Inflation—Deflation Debate

Lu Lei writes in Caijing: Pay Attention: Deflation Looms in China

Looking only at China's first quarter trade surplus, which was 53.6 percent higher than in the same period 2008, one could form a false impression that net exports are still powerful tonic for China’s economic growth. In contrast, total trade fell by 24.9 percent in the first quarter due to a 19.7 percent decline in exports and an even sharper decline in imports, down 30.9 percent.

On one hand, it's not difficult to see that export weakness will remain for awhile. Just look at the recent Canton Fair, China’s most important trade fair, where fewer foreign buyers participated this year and export contracts diminished 20.8 percent in value.

The part about imports is important:

In fact, imports have been sympathetic to exports during the ups and downs of this cycle; imports have always led exports by approximately one month. This is because factories import materials or equipment according to their expectations of how many products they would be able to sell later, abroad or at home.

And there are currency implications:

Both fall-offs in trade and foreign direct investment would serve to ease pressure for appreciation of the yuan, reducing China’s attractiveness for interest arbitrage. Therefore, the "hot money" previously rushing into China for higher returns might head the other way. We have seen evidence of the current account surplus taking as much as 96 percent of the total surplus, reflecting a lack of momentum for capital inflow and an increasing chance that a capital account deficit will emerge. Besides, as growth in foreign exchange reserves slows or perhaps turns negative, China's central bank would no longer need to buy large amounts of foreign exchange from banks to prevent the yuan from appreciating too quickly. The current excess liquidity in the banking system might change as a result.

Another implication of falling trade is future negative growth for inventory investment. This would undermine the driving force of fixed capital investment. Indeed, inventory buildup was suspended roughly at the same time as trade growth turned negative in November 2008. According to the National Statistics Bureau, domestic companies cleared 44.8 billion yuan worth of previously stocked materials in November, which was followed over the following three months by destocking of products valued at 33.11 billion yuan. The direct result is shrinking industrial value added, partly offsetting the government's stimulus package, which invests heavily in fixed capital.

Finally, China's labor costs, as well as land and capital costs, probably would continue to decline along with trade. As businesses get more hesitant about inputs with these factors due to concerns about future profitability, we might see these costs decline.

Each of these aspects point to a greater danger of deflation, which would dampen China's recovery. It may be too early to cheer for the government's enormous investment in infrastructure, since a truly promising up-tick in domestic demand has yet to appear.