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Deflation in China: Causes, Impacts and Policy Recommendations
Long Guoqiang, Ying Lowrey
Since October 1997, retail prices in China have kept falling for more than 20 months. The Central Government of China has adopted active financial and monetary policies to stimulate domestic demand during this period. The trend of deflation, nevertheless, has not been curbed yet. Deflation has disappointedly tended to be even severer than before. Considering the economic well-being and related social stability in China, the paper attempts to find anti-deflation measures. It suggests that anti-deflation must to be taken as a critical task of China’s macro economic management at the beginning of 2000.
I. The causes of deflation
Since the outbreak of World War II, deflation has never occurred in almost all of the Western developed countries. Clearly, there was a good understanding of the serious consequence of deflation by the monetary authorities of these countries and their timely adoption of measures to prevent it. Since the beginning of the Asian Financial Crisis in 1997, governments and economic circles of Western countries have once again expressed their serious concern over deflation after more than 50 years. There has also been a flare up of discussions of deflation in the media of Western countries. The reasoning of China’s deflation, however, is far from adequate.
Deflation is an economic phenomenon. To the contrary of inflation, deflation appears when price indexes drop universally and continuously and the actual purchasing power of a unit currency increases as a result.
There are basically two rationales of why a deflation could occur. First, the drop in production costs of most commodities due to major scientific and technical innovation could consequentially drop price levels as a whole. In reality, however, it is very difficult to find any practical example of deflation due to technical innovation. Second, the drop in prices is due to a relative insufficiency of aggregate demand. The deflation experienced by the Western world from the 1870s to the Great Depression falls into the latter category. Western economists attribute insufficiency of aggregate demand that results in deflation to three sources: (1) insufficiency of monetary supply relative to the amount of commodities and services; (2) insufficiency of consumption and investment demand due to prevailing low economic confidence; and (3) inappropriate tight economic policies, such as increasing tax rates or interest rates, imposed by the government.
Insufficiency of aggregate demand is the general background of the occurrence of deflation. From the experience of most countries in the world and China in the past, however, insufficiency of aggregate demand does not necessarily result in deflation. As for the deflation that has occurred for the first time in China, it is necessary to analyze its real causes by examining China’s recent economic performance and economic policy implementation. Reasons associated with China’s deflation can be found as follows.
Insufficiency of monetary supply
Deflation is a monetary phenomenon. For this reason, it is advisable to start with the role of monetary supply on deflation in China. Generally speaking, the increased amount of monetary supply goes to three parts: the first part is to satisfy the demand of economic growth, the second part is absorbed by monetization in the economy, and the third part goes to the change of price levels. If there is still a surplus of the increased amount of monetary supply after meeting the demand of economic growth and monetization, inflation will occur. If the opposite takes place, then deflation appears.
Price fluctuations are closely related to variance of monetary supply. Using the annual data of the years since 1991, an empirical study shows the positive correlation between changes of price indexes and the monetary supply. The method we have used is to divide the growth rate of the amount of broad money in circulation (M2) by the growth rate of GDP and the growth rate of monetization. The result, termed as Pure Monetary Growth Index (PMGI), is then used for making correlation analysis with the retail price indexes. The result shows that the changes in price indexes are closely related to PMGI, with a correlative coefficient as high as 0.95.
In the second half year of 1993, China began to implement an anti-inflation macro economic policy. The growth rate of monetary supply decreased year by year as a result. The Chinese economy realized soft-landing in 1996 with an economic growth rate of 9.6 per cent and Retail Price Index (RPI) of 6.1 per cent. After the economic soft landing, the anti-inflation policy was not been revised timely. As a result, the growth of monetary supply (M2) kept slowing down substantially, 4.7 and 4.8 percentages lower in 1997 and 1998 than that in the preceding year, respectively. According to the result of the analysis mentioned above, the RPI could be maintained stable only when the growth rate of M2 reached 18.2 per cent in 1998. The actual growth rate of M2 in the year, however, was only 14.8 per cent. As a result, the Chinese economy entered a period of deflation beginning from October 1997.
Over capacity of production and enterprises’ irrational behavior
As a country at the stage of rapid development of industrialization, China has always had a pretty high investment ratio. The average investment ratio increased from 34.8% in the Sixth Five-year Plan to 40% in the Eighth Five-year Plan, which is 20-25 percentages higher than in Western developed countries. As a result of the long-time high investment ratio, China’s economy was turned into a demand dominated one around 1997 from previous “economy of shortage”. According to the general survey of 1995 conducted by the State Statistics Bureau, of the 286 major kinds of products only 6.3 per cent made full use of the production capacity. After 1997, the situation of over capacity became more severe, especially for the production with low technology. Taking color TV tubes as an example, although China need to import a large amount of color TV tubes bigger than 29 inches, it has the capacity of producing 30 million ordinary TV tubes, while market demand is only 18 million.
Over capacity is the fundamental cause of deflation. Theoretically speaking, market competition will drive enterprises with low efficiency out of the market and result in a new equilibrium of supply and demand. In reality, however, the unique irrational behaviors of the Chinese enterprises have deteriorated market competition and further intensified the fall of prices. Because the property rights of state-owned enterprises (SOEs) and lots of township and village enterprises (TVEs) are ambiguous so that the managers of these enterprises ignore the returns of capital. Such enterprises keep operating so long as the market prices of the products are higher than their variable costs, or even only above their labor costs under the condition of intensification of market competition. Considering the fact that they can avoid laying off workers for the time being, governments at all levels, and local governments in particular, would usually support such economic irrationality. As a result, the existence of these economically irrational enterprises has deprived market competition of its function in selecting players with higher efficiency, because enterprises with lower efficiency would not quit the market automatically when the prices of their products are lower than average economic costs or than average variable costs. These enterprises will stop operation only when they have run out of all financial resources and banks no longer provide loans to them. The consequences will be: firstly, the price will fall more than in a normal market economy; secondly, the time of the price decline will last longer; and thirdly, enterprises with higher efficiency would sometimes be hurt seriously before those with low efficiency quit the market. They reap extremely small profits, cut their R&D activities, and see the blunting of their long-term competitive edge.
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