CHINA: HIGH GROWTH AND DEFLATIONARY TENDENCIES

China’s National Bureau of Statistics released data covering 2009 on Jan. 21. The soaring growth rate of 8.7 percent for the year has received much fanfare, given the economic troubles globally, but is not surprising given the country’s massive stimulus efforts throughout the year.

However the simultaneous deflation in consumer prices of 0.7 percent over the previous year reveals a critical imbalance in the Chinese economy, one worsened by the stimulus measures and one that Beijing shows no signs of addressing.

The fall in consumer prices was due in great part to a fall in transportation costs, a byproduct of dropping energy prices throughout 2009. Food prices also fell from February to July, though they increased overall by 0.7 percent on the year. But STRATFOR looks primarily at core inflation, which excludes food and fuel prices. This is because food and fuel are inherently different than other goods. Demand for these goods is relatively inflexible: Demand for food mainly reflects the number of mouths to feed, and demand for fuel reflects the number of cars on the road, jets in the air and factories churning out products. These sources of demand change slowly and with difficulty, and major adjustments would have drastic effects on the overall economy and society. At the same time, the supply of food and fuel is contingent on factors that cannot be changed quickly: entire planting seasons or livestock-raising patterns would have to be adjusted to change food supply. Energy production is similar. Finally, government policy tools (such as monetary policy) do not have much of an effect on food and fuel, especially if they are produced abroad and imported, for the above reasons.

The problem for China is that prices fell in other areas — retail prices on consumer goods fell by 1.2 percent, with clothing and housing prices leading the way. These are areas where consumers have the option of whether to spend or not. And these drops are not attributable merely to poor consumer sentiment during the current economic slowdown. Looking at the Chinese consumer price index over the long run, low inflation is endemic, verging into deflation during global economic troubles (such as 2009, the late 1990s and early 2000s). Inflation has remained below 5 percent for well over a decade (with a brief exception in 2008 at the height of the global bubble).

This is caused by China’s emphasis on overproduction of goods and exports. This creates a glut of consumer goods at home, where private consumption remains underdeveloped, further discouraging consumers from spending. With more than 700 million people barely making $2 per day, poverty prevents consumption from providing a basis for future growth. So far, the government has failed to make the changes necessary to strengthen the fundamentals behind private consumption, such as allowing the currency to appreciate or providing social welfare services that free consumers from their tendency to save for the worst.

This is not to say that there are not pockets of inflation in China. But Beijing cannot rein in credit so sharply as to reduce growth, and therefore the overall trend of low prices due to over-production and under-consumption will remain in place.

Low inflation is especially unusual given China’s consistently high growth rates, which reached 8.7 percent in 2009 despite the global recession. But high growth figures do not necessarily make a healthy economy — they are the result of the government’s fiscal stimulus and use of state-controlled banks to pump 9.6 trillion yuan ($1.5 trillion, 33 percent of GDP) into the economy in 2009. The purpose of such growth is to maximize employment levels for social stability. However, these policies prevented China’s businesses from processing the changes in global consumption patterns and responding to them, and therefore further entrenched the poor allocation and inefficient uses of capital, which will come back to haunt China in the future.

Source: Stratfor