China needs boldness from economic decision-makers

China is in the midst of its third major deflationary episode in the last three decades. The country’s global footprint is now so large that uncertainty about when the country will emerge from the current episode is one of the most important issues in today’s global economy. Previous episodes offer useful tips on the best solution.

China’s first modern deflation was a consequence of the traumas of the Asian financial crisis in the late 1990s. The second resulted from the excesses of the stimulation era of the global financial crisis. The current episode is also a hangover – poor consumer sentiment resulting from the economic and psychological shock of the zero-pandemic era and the long-term contraction of the Chinese real estate market.

The first episode ended with the three forces joining together to accelerate China’s development. Joining the WTO gave China a powerful external driving force. Internally, efforts to clean up financial and corporate balance sheets after the bad loan episode of the 1990s intersected with an urbanization drive that gained tremendous momentum. And third, China’s fixed exchange rate moved from deflationary to reflationary as the US dollar generally weakened in the mid-2000s, resulting in a real effective depreciation of China.

The second stage ended with a combination of demand-side and supply-side policy measures working in tandem. Supply-side reform eliminated obsolete capacity in heavily indebted sectors such as coal mining, steel and aluminum, restoring profitability and correcting a dangerous trajectory on balance sheets. Excess housing stock was removed by loosening macroprudential restrictions. On this occasion, the Chinese yuan strengthened in real terms, making exit difficult.

To achieve a sustainable exit from the current deflationary cycle, despite the many and varied odds, it is important to take into account the lessons of history.

The key takeaway is that recovery from persistent deflationary pressures requires something dramatic. Wandering is a dangerous strategy. The passive approach ignores the pro-cyclical instincts of the average economic decision maker and the role of confidence in the asset price cycle. In the current case, traditional medicine for an economy struggling with a housing collapse – turned outward towards growth – is particularly fraught given the protectionist fervor sweeping the West.

The common thread in all previous deflationary episodes is that balance sheet issues were central to the contraction, and resolving balance sheet issues was a key part of the circuit breaker. This is where policymakers could usefully focus their attention. It is the debt of local governments (broadly understood) and housing developers that are the main problems of the balance sheet today.

The problem of local government requires a decisive reform of the vertical fiscal imbalance. A bold and complementary step would be to introduce a significant one-off transfer of liabilities to the central government. There were no specifics at the Third Plenum as to how to reform the fiscal apparatus and public balance sheet, although the problem of local government finances has been emphasized in numerous official statements about the economy in recent years.

In the case of real estate, policy efforts to date have helped slow the tide of the recession, but have not stopped it. The new idea introduced earlier in 2024 – whereby state entities will acquire properties on the market – is novel and therefore in line with the need to develop something truly out of the box to stem the decline.

Ultimately, reflation is based on a broader thaw in consumer confidence. While households will remain reluctant to spend, policy multipliers will weaken.

Deflation in China is occurring in parallel with the inflation shock in the West, creating a very large gap in cost competitiveness. It is therefore not surprising that under these circumstances, China’s share in world exports has increased. The areas where China’s exports are growing the fastest – green energy and transportation – pose psychological challenges for nations whose identities are hidden in traditional pillar industries.

But claims of an unprecedented nature Internet the surge in exports is off base. China’s current account balance narrowed to just 0.25% of global GDP in 2023 (the year it overtook Japan as the largest car exporter), peaking 15 years ago at 0.65% of global GDP and peaking in 2020s amounting to 0.40% in 2022

Apart from the local government and housing policies recommended above, what else should China do to break the deflationary circuit?

A second round of supply-side reforms in older industries (including upstream real estate such as steel, glass and cement) would be helpful.

Should supply-side reform also be applied to new growth engines such as solar, wind, electric vehicles and batteries? NO. Darwinian domestic competition will take its toll over time, and the world needs China to continue to leverage scale in these sectors to lower the costs of green technologies.

An uncompromisingly expansionary fiscal policy package aimed at households could also be considered. This idea is now the consensus position among private economists in China.

It would also be helpful to allow the Chinese Yuan to find its own level – when the price level falls, your currency is too strong. However, the Chinese government may not have an appetite for this solution, given the likely international reaction and the uncertainties associated with relinquishing control during a period of pent-up depreciation pressure.

Republished from the East Asia Forum on September 22, 2024.