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Economists Warn China's Deflation May Become International Problem

Lanon Wee

The data published in July has highlighted the grim economic conditions in Beijing, revealing deflation for the first time in two years. This creates a challenge opposed to that of major central banks in the West. According to economists from Pimco, a weaker yuan and an extensive sum of stockpiled merchandise compared to sales could potentially lead to lower costs of Chinese merchandise in foreign markets. July's economic data in China pointed to rapidly deteriorating fundamentals, with deflationary pressures mounting, credit demand plunging, and the real estate sector facing a deep crisis. This was evidenced by plummeting consumer prices, Country Garden on the brink of default, and the bankruptcy protection filing of Evergrande Group in the U.S. All these events have posed a global concern, with economists expecting deflation to accelerate in the upcoming quarters. The core inflation has been further impacted by weakened prices of shelter and related categories. The weak economic performance of China is likely to affect the worldwide markets, as the country is still a major manufacturer. Western central banks, looking to quell inflation, might benefit from this development for the time being. As Western economies emerged from the Covid-19 pandemic with heightened inflation resulting from limited supply and increased demand, China has not had the same circumstances thanks to its resilient domestic manufacturing sector which served to address supply shortages and moderate global commodity rates.Yet, Wilding and Pimco's China Economist Carol Liao pointed out in a research note last week that domestic demand has weakened, leading to unutilized manufacturing capacity, along with increased deleveraging in the property and local government financing areas which had further reduced domestic investment and caused "far-reaching excess capacity in manufacturing.""What is more, the government's response to these weakening fundamentals has not been strong enough. The move to restore and secure growth with easily-accessible credit, mainly to state-owned enterprises and for infrastructure investment, was unsuccessful in negating the impact of the property sector as the amount of new credit to the economy has decreased in the previous year," the Pimco economists added.In face of the poor set of data and declining customer assurance, China's central bank tried to slow the currency's fast depreciation on Friday, but the market still felt that Beijing had not done enough to reverse the most recent developments. Skylar Montgomery Koning, senior global macro strategist at TS Lombard, warned in a research note last week that market disappointment is likely to persist as government fiscal stimulus measures will involve only "stronger versions of current easing measures" rather than the "broad-based stimulus needed to revive confidence in prices." Highlighting the negative impact of China's failing rebound on global sentiment and growth, she noted that there is a delicate balance for risk assets due to the significant appreciation of the U.S. dollar against the Chinese yuan. Montgomery Koning maintained a long position on the U.S. dollar against the yuan, given the projected slowing of growth, restricted stimulus, reduction in trade, and capital outflows in the upcoming quarter. The prevalence of Chinese manufactured goods across U.S. consumer markets has had a bearing on this situation, with data from the U.S. Census Bureau demonstrating that prices of goods imported from China have decreased 3% since last year while producer prices of consumer goods in the same nation are down 5% in dollar terms. This moderation is projected to spread to other developed countries as the U.S. inflationary trends have assumed a leading role since the pandemic started. Exports from China have dwindled in recent months, which Wilding and Liao predict Beijing may try to combat with fiscal policy, potentially increasing the influx of cheap consumer goods into the international market - as observed in Germany with electric vehicles. In addition, Chinese burden as a heavy commodity importer is weighing on global disinflation. Wilding and Liao noted weak domestic investment, excess capacity in manufacturing, and lackluster new housing and land sales likely will further drive global commodity demand down. This observation is supported by TS Lombard's Montgomery Koning, who pointed out Beijing's stimulus measures primarily concentrate on consumer-focus, leaving industrial commodity demands lagging behind expectations. Pimco's Wilding and Liao suggested that deteriorating Chinese economic fundamentals have created deflationary effects already being reflected in inflation rates both in China and global markets supplied by Chinese goods. They expect discounting to further intensify over the next few quarters, but note that the extent of deflationary pressure in the long-term depends on the government's fiscal policy responses in the immediate future. If adequate stimulus is provided to increase domestic demand, inflation has the potential to reaccelerate, whereas inadequate action may start a downward spiral. The authors additionally stated that Chinese deflation could spread to developed markets, as a weaker yuan and expanded stock-to-sales ratios would cause the cost of Chinese exports to be cheaper. Deutsche Bank strategists Uleer and Raab have observed that despite China's central bank rate cuts and assurance of stimulus, market jitters in Europe are still deep-seated. With 10% of European profits stemming from China, the analysts believe there is potential for a recovery in the fourth quarter, but are hesitant to be optimistic until there is further evidence.

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