Thu, Dec 02, 1999 page8

• China's strange deflationary boom

  • Christopher Lingle
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  Price instability has become a persistent phenomenon in China's economy. In the late 1980s up to the mid-1990s, economic policy analysts in Beijing focused upon halting inflationary tendencies arising from China's reform program.

  More recently, China has been battling to offset an equally pernicious threat from the opposite end of the pricing spectrum, deflation. Faced with a persistent decline in the overall price level of goods and services, China faces a cycle of falling prices that conjures up images of the Great Depression.

  The problem with deflation is that it has a momentum which is self-fulfilling. It occurs when buyers' expectations of falling prices induce them to delay purchases until the next round of declines. Manufacturers and sellers of resources end up holding excess inventories and may be unable repay their accumulated debts. This leads to increased layoffs, rising loan defaults and subsequently a greater number of bankruptcies.

  Deflation is commonly associated with declines in output. However, China continues to report high rates of economic growth, albeit there has been a decrease in the rate of increase in economic output.

  Growth statistics conjured up by the Chinese government continue to be impressive. Industrial output was reported to have risen by 8.9 percent in 1998 and then 10.1 percent in the first quarter of 1999 compared with the same period the previous year.

  In some way, China's experience mirrors the 1970s and 1980s when mismanagement by governments led to a peculiar and previously unimagined combination of economic stagnation along with inflation. This situation where unemployment and inflation rose simultaneously became known as stagflation.

  China faces a peculiar combination, where deflationary conditions coincide with rising unemployment despite respectably high growth. This situation might eventually be known by a homely and cumbersome phrase such as a "deflationary boom".

  So how did China wind up with a deflationary boom? It can be traced back to the irrational economic policies and distortions from the era of central planning. Consequently attempts to modernize their economy involve overcoming painful historical hangovers.

  In particular, the Marxist fixation with expansion of industrial capacity left China with a large number of state-owned enterprises that were driven by political rather than economic incentives. Most were kept open with subsidies to avoid massive increa-ses in unemployment, leading to considerable overcapacity in manufacturing and mountains of unsold or unsellable output.

  These rising inventories are both a cause and an effect of the deflationary cycle. With consumers buying less and with declining export growth, there is little incentive to maintain workers or hire new ones.

  China faces a formidable challenge. An additional 10 million new jobs must be created each year in order to hold the line against rising unemployment. That means that China's economy must grow at about 8 percent annually to absorb that number of new entrants and those whose jobs disappear with restructuring.

  And so what is China trying to do about this problem? Lots. In hopes of boosting domestic spending, the central government has been running a budget deficit. Interest rates have been cut seven times in three years, consumer credit has been loosened, a 20 percent tax was imposed on bank interest earnings, bank lending has been increased, and purchasing shares on the stock market has been declared to be a patriotic duty. The latter is supposed to generate a "wealth effect" whereby rising portfolio values would induce shareholders to spend more as asset values climb.

  Yet taking the notion of a "wealth effect" seriously requires a leap of fantasy. While there are currently only about 34 million retail shareholders, more than 100 million workers in the SOE sector are reluctant to spend because they worry about losing their jobs. Consequently, the amount of additional income saved rather than spent has been rising. In 1998, household spending out of increased income was only 55 percent, a sharp decrease from an average of 80 percent between 1991 and 1997.

  And the problem is not just with household spending. Deflation causes the real cost of capital to rise. As prices fall for a given level of nominal interest, so-called real interest rates rise. Enterprises require higher profits to offset higher borrowing costs relative to declining prices from their sales of output. China's real interest rates are nearly 10 percent. As overall spending falls, the number and amount of non-performing loans grows. Beijing admits that bad debts held by state banks stands at about $50 billion or nearly 12 percent of GDP. Others estimate that non-performing loans are more likely to be about 25 percent of GDP.

  China's leaders have taken some resolute steps to make some sectors of their economy more market-friendly. Unfortunately, they will be plagued by the legacies of communist policies until there is extensive private ownership of property and commercial enterprises. Such radical changes are needed to purge the specter of a pending banking crisis and possible industrial collapse.

  Christopher Lingle, an independent corporate consultant and adjunct scholar at the Center for Independent Studies in Sydney, is the author of The Rise and Decline of the Asian Century.
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