Unmasking China’s Supposed Debt-Deflation Risks

Is the deflation doom loop finally taking hold in China? Alarm bells are ringing once again in publications we read following the Middle Kingdom’s renewed consumer price index (CPI) dip in October. Broadly falling prices—deflation—spark warnings from commentators we follow that this proves Chinese economic problems are mounting. But a look under the bonnet doesn’t support that conclusion, in our view, suggesting this is another false alarm in the young bull market’s (broadly rising equities’) proverbial 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 coverage we review, falling prices supposedly herald weak demand as people 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, analysts we follow say, this creates a vicious cycle whereby mounting defaults lead to credit constriction, which freezes spending, fuelling further price and debt deflation. Lather. Rinse. Repeat.

Exhibit 1: Headline Chinese CPI Dips Negative

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

Headlines we saw suggest China’s apparent foray into deflation is evidence its long-standing property woes will snowball into spiralling defaults, financial crisis and a hard landing. But as Exhibit 1 shows, China’s core CPI—the index excluding volatile food and energy prices—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.^[iii] Meanwhile, although housing-related components continued to weigh on core prices, non-housing categories have more than offset them.^[iv] So far at least, it seems to us deflation isn’t widespread or representative of the broader Chinese economy, which 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.^[v] It grew throughout (albeit at least partly because of a massive public infrastructure buildout).^[vi] Whilst China’s brush with deflation in late 2020 and early 2021 came with economic contraction, that was due to COVID lockdowns.^[vii] When those ended, so did deflation, whilst growth resumed.^[viii] Deflation didn’t drive doom, in our view, but rather it moved concurrently with global economic issues. We don’t think it said anything about future domestic consumption or debt repayment trends.

Is this time different? Whilst we think China’s property slump is challenging, it is also well known, likely priced in to stocks to a great extent (or even excessively) and being addressed, based on our observations of government actions. Although many commentators we follow warn of 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, in our view. Chinese growth may be relatively slow and uneven, but that is nothing new—and a far cry from implosion.^[ix]

Lastly, we take issue with the idea that deflation by itself—in China or elsewhere—is the automatic economic catastrophe coverage we read suggests. For example, we don’t think most would consider past technological deflations—when technology improvements cause prices to decline, like 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.

Whilst supply-driven abundance isn’t cause for worry, in our view, persistent demand destruction may be, especially if accompanied by protracted money supply contraction—like in the Great Depression. It seems to us 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.^[x] Deep US deflation during the Great Depression was chiefly about America’s Federal Reserve errantly shrinking money supply by nearly a third during the 1929 – 1933 span, with the attendant bank failures compounding the effect.^[xi]

This doesn’t appear to be the case in China. Whilst Chinese M2 money supply and total social financing—a broad measure of aggregate credit creation—have decelerated this year, they remain far from contracting.^[xii] (Exhibit 2) In our view, 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 13/11/2023.