in debt, China faces a deflationary spiral

Like many Western countries, China’s debt level has risen to quite unsustainable levels – which means that to solve the debt and deflation problem, there will probably be more aggressive money printing and economic stimulation than before.

Data published in mid-September show that, with the exception of food prices, prices in China remain practically unchanged. At the same time, people’s incomes have come under severe pressure. In the current monetary system, this is a bad stew because it can lead to a deflationary spiral, which is also discussed in this story.

The gross domestic product (GDP) deflator, which broadly measures the prices of the entire economy, has fallen for five consecutive quarters, and economists and analysts expect it to fall further. Next to the consumer price index, the GDP deflator is one of the most important price level indicators in the economy. In essence, this indicator strongly indicates deflationary processes in the Chinese economy.

The last such long period of deflation was in China in the late 1990s. At that time, the country was hit by the last major financial crisis, then China was still in the earlier phase of economic reform and opening up. At that time, China’s economy made up about 4-7 percent of the total volume of the world economy based on purchasing power parity, now it is already 19 percent. Thus, China has become one of the leading forces of the world economy, whose influence on the global economy is already comparable to that of the United States.

Dangerously high debt levels

“We are definitely in deflation, and there will likely be another stage of deflation,” Robin Xing, China economist at Morgan Stanley, told Bloomberg. He pointed out that wages in China are also falling. “Japan’s experience says that the longer deflation lasts, the more it is necessary to stimulate the economy to solve the debt-deflation problem.”

Deflation is also indicated by a long decline in the producer price index. Producer prices reflect the prices companies receive when selling their products, i.e. they are essentially wholesale prices. The producer price index has been in decline in China since the fall of 2022.

China’s public and private debt levels have risen dangerously high. The ratio of China’s national debt to GDP has risen to 89 percent this year, compared to only 40 percent 10 years ago. This means that, unlike in the 1990s and 2000s, China’s economic growth has been stimulated over the past decade mainly by increasing debt. At the same time, the debt level of the private sector is 123 percent of GDP, and that of households is 61 percent of GDP.

The graph below shows how China has tried to maintain high economic growth during the last 10-15 years mainly with the help of loan money. This has brought the debt burden of the public sector to a dangerously high level, which amplifies the impact of all kinds of deflationary processes on the public finances and the economy as a whole.

In addition, local governments have increased their debt levels considerably. Although the debts of local governments are not directly the responsibility of the central government and it is unlikely that they will become the responsibility of the central government, their debt level can be added to the debt burden of the public sector. If you add this figure, China’s government debt burden is comparable to that of the United States, Canada, France, Italy and the United Kingdom.

Deflation highlights the debt problem

This means that the impact of any deflationary processes on the Chinese economy is in many ways amplified, because deflation makes it more difficult to pay off debts. If the level of debt remains the same, but wages and prices fall, it becomes more and more difficult to repay the debt.

There is also a danger in China that mild deflation can turn into a deflationary spiral, which is disastrous for the economy in the debt-based system that exists in today’s countries. Since the money in circulation is created as a debt with added interest, the amount of money must constantly increase (and its value decrease). Otherwise, debt repayment and servicing will become very difficult, leading to large waves of bankruptcies and economic recession.

A deflationary spiral can be caused, for example, by households that start saving more as the purchasing power of the currency strengthens. Purchases are also being postponed because prices are expected to fall further. The turnover of companies then starts to decrease, which in turn leads to a decrease in investments. Pay cuts, layoffs and bankruptcies follow.

Wage growth has stopped

Bloomberg writes that polls conducted by the private sector confirm the beginning of this process. In sectors favored by the government – ​​such as electric car manufacturing and renewable energy – wages for new hires have fallen 10 percent from their peaks in 2022, according to data from Caixin Insight Group and Business Big Data. According to Zhaopin’s data, wages in China’s 38 major cities have not changed substantially in recent years, and before the corona crisis, wages grew by 5 percent per year.

The bursting of the real estate bubble

Similar to Japan in the 90s, real estate prices in China are falling, with a bubble already bursting at the end of 2021 centered on the insolvency of Evergrande, China’s second largest real estate developer.

Property prices in China have fallen at the fastest pace since 2015 this summer. The prices of new homes fell by 5.3 percent in August and by 4.9 percent in July.

Evergrande’s debt had risen to more than $300 billion in 2021, making it the world’s most indebted real estate developer. The decline of the entire real estate sector has now begun to noticeably affect the revenue base of municipalities, as a large part of the revenue was obtained from the sale of land.

Much of China’s household wealth had flowed into real estate over several decades. At the peak of the bubble, activities related to the real estate sector accounted for almost a third of the country’s GDP. In countries, its normal share remains at around 15-18 percent of GDP. The decrease in the value of real estate significantly worsens the financial situation of households, which in turn makes them save more and spend less.

Tens of millions of unsold apartments

According to various estimates, there are about 60 million unsold apartments in China that would take more than four years to sell without government help. According to several analysts, the number of unsold apartments is the largest in Chinese history. Oversupply is the main reason prices are falling at their fastest pace in a decade.

The graph below shows that in 2022, the number of apartments sold dropped by 30 percent to 9.6 million. However, real estate developers have taken into account that the rapid sales growth of previous decades will continue. This has put many developers in a very poor position.

China’s central bank announced in the spring that it will give 300 billion yuan (about $41 billion) to local governments to buy real estate. This is an attempt to boost the sector which is in a bad situation.

Gold from real estate

The Chinese have been pessimistic about stock markets for some time – the Shanghai Composite, which reflects the performance of the local stock market, has so far not exceeded the peaks of either 2007 or 2015. Meanwhile, the index is currently trading almost half below its 2015 peak.

Now the situation of the real estate market has deteriorated significantly, and the Chinese are looking for other ways to invest their money. A large part of them have chosen gold for this investment, following the example of the country’s central bank, which has been the world’s largest buyer of gold in recent years.

In addition, China’s gold-backed exchange-traded funds have seen inflows for 18 consecutive months, meaning purchases have exceeded sales. This year, 46 tons of gold have been bought through the funds, last year 19 tons.

China no longer provides a “safety net” for the global economy

What is happening in the Chinese economy is very important because the country has become the world’s largest economy based on purchasing power parity. In nominal terms, China is still behind the US – their total economy is $18.5 trillion, while the US’s is $28.8 trillion.

In recent decades, China has been the biggest growth engine of the world economy. In addition, in the course of globalization, China has helped to make the production of Western companies more efficient and affordable through cheap labor and industrial production. Now both of these trends have reversed – if in the 90s and 2000s China’s average annual growth reached 11 percent, now it is barely 4-5 percent.

In addition, the process of deglobalization is taking place, which means that the era of cheap labor in China is essentially over, and Western companies are bringing production home rather than taking it abroad. This is one of the most important trends that keeps inflation high on a global scale for a long time.

In tandem with deglobalization, geopolitical polarization has also accelerated. In the financial world, this is very well reflected by the fact that China is massively selling decades of accumulated US Treasuries, buying gold instead.