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Has China finally slid into a debt/deflation spiral?

21 August 2023 David Rees, Senior Emerging Markets Economist at Schroders
David Rees

David Rees

Although weaker Chinese domestic demand is causing concern, this may not be the start of a long-term economic depression.

The latest batch of data will have done little to calm fears about the health of China’s economy. An apparent collapse in domestic demand meant that imports were far weaker than expected in July, while the economy slid into deflation last month as consumer prices fell by 0.3% compared to the same period a year earlier (y/y).

If ever evidence was needed to back up claims of "Japanification" and a debt/deflation spiral, then this appeared to be it. This is in marked contrast to most other parts of the world where our regime shift work suggests that the risks to structural inflation and interest rates are skewed to the upside.

Fears of a debt/deflation spiral cannot be dismissed entirely. After all, China is an economy that has excess supply, while demand is softer than we had assumed following the removal of the zero-Covid policy.

Booming travel failed to translate into broader economic growth, not least because the clampdown on speculative real estate purchases in recent years has cut off a key source of demand in the economy and avenue for policy transmission. Indeed, the July credit data again showed that, with house purchases still very weak, there is little demand for credit from households. This helps to explain why plentiful liquidity has so far failed to make it into the real economy in recent months. And China’s enormous stock of debt is well documented.

We will in due course look at the prospects of China descending into a long-term deflationary spiral like that seen in Japan. And there are clearly some parallels given the amount of leverage exposed to the over-supplied and expensive real estate market.

However, there are a few reasons to think that July did not mark the beginning of a long-term depression.

For a start, it is not obvious that the collapse in China’s imports in July was entirely due to weak domestic demand. Part of the slump in imports was due to weak purchases of high-tech intermediate goods such as semi-conductors. Some of that may have been caused by the US ban on technology exports to China that has been ratcheted up in recent weeks. As we have discussed in our regime shift work, the emergence of a new world order is a threat to globalisation. However, much of the recent decline in technology imports appears to have been due to cyclical weakness in the global manufacturing cycle. This may soon start to reverse, with some leading indicators suggesting that global manufacturing PMI will climb back above 50 by the fourth quarter of this year.

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