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China: Exporting Deflation [Teaser:] Low core inflation and relapses into deflation are hardwired into the Chinese economic system. Summary Lower consumer-price-index numbers don’t necessarily spell deflationary doom for China. But the country is having a hard time creating more robust consumer demand, despite its abundant production of exportable goods. In essence, China is exporting the positive effects of deflation while absorbing the negative effects, proving that what is good for global markets is not necessarily good for China. Analysis China's consumer price index (CPI) fell 1.1 percent in the first nine months of 2009 compared to the previous year, according to data from the National Bureau of Statistics for the first three quarters of the year, published on Oct. 22. China has seen domestic price levels fall since February, most likely bottoming out in July. Food, energy and housing have led the deflation, reflecting the character of the past year's global recession. However, looking at China's core inflation -- excluding energy and food -- there remain drops in prices of clothing, transportation, communication and other services such as entertainment and education. The negative readings in these categories suggest that consumer demand in China remains weak -- a fundamental deficiency of the Chinese economic structure with profound ramifications for the country's future. [INSERT GRAPHIC: https://clearspace.stratfor.com/docs/DOC-3918] The Nature of Deflation Entrenched deflation is one of the most enervating economic phenomena in existence. It works something like this. Lower prices in a wide range of products change the expectations of consumers, shifting their mindset from excitement over “sales” to a belief that most products will be cheaper in a few days. That leads them to defer their purchases, which reduces the income of retailers and, over time, that of manufacturers. With less income, manufacturers invest less money in updating their facilities and products. If investment in product improvement is not made, there are no “new and improved” products to replace the old products, and inventories of the old products keep mounting. With warehouses full, manufacturing slows down, allowing businesses to begin cutting costs by shedding workers. Then as unemployment rises the consumer pool shrinks, while those who still have jobs notice the downward trend and wonder if they are next, thus further delaying purchases in order to save for a potential layoff. Demand continues to skew down while supply continues to skew up, and the deflationary cycle continues and deepens. The entire process is known as a deflationary spiral. However, not all deflation is bad. Deflation in food or energy doesn’t enervate consumption because people have to eat and use power and fuel. A certain floor of consumption is built into such products, which will prevent their prices from sinking endlessly into an abyss. Technological advances also play a role: When technology is applied to the production process, resulting in improved products, the price of older products tends to fall over time. The old products simply aren’t as highly sought after anymore and are being replaced by something better (think computers: that new iPhone has more processing capacity than NASA did in the early 1960s). Such upgrades are a critical part of the modern economy as they continually generate new demand. Deflation turns bad when the issue is oversupply of an existing product for which a demand floor does not exist -- for instance, when consumers put off buying household appliances, cars, clothing and other goods that are not life-sustaining or quickly replaced by new innovations. If this bad sort of deflation persists, the economy’s industrial capacity becomes outdated, even as unemployment ticks higher and consumption languishes. Sustained economic growth in such a scenario is nearly impossible. China's Economic Structure However, China represents a twist on “normal” economic laws. In ordinary circumstances, lack of product demand forces manufactures to reduce output, which lessens the chance of triggering a deflationary spiral in the first place -- less product, less chance of oversupply. This has nothing to do with responsibility and everything to do with profit motive. If a manufacturer cannot sell his product, he tends not to want to make much of it. Not so in China. Unlike in the United States, profit is not king in China, where the state (sometimes directly, sometimes through the state-run banks) shoves out as much credit as businesses and manufactures can swallow in order to maximize economic activity regardless of profitability. So far in 2009, in addition to China's massive fiscal stimulus of some $600 billion, banks have provided a record $1.27 trillion worth of new loans to buoy the economy (a 75 percent increase over 2008). All of this money is meant to keep the wheels of society turning. China's fear isn’t lack of profitability, it is unemployment. Weak demand for a product does not overly affect Chinese decision making since, after all, most of the product is meant for export. Internally, more Chinese people keep their jobs. Externally, the result is a rising tide of cheap products -- which are getting cheaper -- going from China to international markets. This rising tide has a few atypical effects. First, Chinese productive activity is a constant competitive pressure on manufacturers the world over. Many of these manufacturers cannot compete with China’s subsidized capital policies and simply go out of business (making anti-China issues a magnet for organized labor in many countries). Those who survive, however, become so brutally competitive that they can survive just about anything. The United States is a case in point: U.S. manufacturing now produces 171 percent more product by value than it did in 1979, when China’s opening to the world commenced, despite using 20 percent fewer workers. Nevertheless, U.S.