China Frets Over Deflation Threat

An analysis by Michael Lelyveld
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A worker walks on steel rods in a steel market in Qingdao, Shandong province, March 17, 2014.
A worker walks on steel rods in a steel market in Qingdao, Shandong province, March 17, 2014.

China has taken pains to deny that it is suffering from deflation as the government tries to keep low price growth from stalling the economy this year.

Responding to questioning at a press conference marking the end of China's annual legislative sessions on March 15, Premier Li Keqiang disputed reports that the economy is already getting stuck in a deflationary slump.

"I don't think there is deflation in China," said Li, citing weak but positive consumer price growth in the first two months of 2015.

Li also denied that China has been "exporting deflation to other parts of the world," state media reported.

"The truth is, it is at the receiving end of deflation,"

Li said that the country's import volume of major commodities like crude oil and iron ore increased last year, but that falling world prices had lowered the value in dollar terms.

Experts say Li is technically correct in defining deflation, but deflationary pressures have become a preoccupation for policymakers because of the risks to China's economy.

"Dangerous right now would be too strong a word, but I would put it as a high worry level for the government," said Gary Hufbauer, senior fellow at the Peterson Institute for International Economics in Washington.

"I would put this among the top three worries that they should be having at the moment," Hufbauer said.

Concern over prices

Inflation was China's biggest worry during most of the boom years of the past decade, but that has been replaced during the slowdown with concerns that prices are growing too little instead of too much.

Experts say that a moderate amount of inflation is needed to keep consumer activity and investment moving ahead.

Without it, buyers postpone purchases while waiting for prices to fall and investors sit on the sidelines, expecting poorer returns.

In weighing the consequences for the economy, China's policymakers have only to look next door at Japan, which has struggled with deflationary pressures and stagnation since the 1990s after a similar period of explosive growth.

China's monetary managers are trying not to fall into the same trap.

"To change that psychology, once it gets going, is not easy," Hufbauer said.

One measure of China's concern is a Reuters report that regulators have been keeping in touch with Japanese counterparts on possible policy solutions, despite diplomatic tensions between the two countries.

"They aren't a single bit interested in Japan's successes," the news agency quoted a China-based source as saying.

"Their biggest interest is in Japan's mistakes," Reuters' source said.

Greater influence seen

The signs of economic weakening come at a time when China is seeking recognition as the strongest force in the Asian region and perhaps, ultimately, the world.

Speaking Saturday at the annual Boao Forum for Asia in China's southern Hainan province, President Xi Jinping told an international audience that the country's economic influence would rise, even if it grows at slower rates.

"The economy is highly resilient and has much potential, which gives us enough room to leverage a host of policy tools," Xi said.

Xi argued that greater efficiency and quality would more than make up for the country's "new normal" pace of economic growth with a target of 7 percent this year, down from the 7.4-percent rate recorded in 2014.

Over the next five years, China would import more than U.S. $10 trillion (62 trillion yuan) worth of goods and invest over U.S. $500 billion (3.1 trilion yuan) abroad, said Xi.

On Monday, China's stock indexes climbed to seven-year highs after officials outlined plans for the country's "Silk Road" and "Maritime Silk Road" investment and trade initiatives, boosting hopes for new infusions of funds.

Despite the assurances, China's price growth has been sinking toward the deflationary pit.

Last year, the country's consumer price index (CPI) rose by a mild 2 percent, far below the government's upper target of 3.5 percent.

This year, Li has lowered the government's upper limit for inflation to 3 percent, but so far there are few signs that price growth will come close.

While the CPI rose by a scant 0.8 percent from a year earlier in January and 1.4 percent in February, drops in the producer price index (PPI) have been sustained, posting year-on-year declines for 36 months in a row.

Oil 'not the problem'

Li is making the case that sliding producer prices have been the result of imported deflation rather than China's economic management, thanks in part to the global plunge in the price of crude oil.

But analysts say the argument tells only part of the story, since falling oil prices are relatively recent.

"People talk about it being oil now, but oil hasn't been declining for 36 straight months," said Derek Scissors, an Asia economist and resident scholar at the American Enterprise Institute.

"What's been weakening for 36 straight months is Chinese housing, steel, aluminum, energy supplied to those industries, and coal. Those have been weakening for three years," he said.

On Monday, China's banking and finance regulators announced steps to stimulate the housing market by increasing some tax exemptions and lowering down payment requirements for second home sales.

Scissors agrees that China has been importing deflation due to lower oil prices, but citing this as a main factor "tells only the last six months of the story."

Even during the most recent period, China's weakening demand has been a major element in lower world commodity prices, since its previous decade of high growth rates provided the push behind prices for so long.

Overcapacity at fault

China's struggle with deflationary pressures can be traced to the excesses of its boom times, when it allowed industrial overcapacity to get out of hand.

Now that economic growth has slowed to the "new normal" level, overcapacity in industries like steel has become a major deflationary force.

China's attempts to ship more steel abroad into a low-priced world market also pose a challenge to Li's insistence that the country is not exporting deflation.

"You could say overcapacity or shortage of world demand," said Hufbauer. "They're two sides of the same coin, but the steel story in China is clearly the exemplar of overcapacity."

Last year, China's steel production edged up 0.9 percent while its price index toppled 16.2 percent in December from a year earlier, according to the China Iron and Steel Association. But the country's steel exports in January soared 63 percent, The Wall Street Journal said.

Even if deflation does threaten, Li has voiced confidence that China has the tools to deal with it.

"We are prepared to cope with such a situation," Li said at his legislative press conference, without going into details.

Modest, targeted measures

Since taking office in 2013, the government has resisted pressure for a big-bang economic stimulus, like the one announced in 2008 that touched off a building and borrowing binge with an avalanche of debt.

Instead, Li has opted for modest or targeted liquidity measures, including two interest rate cuts since November and reductions in the reserve requirement ratio for select banks.

Analysts expect further moves on interest rates this year.

But Scissors argued that China's monetary tools have long since ceased to work because the economy is already awash with liquidity.

Corporate profits have been protected by the continuing spread between CPI and PPI rates, he said, adding that the problem is not too little liquidity but too little demand.

China's monetary tools may not help because they have been geared toward increasing production.

"If you stimulate production, you're going to get more deflationary pressure, which is going to worsen consumer hesitance. So the danger here is they get caught in a deflationary spiral that hits the consumption side," Scissors said.

One solution might be consumption-boosting measures like previous government programs to discount sales of appliances and computers, he suggested.

In 2008, the government launched a series of programs to subsidize sales of home appliances and trade-ins for more energy efficient models, sparking a buying spree, particularly in rural areas.

The discount programs expired in stages by mid-2013.





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