China on the cusp of a deflationary vortex

The last thing the world needs now is a deflationary shock from China

Ambrose Evans-Pritchard

the Telegraph,

9 July, 2012

China is on the cusp of a deflationary vortex.

This was signalled late last year by the sharpest contraction in the (real) M1 money supply since modern records began. The hard data is now confirming the warnings.

Consumer prices have been falling for the last three months, producer prices have been falling for four months. This is not a food cost story. It is systemic.

"While an economy-wide generalized deflation is yet to be seen, the deflationary spiral looks to have started in some industrial sectors, attesting to considerable stress with the economy. Persistent deflation can be poisonous," said Xianfang Ren from IHS Global Insight in Beijing.

Indeed it can be poisonous, and China already has the twin-afflictions of the deflation malaise: a fast aging nation, and a surfeit of factories and industrial plant.

Meanwhile, Japanese machine tool orders fell 14.8pc in May, the biggest drop since 2001 – when Japan’s deflation began in earnest. The post-Fukushima reconstruction boom has run its course. Asia is turning stone cold.

All engines of the global economy are sputtering at the same time.

Chinese premier Wen Jiabao called for a "proactive fiscal policy" to keep the economy afloat, warning that "downward pressure is still relatively large."

Is this the long-feared hard landing? Of course it is.

Macao’s casino revenue – that closely watched proxy for the Chinese economy – dropped 11pc in June. Commodity stockpiles are grinding ever higher, with coal depots bursting at Tianjin and other key ports.

Zarathustra has a good list here.

The authorities have begun to devalue the yuan – despite protectionist threats from Capitol Hill – the clearest evidence that last year’s carefully planned monetary tightening has slipped control.

The fact that China DELIBERATELY engineered the slowdown changes nothing.

The Fed deliberately popped the Wall Street bubble in 1928 and the Bank of Japan deliberately popped the Nikkei bubble in 1989-1990, only to find that boom-bust deflation can have its own unstoppable momentum

The problem was the explosive growth of credit in the preceding years. China was no slouch in this area. The IMF’s Zhu Min says loans doubled to almost 200pc of GDP between 2006 and 2011, including off-books lending.

This is roughly twice the intensity of credit growth – around 50 percentage points of GDP – before the US and Japanese blow-offs.

There seems to a near universal assumption that China can pull the levers of the state banking system and set off a fresh credit boom whenever it wants.

Well, perhaps, but loan demand has withered. The big four banks lent just 190bn yuan in June, down from 253bn in May.

"Large banks are all offering money, but no one is taking it," said a Shanghai dealer quoted by Reuters. This is more or less what happened in Japan in the 1990s, what is happening in Europe now. It is what happened to half the world in the 1930s.

The World Bank says China still has plenty of scope for fiscal largesse – cutting taxes and boosting spending – so it should at least avert full depression. If only the West were so lucky.

But at the end of the day, the country is bursting with industrial over-capacity. As Caixin reported recently, eight of the ten largest shipyards did not receive any new orders in the first five months of the year.

Albert Edwards from Societe Generale said the danger now is that China suddenly lurches into a deeper downturn, unleashing a flood of excess goods onto global markets and sending a powerful deflationary impulse across the world.

The global deflation shock of the Asian crisis in 1997 to 1998 caused inflation expectations in the West to fall by 3 percentage points in short order.

The Asian bloc is a much bigger animal today, and the elastic band of China’s credit is stretched further. And this time the West is in fit state to cope. Large parts of the Atlantic system are already disturbingly close to deflation.

Woe betide the world if China does indeed land with a thud. We will then have a synchronised planetary slump for the first time since you know when.