China is drifting toward a deflation trap


Japan offers lessons on importance of not delaying intervention

China is at growing risk of slipping into deflation. To escape a scenario of severe deflation like Japan experienced in the 1990s will require a dramatic reset of the policy mindset in Beijing.

If we are right about China slipping into a deleveraging and deflation phase, the optimal policy probably would be to speed up debt restructuring and provide direct income or consumption support to households.

China's reopening recovery has been disappointing to date. Following a decent rebound in the first quarter of 2023, activity indicators slowed sharply across the board except for the service sector, highlighting the weakness of domestic demand.

Worse, there are growing signs that the property sector may be at risk of a double-dip recession. Meanwhile, inflationary pressure has been lackluster lately, with the consumer price index flat in June with a year earlier and the producer price index down 5.4%.

The key reasons for the soft recovery are twofold.

First, Chinese companies and households are still suffering from the scarring of the pandemic, which lasted for a lengthy three years.

The service sector is dominated by small, midsized and individual businesses whose revenue was crushed. They have remained cautious about hiring and expansion since the removal of zero-COVID restrictions.

As for households, without the major direct income support provided in Western economies, they remain cautious about spending and are accumulating precautionary savings. Retail sales are still running more than 10% below the trend level pre-COVID while the household savings rate is still 3 percentage points above 2019 levels.

More importantly, structural adjustments in the property sector are damaging confidence and prompting households to deleverage. Under the government's campaign to curb speculation, home prices corrected last year by the most since 2015.

With the introduction of a property tax on the horizon, the long-held belief among households that home prices will just keep on rising appears to have vanished. Some have started to make mortgage prepayments or sell apartments previously purchased for investment.

As a result, household debt has stabilized at 60% of gross domestic product since 2020 after doubling over the previous decade. If home prices fail to stabilize, deleveraging behavior will likely intensify. This, together with dim income prospects, will weigh on consumer demand and pressure prices.

The risk of deflation is further exacerbated by China's overinvestment in traditional infrastructure. According to World Bank research, China's government capital stock per worker already reached levels comparable to that of member nations of the Organisation for Economic Co-operation and Development in 2018.

The overinvestment problem has manifested itself in the long-term decline in the profitability of local government financing vehicles (LGFVs). The debt carried by these entities adds up to nearly half of China's annual GDP. Research by the IMF found that the assets tied to around 40% of the LGFV debt did not generate enough earnings to cover interest expenses for the three years through 2020.

Given that the fiscal position of China's local governments weakened substantially amid the pandemic and the property slowdown, concerns over the ability of the LGFVs to pay back their debts have mounted.

Currently, policymakers seem to prefer "soft restructuring" of the debt of some of the insolvent LGVFs through interest rate cuts and adding years to repayment terms. This would avoid imminent defaults that could trigger financial instability, but keeping zombie LGFVs alive will pose risks to banks' capital, undermine productivity, and intensify the problem of capital misallocation.

Slower income growth will weaken aggregate demand, which will make it harder to sustain unproductive assets. The longer the restructuring of LGFV debt takes, the longer this downward spiral could last and the more entrenched deflation could become.

China's economic position shares a lot of similarities with that of Japan's three decades ago, including a housing bubble, bad debt and aging demographics. The key lesson from Japan is that policymakers should avoid doing too little, too late and step up easing to avoid slipping into a deleveraging-deflation spiral.

This is particularly crucial given that external demand will likely remain a headwind. On top of the usual stimulus playbook of monetary easing and infrastructure spending, it would probably make sense to speed up debt restructuring and provide direct income or consumption support to households to revive confidence.

Many countries provided such support during the pandemic but China has been hesitant due to fiscal debt sustainability concerns. If the cost of broad-based stimulus is too daunting, aid could be targeted at low-income groups, which have a higher propensity to spend and which suffered the most during the pandemic due to limited savings.

In the face of high youth unemployment, the government could encourage hiring by giving companies a break on social welfare levies and lessening regulatory pressure on certain service sectors.

China needs to accelerate the restructuring of local government shadow debt with the use of the central government's balance sheet. The debt burden of local governments is curbing their ability to spend on infrastructure and social welfare.

The smart solution would be to announce a debt swap of sufficient size to resolve the shadow debt that is deemed unsustainable. The central government, whose debt is equivalent to 20% of GDP, has the fiscal capacity to carry out a swap, but so far has shown limited willingness to embark on a major debt swap given concern that bailing out local governments that mismanaged their finances could discourage more careful management in the future.

The upshot is that China has policy options that would allow it to avoid a deleveraging-deflation trap, but all of them would require a reset in the government's conservative mindset toward fiscal discipline.

A comprehensive package consisting of monetary, infrastructure, income support and debt restructuring needs to be rolled out in a timely fashion to restore confidence and support the economy as it adjusts to stagnant property market growth.

This article was originally published by the Nikkei Asia.