Overcapacity threatens China's orderly deflation

Overcapacity threatens China's orderly deflation



By William Pesek

New York - Has anyone noticed how quickly "overheating" has been
dropped from investors' China lexicon? In the annals of word
disappearance cases, it warrants a mention.

"Not long ago, overheating was all anyone could talk about," says John
Chan, the managing consultant at Shanghai-based China Streetsmart.
"Now, fears of China getting too hot rarely come up."

To give credit where it's due: Chinese officials seem to be pulling off
an orderly deflation of their nation's economic bubble. Along with this
year's deftly handled 2.1 percent revaluation of the yuan, the feat
suggests that leaders in Beijing know what they're doing.

The risk is that China may be flirting with the opposite of
overheating: deflation. Sound like a reach? Not to economist Andy Xie
of Morgan Stanley. He's eyeing a scenario in which China experiences
falling prices as soon as next year.

The reason: overcapacity. China is still producing too much cement,
aluminium and textiles. It's also constructing too many buildings.
Officials in Beijing have used administrative measures to reduce
overinvestment.

Doing it slowly to achieve a soft landing means capacity growth stays
high, causing an oversupply even when China's annual growth of over 9
percent slows. Cutting interest rates may even worsen deflationary
pressure by encouraging capacity growth regardless of corporate
profitability.

As Hong Kong-based Xie explains: "Plentiful liquidity keeps interest
rates low and, hence, sustains the ongoing investment projects and
funds new investments in bottleneck areas." Pushing China towards
deflation is a high savings rate.

While Americans save too little, Chinese save too much. China needs to
get its consumers to spend more.

To do that, Xie argues that the government should privatise state-owned
assets, shift fiscal expenditures away from investment and modernise
pension, healthcare and education systems.

The spectre of falling Chinese prices runs against most views of the
world's sexiest economy. China ended five years of deflation in 2004 by
stimulating investments in real estate, vehicle manufacturing and
others.

And it worked. Inflation climbed as high as 2.3 percent in the first
six months of 2005.

"We can't go on stimulating the economy this way as this method will
inevitably lead to oversupply, which in turn will take us back to
deflation," says Justin Lin Yifu, a professor at Peking University. Lin
thinks China could slip back into deflation by the end of this year or
early 2006.

All this could have big economic implications.

For one thing, it suggests that Chinese currency revaluations may be
smaller than investors and the Bush administration would like.
Deflationary pressures and a weaker Japanese yen may leave Beijing even
more reluctant to let the yuan rise.

"A common figure cited for another move, 20 percent to 25 percent,
would be devastating to China. It would cause deflation, cut economic
growth, cut off foreign direct investment and would destabilise Asia,"
says Robert Mundell, a Columbia University economics professor.

Economist Stephen Green of Standard Chartered Bank says Chinese
officials are concerned that a rising yuan "might derail economic
growth". It means China's trade surplus may increase even more as
Chinese companies seek to increase exports. Also, a shift towards
deflation might cool global commodity markets.

The steel industry, Xie says, "is facing serious overcapacity".

Would Chinese deflation be a crisis? Not as long as it doesn't get out
of control. Besides, such a trend wouldn't be the cause of China's
problems, but a symptom of its failure to create a healthy consumer
market.

There is a nightmare scenario. In it, investment in China plunges,
exposing industrial overcapacity. Consumption collapses as workers lose
jobs.

Trade frictions worsen with the US as Chinese companies scramble to
export more. China's central bank is unable to restore confidence among
consumers, executives and investors.

Or the opposite might happen: deflation compels China to upgrade its
economy, improving the business environment and increasing government
efficiency.

In other words, deflation drives positive change, as it has in Japan.
Risks emanating from China haven't gone away, though they might be more
about falling prices than rising ones. And that would have consequences
far beyond China's borders. - Bloomberg

Published on the web by Business Report on December 4, 2005.
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© Business Report 2005. All rights reserved.

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