Is deflation bearing down on Asia?
Try sleeping after reading Nomura’s latest look at China and Hong Kong, the bank’s top candidates for economic crises within the next 12 quarters.
“The world’s second largest economy, to which the rest of Asia is very exposed, is flashing several signs of vulnerability,” warn Nomura analysts Rob Subbaraman and Michael Loo. Hong Kong, too, faces what they call “large credit and real property gaps.” Should things unravel, they say, “contagion to the rest of Asia could be substantial.”
Sleeping pills, anyone?
Let’s pretend, for a moment, China can continue to beat the system—one that has seen virtually every industrializing nation in history hit a wall. It happened in Europe, Japan, East Asia and America. Perhaps it is true that Beijing is run by financial geniuses, that its rise is unstoppable and that, this time, things really are different. But even if China proves to be the exception to the rule—and I’m unconvinced it is—there’s another outcome that should worry us: deflation.
China’s debt-and-credit-bubble profile, it’s often observed, bears troubling similarities with Japan, circa 1990, and South-East Asia in 1997. True, investors haven’t made much money betting against Beijing’s market-protection team. It beat the odds in 2008 after Lehman Brothers collapsed, in 2013 when the “taper tantrum” slammed emerging markets and in 2015 when Shanghai stocks crashed. President Xi Jinping’s modus operandi is the financial equivalent of US general Colin Powell’s military doctrine: attacking a problem with overwhelming force.
Xi has marshalled tens of trillions of dollars of fresh debt and credit, bent regulations to save markets at all costs and made the No. 2 economy more of a black box. The dark side is that Xi is papering over older bubbles with new ones. The fallout from this overwhelming-force gambit is epic overcapacity that’s increasingly spilling over into the global economy. US President Donald Trump isn’t completely off base when he says Beijing is trying to lift growth on the shoulders of other nations dealing with their own traumas.
If it were working, officials from Tokyo to Washington might figure the end justifies the means. If what Beijing is doing leads to a recalibrated, stable and trusted growth engine, then by all means, President Xi, do your worst. But as Beijing exports excesses via steel markets, Hong Kong’s markets and a huge carbon footprint, it’s getting less traction at home. China is at the crossroads where the ideologies of John Maynard Keynes and Milton Friedman meet: aggressive stimulus over time loses potency, requiring ever bigger doses. Xi has gotten around this pushing-on-string problem by adding ever more levers to the boosting-growth effort. He’s running out of them, though.
China’s diminishing-returns quandary can best be seen in inflation pressures, or lack thereof. Optimism met news that producer prices rose 5.5% in June—well off the 7.8% pace earlier in the year, but above the 5.3% rate at the end of 2016. Consumer price trends are far more troubling, rising 1.5% last month (versus 1.6% in May). Given the margin of error, price gains could indeed be zero. What’s more, consumer price dynamics suggest produce prices are only held up by efforts to restock inventories, which would mean weak readings to come.
All this matters because China was the last best hope for the global reflation trade. The fact the US, Europe, and Japan are largely devoid of pricing power seemed less dire when Asia’s biggest economy—the world’s factory floor—could pick up the slack. China’s soft inflation readings aren’t just a problem for US Federal Reserve chair Janet Yellen and European Central Bank head Mario Draghi, but governments throughout Asia. In the short run, it will stoke fears that Beijing will devalue the yuan, sparking a currency war and raising the odds Trump will make good on his 45% tariffs threat.
Asia, unfortunately, will now live in near-constant fear as #ChinaMeltdown moves from hashtag to reality. What Japan’s crash in 1990, South-East Asia’s in 1997 and Wall Street’s in 2008 have in common is how few people genuinely saw them coming. Loads of “experts” claimed to afterwards, but markets were caught flat-footed when the Nikkei 225 plunged, Thailand devalued the baht and US authorities let Lehman fail. Xi, meanwhile, has spent his four years in power intensifying media censorship efforts, clamping down on smartphone texting apps and turning financial opacity into an art form. That handiwork makes discerning the size and scope of the shadow-banking system, the interplay between off-balance-sheet vehicles and state-owned enterprise activities even harder. A bubble in murkiness coincides with bubbles in debt, credit, property and stocks. The upshot is that Xi made it harder for rating companies and investors to gauge the “early warning indicators” of which Nomura speaks.
Should China hit the wall so many others have, when an unbalanced, debt-fueled expansion comes to a sudden end, markets from New York to Mumbai won’t know until it’s too late.
William Pesek, based in Tokyo, is a former columnist for Barron’s and Bloomberg and author of Japanization: What the World Can Learn from Japan’s Lost Decades.
His Twitter handle is @williampesek