China Must Avoid a Debt-Deflation Spiral

Originally published at Project-Syndicate | Sep 4th, 2023

With high debt levels and falling consumer and producer prices, China faces the prospect of a vicious cycle whereby lower demand leads to lower investment, lower output, lower income, and thus even lower demand. To avoid Japanification, policymakers must pursue aggressive aggregate-demand stimulus, starting immediately.

NEW YORK – The Chinese economy is underperforming relative to its growth potential. Not only are investment and consumption demand weaker than hoped, but the country is facing the challenge of two Ds: deflation and debt. While consumer-price inflation is close to negative territory, producer-price inflation has already been negative for a year. At the same time, the private and public sectors have accumulated massive debts, owing to higher spending during the pandemic and the broader response to the easy-money conditions of previous years.

The two Ds are a toxic combination. By increasing the real (inflation-adjusted) value of existing debt, deflation makes it harder for firms to secure additional financing, thereby raising the prospect of bankruptcies – a trend that is already discernible in China. Moreover, once the combination of debt and deflation becomes entrenched, it can generate a vicious cycle whereby lower demand leads to lower investment, lower output, lower income, and thus even lower demand.

This dangerous spiral has two implications for policymaking. To prevent deflationary expectations from becoming entrenched, increasing the inflation rate through aggregate-demand stimulus becomes an urgent necessity. But relying solely on more public or private borrowing is best avoided in favor of aggressive monetary easing – including the monetization of debt (meaning the central bank purchases and holds government bonds).

To be sure, Chinese authorities have pursued a variety of policies to boost the economy, including reducing mortgage interest rates, rescinding restrictions on real-estate firms’ access to funding, and implementing measures aimed at boosting domestic stock prices (with the hope that this will raise consumer spending). But these responses, so far, have not achieved the desired outcome.

Curiously, monetary-policy action – massive injection of more liquidity by the People’s Bank of China (PBOC) – has not taken place. This restraint seems to reflect four considerations: a fear of triggering high inflation; perceived limited space for further monetary easing; a belief that monetary stimulus will have only a limited effect; and concerns about further renminbi depreciation against the US dollar and other key currencies.

But all four concerns are misplaced, given the current state of the Chinese economy. China should not be worried about inflation when it is already facing the opposite problem: a decline in prices and nominal wages across many sectors. If consumers and firms expect prices to fall in the future, they will delay purchases, further suppressing demand. Preempting the debt-deflation spiral must take priority.

Similarly, those who believe the scope for monetary easing was limited by already-low interest rates have it wrong. As Chinese financial authorities have now acknowledged, they can further reduce banks’ required reserve ratios, currently at 10.75% for large state-owned commercial banks and at 6% for other banks. Even though the required ratio for Chinese non-state-owned banks will fall to 4% starting on September 15, that is still high compared to the reserve ratios of 0% and 0.8% in the United States and Japan, respectively.

Moreover, like central banks in high-income countries after the 2008 financial crisis, the PBOC could still avail itself of quantitative easing, with large-scale purchases of government bonds giving commercial banks more liquidity for lending. If the goal is to achieve higher inflation – as is the case in China today – there is no mechanical limit on the additional stimulus that can be applied to the economy through this channel.

Some might doubt that monetary-policy easing will succeed in boosting aggregate demand, considering that the economy’s performance remained weak after previous cuts in the prime lending rate from 3.65% to 3.45%. But an insufficient increase in aggregate demand following a timid monetary stimulus is not proof that more aggressive easing would fail.

China needs the “whatever it takes” approach that the European Central Bank pursued a decade ago when it, too, was facing a debt-deflation spiral. The PBOC should publicly declare a strategy to monetize a big portion of government debt and to incentivize more private-equity investment.

To induce a general and coordinated increase in nominal wages, policymakers should consider a three-pronged approach featuring a reduction in employer contributions to the social-security fund in exchange for pay hikes; a fiscal transfer from the Ministry of Finance to the social-security fund, financed by long-term government bonds, to compensate for the lost contributions from firms; and monetization of that fiscal transfer by the PBOC (by buying and holding the government bonds). These measures can be reversed in the future, as needed, to combat inflation. For now, though, fighting the two Ds is much more important.

Finally, proposals for aggressive monetary easing tend to raise concerns about exchange-rate depreciation. The Chinese currency has lost about 5% of its value relative to the US dollar over the last 12 months, owing to asymmetric interest-rate changes in the US and China. The fear, now, is that additional renminbi depreciation could increase the expectation of further depreciation, triggering capital flight – a concern that has probably played some role in limiting the PBOC’s appetite for aggressive monetary easing.

But if the price of saving the economy from entrenched deflation is a weaker renminbi, it is a price worth paying – and could even serve as a useful adjustment mechanism by boosting foreign demand for Chinese products. Rather than trying to manage the exchange rate, which would artificially justify an expectation of depreciation, Chinese authorities should leave such adjustments to market forces. After all, a sufficiently sizable one-time depreciation would leave little room for further depreciation expectations.

China urgently needs to avoid entrenched deflationary expectations akin to what happened in Japan after the 1980s. It also urgently needs to restore business and household confidence, which is impossible without boosting aggregate demand. There is a strong case for immediate, aggressive monetary stimulus and a public commitment to halt the debt-deflation spiral.

Once China’s growth returns to the path of its growth potential, monetary policy can be normalized and the renminbi will naturally appreciate again.

Shang-Jin Wei: A former chief economist at the Asian Development Bank, is Professor of Finance and Economics at Columbia Business School and Columbia University’s School of International and Public Affairs. 

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