-China trade tensions follow in great part from the pressure that American manufacturers feel from their competitors across the Pacific. China is, in essence, exporting deflation. This might sound deadly, but bear in mind that deflation’s negative impact is largely limited to the production-and-employment cycle (fewer sales, less income, lost jobs). That cycle is operating increasingly in China. Outside of China the net effect is lower prices, especially for consumer goods, worldwide. Therefore the process is a net damper on the negative impact of inflation globally -- a broadly positive development that increases purchasing power for other countries' economies and frees up capital for other uses. So if the positive impact of deflation is felt globally, the negative impact of a globally deflationary trend is concentrated locally, in China. This trend greatly weakens a primary pillar of the Chinese central government's economic policy: to develop an internal market. China would dearly love not having to rely on external export markets, but so long as it is always awash in a sea of goods whose prices regularly drop in real terms, its citizens will have little reason to purchase items immediately. An exception would be if they can be given a major encouragement, and Beijing has attempted to do so during the current recession by providing purchasing subsidies (on cars and household appliances, for instance). But these consumption-boosting stimulus measures have only temporary effects and perpetuate inefficiencies throughout China by creating inherently unsustainable demand. China's Future Do the latest deflationary CPI numbers spell doom for China? Probably not. China reports its CPI data year-on-year, and the highly inflationary period of the first half of 2008 (especially on food, energy and housing) has made for a sharp contrast with falling prices in most of 2009. Moreover, the most recent monthly data suggests that despite negative CPI readings through most of 2009, China's CPI has been ticking back up toward positive territory. Nevertheless, low core inflation and relapses into deflation are hardwired into the Chinese system for the reasons outlined above -- the government simply cannot create more robust domestic private demand, and the people are familiar with falling consumer prices and have no reason to accelerate their purchasing habits. Core inflation today is in the same territory as it was in the 2002-2003 period, and it took China three years of low inflation, occasionally dipping back down into the red, before prices really began to grow in a way that could inspire consumers to make purchases sooner rather than later. While China’s exposure to the global system allows it to escape many of the immediate effects (higher unemployment), it also entrenches the longer-term effects (inefficiency and a dearth of consumer demand). China's domestic consumption as a percentage of gross domestic product has declined from the mid-40 percent range to the mid-30 percent range over the past decade (lower than most comparable economies). How long can China keep it up? Probably a long time. Ultimately, however, China will have to reckon with the deflationary tendencies within its domestic economy. This precise sequence of causes -- dropping prices linked directly to subsidized capital that props up massive production -- has now held Japan in its grip, on and off, for over a decade. Kicking deflation ultimately requires something that forces prices up. During the Great Depression -- humanity’s most memorable deflationary event -- Sweden overcame the problem by abandoning the gold standard, printing boatloads of currency and setting targets for inflation rates -- all of which contributed to establishing the expectation of positive future inflation and revived consumer demand. It crashed their economy in the short run but laid the groundwork for growth in the long run. The United States, which raised interest rates to avoid dropping the gold standard, happened to find a different way to escape -- it stimulated demand sufficiently to chew through all its excess products by going to war. This means that while China may not yet be facing a deflationary spiral as enervating as those that threatened the world in the 1930s or Japan in the 1990s, it will eventually have to face one. And getting out of it will require some very uncomfortable dislocation and adjustment. RELATED LINKS http://www.stratfor.com/analysis/20090620_recession_japan_part_1_lost_decade_revisit ed http://www.stratfor.com/analysis/20090817_eurozone_danger_deflation http://www.stratfor.com/analysis/20081119_united_states_pitfalls_negative_inflation http://www.stratfor.com/analysis/20081016_financial_crisis_japan_and_china