Must-know: Is deflation China’s largest export?
Inflation in China
The below graph reflects China’s history with inflation. China’s early years of capitalism saw significant rises in consumer prices in the early 1990s, as China’s early phase of economic development was accompanied by a high level of imports from relatively high–cost base overseas exporters. However, inflation has remained at relatively low levels post-1997, as China’s economy has grown rapidly from a very small centrally managed domestic economy. This article considers why the tame inflation environment could change in the future, and what could happen to Chinese equity prices as a result.
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With global economies experiencing significant asset deflation post-2008, it will be important to monitor the net effect of global inflation and deflation on China’s economy as well. Should deflation or low levels of inflation persist in the US and Europe, this could dampen consumption and ripple through to China, cooling both the domestic economy as well as export growth.
Trade surplus drives CPI
China saw inflation rise steadily into 2008, as oil prices hit record highs of $147 per barrel and China’s currency remained relatively weak in comparison to the euro while appreciating slowly against the weak US dollar. Since the crisis, China has returned to a more normal level of inflation, of around 2.5%, which can be considered consistent with a high degree of economic growth and a fairly stable currency.
Growing foreign currency reserves: The deferral of deflation and a strong yuan?
China seems to do an excellent job of managing its trade surplus, which hasn’t yet translated into a rapidly appreciating currency. A rapidly appreciating currency could lead to rapidly declining inflation, or eventually deflation, as was the case in Japan. This is because China has maintained a large and growing base of foreign reserves. By recycling its trade surplus into the fixed-income securities of its trading partners, China has been able to manage the gradual strengthening of its currency.
This arrangement also serves to keep interest rates lower for China’s importing customers. However, as we pointed out earlier in this series, this trend could slow or reverse in the future, should US and European economies weaken and import less from China. Such a change in events could lead to an unwinding of the trade surplus, which would involve the sale of foreign securities in favor of buying back the Chinese yuan. This could lead to a strengthening yuan, which would likely lead to lower levels of inflation and potentially deflation in the domestic economy. This wouldn’t be a positive development for Chinese equity markets, as economic growth would likely slow and the corporate profits of exporters could be pinched by even higher production costs and more expensive goods.
Stretching a rubber band?
As China’s trade surplus continues to recycle in foreign currency holdings, both the US and Europe have seen progressively lower and lower interest rates. While this should be a positive development that encourages investment in the United States and Europe, it hasn’t, and consumption growth rates have declined. It’s possible that China’s foreign currency reserves of $3.3 trillion have become too large and created a distortion in the global economy—as though the weight of the growing trade surplus had been pushing farther and farther down on a rubber band. Should the economies of both the US and Europe fail to fully recover to strong growth levels, the rubber band could start to snap back, with foreign holdings repatriating to China. This could lead to significant appreciation of the Chinese currency, which would cool the current rate of inflation in China—and potentially lead to asset deflation, as was the case in Japan.
Will China’s deflation export boomerang?
In fact, a slowing global economy accompanied by net foreign securities liquidation and a strengthening yuan could have a boomerang effect. After decades of exporting cheap goods into global economies, global economies may slow purchases of increasingly expensive Chinese exports and essentially leave China to absorb its own productive capacity. With a very limited domestic economic base and a GDP that’s nearly 30% exports, this could have a somewhat devastating impact on the Chinese economy.
Looking forward, investors will need to monitor China’s export data very closely. Should global economic growth slow and major economies import less from China, China could end up slowly liquidating its foreign reserves and seeing the yuan appreciate. As we pointed out earlier, the growth rate of foreign reserves has been 28.7% from 2001 through 2012. However, from 2011 to 2012, China’s foreign reserves increased a mere 4.1%. This represents a major change in trend, and if this trend becomes negative, China could see its currency and domestic cost base rise dramatically. Inflation could become the least of China’s problems—just like Japan post-1990.
Walmart: A canary in the global coal mine?
As the recent problems at Walmart suggest, it’s possible that we’re reaching the limit to how much deflation the world can import over a given period. While the growth of cheap exports from China are welcomed by economies that are running at or near full employment, these same cheap exports may be going too far in deflating the economies of their importers.
While economic theory would suggest that cheaper imports are typically a positive—freeing up labor in the importing economy for more productive purposes—the rate of outsourcing productive capacity, if excessively fast, can lead to near-term deflation and excessive labor dislocation in the importing country. As was the case in Japan post-1990, once deflation takes root in an economic system, consumption can decline. This then reinforces a decline in future productive investment, as seems to be happening in the US.
So excessively rapid growth in cheap imports could be causing imbalances in the global economic system. Should current deflationary pressures intensify in developed economies, it’s possible that, at long last, even China may have to ponder deflation—rather than inflation—as a cause for concern.