June 19th, 2012 | Shanghai Daily Preparing for a deflationary circle
THOUGH not definite yet, we have started to sense the emerging force of deflation in the Chinese economy, as it loses momentum quickly.
The input price index in the manufacturing Purchasing Managers’ Index survey dropped by 10 percentage points to 44.8 percent in May. The fee charged index in the non-manufacturing PMI also declined by 4 percentage points to 47.8 percent in the same month.
Both dropped to levels not seen since in the aftermath of the Lehman crisis, decisively below the threshold of 50. Even worse, unlike 2009, there seems to be no easy way out, as authorities in Beijing seem to believe that the 4 trillion yuan (US$635 billion) launched in 2009 has caused more trouble in the long run than short-term counter-cyclical gains.
The Chinese government did cut interest rates to allow more bank lending, but we do not believe these policies are either effective or will have a lasting effect. The funding costs are not particularly high and banks no longer lack liquidity. The problem is that private sector lacks interest in investing in real business, due to over-capacity, surging costs and weakened demand.
These cannot be addressed by monetary easing. On the fiscal front, the planning agency has moved on the fast track in approving local infrastructure projects. That should help ease growth pains in the short run, but we suspect the investment momentum could fade away quickly once the central government’s funding is used. The fact is local governments do not have the money for their share of investments. Banks are only willing to lend to the top-tier local governments.
Credit Suisse has revised the forecast for China’s Consumer Price Index significantly for 2012 and 2013. For 2012, CPI is revised down to 3.1 percent from previous 3.7 percent, and for 2013, to 2.3 percent from 4.5 percent.
From the CPI point of view, it is technically more of a disinflation than deflation, but to many parts of the economy, it would feel like deflation, as companies are losing pricing power.
We call it deflation to express our view that corporate profits margins will get squeezed, cash flows will be a problem, and the risk of seeing the debt-chain breaking down will be on the rise. We also wish to point out that (1) nominal GDP growth is expected to slip much faster than real GDP growth; (2) Real GDP growth is lifted by an expansion in net trade due to falling demand for commodities and machinery; (3) Until private investments return, this phase of deflation may last long, yet the pressure is probably mild enough for the government not to launch an all-out stimuli.
Looking back in history, almost every ten years China has one top-down structural reform to unleash productivity improvement. In the early 1980s, during the aftermath of the Cultural Revolution, rural reforms took place. Agricultural production surged after farmers gained the right to use land. That was a productivity gain.
In the early 1990s, when the economy was stalled, Deng Xiaoping’s launches of special economic zones resulted in an influx of foreign direct investments, setting the stage for China to become the world’s factory. That was also a productivity gain.
In the early 2000s, the economy was in deflation, Zhu Rongji initiated the effort to join the WTO and implemented banking sector reforms. That was again a productivity gain.
At this moment, China has largely consumed the benefits of previous reforms, and the economy needs a new structural breakthrough.
But instead, China is following the example of their western counterparts by printing money and burning fiscal dollars.
These kind of stimuli can help ease the pain on slow growth and prevent a hard landing, but are unlikely to generate an upward growth momentum and take the economy to new heights, in our view. In fact, government spending has crowded out private investment.
In our view, the solution is to open up the service sector, to break the monopolies in the banking and utility sectors, and to deregulate interest rates and exchange rate.
By doing so, the government can cut the dead-weight losses from the monopolies, inspire private investment in the new (and lucrative) fields, and improve the efficiency in capital allocation.
It is encouraging to see that the government has taken a small step towards deregulating bank interest rates, but it probably would take years and much stronger political will and wisdom to become successful. Until then, we expect a prolonged period of weak growth and corporate earnings in China.
The article was adapted from the Asian Daily note issued by Credit Suisse on June 14.
By Tao Dong