Unmasking China’s Supposed “Debt-Deflation” Risks

Is the deflation doom loop finally taking hold in China? Alarm bells are ringing once again following the Middle Kingdom’s renewed CPI dip in October. But a look under the hood doesn’t support that conclusion, suggesting this is another fear in the young bull market’s wall of worry.

After a two-month reprieve following July’s -0.3% y/y deflation dip, China’s headline CPI returned to year-over-year decline in October, falling -0.2%.^[i] (Exhibit 1) According to pundits, this proves Chinese economic problems are mounting. Falling prices supposedly herald weak demand as folks hold off purchases, awaiting better deals ahead. They will also allegedly trigger more insolvency as fixed nominal debt payments become harder to make as prices and incomes shrink. Theoretically, this creates a vicious cycle whereby mounting defaults lead to credit constriction, which freezes spending, fueling further price and debt deflation. Lather. Rinse. Repeat.

Exhibit 1: Headline Chinese CPI Dips Negative, Notably Core Didn’t Though

Source: FactSet, as of 11/9/2023.

Headlines suggest China’s apparent foray into deflation is evidence its long-standing property woes will snowball into spiraling defaults, financial crisis and a hard landing. But as Exhibit 1 shows, China’s core CPI—excluding food and energy—is still rising, up 0.6% y/y in October. That reveals skew from a narrow, volatile category: Primarily, pork prices, which plunged -30.1% y/y, swinging from a high base last year because of a swine-flu shortage to a supply-glut low today.^[ii]

Base effects from high energy prices last year also depressed headline inflation, but those are receding as they fall out of the year-over-year denominator. Meanwhile, although housing-related components continued to weigh on core prices, non-housing categories have more than offset them. So far at least, deflation isn’t widespread or representative of the broader Chinese economy, which we think rather undercuts the notion of rampant demand destruction.

As Exhibit 1 also shows, China has seen occasional bouts of deflation on both a headline and core basis, which add perspective on today. In 2008 – 2009, Chinese prices succumbed to the global financial crisis but, notably, its economy didn’t. It grew throughout (albeit at least partly because of a massive public infrastructure buildout). While China’s brush with deflation in late 2020 and early 2021 came with economic contraction, that was due to COVID lockdowns. When those ended, so did deflation, while growth resumed. Deflation didn’t drive doom. Instead, it moved concurrently with global issues. It told you nothing about future domestic consumption or debt repayment trends.

Is this time different? No question China’s property slump is challenging. But it is also well known, likely priced in to a great extent (or even excessively) and being addressed. Although many fear worse to come, we think this underrates the government’s chief aim—to maintain social stability. This, plus Beijing’s formidable financial firepower, give it the means and motive to step in if needed. Chinese growth may be relatively slow and uneven, but that is nothing new—and a far cry from implosion.

Lastly, we take issue with the idea that deflation by itself—in China or elsewhere—is the economic bugaboo pundits imagine. For example, we don’t think most would consider past technological deflations—when technology improvements cause prices to decline, like with mass production during the Industrial Revolution, illumination costs following electrification or personal computer and electronics prices in the last couple of decades—as particularly troublesome.

While supply-driven abundance isn’t cause for worry, persistent demand destruction may be, especially if accompanied by protracted money supply contraction—like in the Great Depression or as depicted in It’s a Wonderful Life. The problem isn’t deflation per se, but when protracted and deep, the economic and monetary conditions it stems from.

Inflation—and deflation—are always and everywhere monetary phenomena of too much (or little) money chasing too few (or many) goods and services. The Great Depression was chiefly about the Fed errantly shrinking money supply by nearly a third during the 1929 – 1933 span, with the attendant bank failures compounding the effect.

This doesn’t appear to be the case in China. While Chinese M2 money supply and total social financing—a broad measure of aggregate credit creation—have decelerated this year, they remain far from contracting. (Exhibit 2) Prolonged deflation is unlikely to take hold when both money supply and credit are expanding. So upon closer inspection, we don’t find dour sentiment toward China close to matching its reality.

Exhibit 2: Chinese Money Supply and Credit Slowing, but Still Expansionary

Source: FactSet, as of 11/13/2023.