemma” leaves everybody worse off. “We view a meaningful yuan devaluation as a major tail-risk for the global economy,” he said.

If this were to happen, it would send a deflationary impulse worldwide. China spent $5 trillion on fixed investment last year, more than Europe and America combined, increasing its overcapacity in everything from shipping, to steels, chemicals, and solar panels, to even more unmanageable levels.

A yuan devaluation would dump this on everybody else. It would come at a moment when Europe is already in deflation at minus 0.6%, and when Britain and the U.S. are fast exhausting their inflation buffers as well.

Such a shock would be extremely hard to combat. Interest rates are already zero across the developed world. Five-year bond yields are negative in six European countries. These are no longer just 14th Century lows. They are unprecedented.

My own guess that we would have to tear up the script and start printing money to build roads, pay salaries, and fund a vast New Deal. This form of helicopter money or “fiscal dominance” may be dangerous, but not nearly as dangerous as the alternative.

China faces a Morton’s Fork. Li Keqiang has made it his life’s mission to stop his country drifting into the middle income trap. He says himself that the investment-led model of last 30 years is obsolete. The low-hanging fruit of catch-up growth has been picked. China passed the point of no return five years ago.

Why China poses the next great risk for a deflationary world | Financial Post
 
Gordon Chang is better than this author.

I guess they are wearing the same trousers, one morning shift, the other night for the last 30 years which keeps stinking to this day
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That meant you did not understand one bit of that article.

Spill your beans
 
Whatever the case, I hope that our Chinese colleagues can weather this deflationary issue. I'm sure with continued reforms being implemented, fiscal regulations -- these problem(s) will be abated. China is a competitor, no doubt, but one that is heavily intertwined to Japanese economy. So, the health and performance of China is critical to us -- in that case, we wish them the best.
 
Whatever the case, I hope that our Chinese colleagues can weather this deflationary issue. I'm sure with continued reforms being implemented, fiscal regulations -- these problem(s) will be abated. China is a competitor, no doubt, but one that is heavily intertwined to Japanese economy. So, the health and performance of China is critical to us -- in that case, we wish them the best.

@SvenSvensonov - Sometimes I wonder why @Nihonjin1051 didn't become a Diplomat ? He doesn't say anything controversial and even when he disagrees he does so in the politest manner possible ! :unsure:

On Topic: China has continually shown that its got an uncanny ability to improvise and be flexible enough to deal with changing dynamics to achieve something which is beneficial for China and the Chinese people. I think we ought to realize that the policy makers in China who've achieved such admirable economic figures in the past 2-3 decades aren't exactly incompetent so as not to figure out how to tackle this issue as well.
 
On Topic: China has continually shown that its got an uncanny ability to improvise and be flexible enough to deal with changing dynamics to achieve something which is beneficial for China and the Chinese people. I think we ought to realize that the policy makers in China who've achieved such admirable economic figures in the past 2-3 decades aren't exactly incompetent so as not to figure out how to tackle this issue as well.

Absolutely. The Chinese Leadership, actually, has shown great transformational leadership throughout the existence of the People's Republic of China and one of the driving pillars for continued economic improvement, civil development , and overall infrastructural leaps and bounds has been centered on policy / procedural promulgations vis-a-vis the 中国五年计划 (Five Year Plans). Every Five Years, the Communist Party, specifically the Central Committee, pass laws that are based on sound fiscal (economic) redress. The last 5 year Plan was the 12th Plan (2000-2015) and so far has been successful in changing Chinese corporate law, anti-corruption drive, judiciary independence, as well as defense plans. The Chinese are (quite similar to Japanese, actually) in that they base their decision making in said Plans by performance criterium. There is a methodology in their decision making , and one that is not anachronistic with spontaneity or ineffectual planning.
 
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