China’s troubling drop into deflation

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China’s flagging economic performance is a crucial issue for Beijing and for the wider world. The domestic impact of slowing growth is mounting as labour unrest spreads, youth unemployment spirals, and weak property prices make families feel poorer. News that China has officially fallen into deflation, with consumer prices dropping 0.3 per cent last month, has raised concerns that its economy will become trapped in a downward spiral.

Sputtering Chinese growth — if it persists — is set to have an outsized international impact as many economies struggle to recover from the pandemic. In May, the IMF forecast China would grow at 5.2 per cent this year, contributing 35 per cent to global growth.

But major investment banks have recently cut their GDP growth forecasts for 2023. Big structural headwinds such as hefty local government debts, an ageing population and regulatory curbs on the private sector are weighing more heavily on the national psyche. Increasingly strained economic ties with the US, typified by new restrictions announced on US investment into Chinese technology, create further international headwinds.

With so many indicators flashing red, China should stop tinkering and adopt a bolder programme of reform and stimulus. The follow-up to a politburo meeting in July, which called for “stepping up countercyclical measures”, has been more rhetorical than actual. Beijing should focus on the country’s two biggest impediments. One is the fear of looming defaults by local governments that have racked up $9.3tn in debt through thousands of sometimes shadowy financing vehicles. Second is a general psychological funk that inhibits households from spending.

To rehabilitate local government finances — and so boost investment at the local level — there is a strong argument for Beijing backing a practice that has already started quietly in some parts of the country, according to Gavekal Dragonomics, a research company. It should call upon state-owned financial institutions to restructure large tranches of local government debt by extending maturities and lowering interest rates. China’s deflationary pressures should assist the cause for lower rates. 

Such assistance should not come without a price. Local governments ought to be forced to publish accurate balance sheets of their local government financing vehicle investment portfolios, including projects that have gone bad. Without clear accounting, it will be hard to move to the next stage in local governments’ financial rehabilitation: a big sell-off of non-performing assets — with appropriate haircuts — to state and private companies.

Beijing is likely to resist this course because, for all its rhetorical support for private business, the party-state run by Xi Jinping objects to entrepreneurs getting their hands on “state assets”. Yet if such opposition cannot be moderated, China will struggle to resolve one of its most intractable economic problems.

The other focus must be alleviating the psychological malaise that besets many Chinese households. Big cities should be able to find ways to at least stabilise the property market; Beijing, Shenzhen and Guangzhou have already said they plan as yet unspecified measures. Cutting mortgage interest rates, downpayment ratios and various other restrictions would be a good start. If property price falls can be arrested, households will feel that their main store of wealth is no longer diminishing.

A recovery in sentiment could then help to spark a more convincing consumer rally, creating a potentially virtuous circle. Failure to take substantive measures now to boost the economy could, by contrast, undermine already fragile confidence — and risk hastening a deflationary shock.