Evolution of China's deflationary phenomenon

Sustained deflation first emerged in China in April 1998 on the back of the Asian financial crisis. China then faced the double whammy of weak domestic demands and a strong RMB. The deflation lasted for two years until May 2000, with the CPI once registering the largest monthly decline of 2.2%. Price began to climb slowly for the next one and a half year. Exports and FDI driven strong growth along with fiscal stimulus contributed to the turnaround. But deflation reared its head again in September 2001. For the first nine months of this year, the CPI was down 0.8% YoY. Consumer goods, food and non-food items all recorded price decrease while service items recording increase.

The price behavior in the US shared similar pattern with goods price falling while services price rising. Obviously in China, the drop in goods price can more than offset the rise in services price. And the deflation this time takes on a much different economic backdrop of a weak global recovery and a weak dollar. Together with the structural change China is undertaking, they all put pressure on the price level.

Characteristics of China's deflation

Generally speaking, deflation can weaken current demands because consumers, expecting further price declines, may choose to defer consumption. Moreover, as the real cost of capital increases and returns decrease, investments are curbed. By August 2002, Japan's deflation entered the 35th month while Hong Kong's was at its 46th month. For years, deflation and recessions have plagued the two once-vibrant economies. The vicious deflationary cycle they have been facing is the result of economic recession. And it in turn prolongs the tenure and aggravates the damages.

China's deflation is completely different from that of Japan and Hong Kong in terms of its cause and impact. China's economy grew 7.8%, 7.1%, 8.0% and 7.3% respectively in the last four years. During the first three quarters of this year, its growth rate continued at a high level of 7.9%. And sustained growth under a deflationary environment demonstrates the uniqueness of China's deflation.

Theoretically, price has to come down when supply exceeds demand until equilibrium is reached. But for China, such a simple explanation tends to mask the structural change its economy is undergoing with the dispersement of productivity gains. Its exports to GDP ratio is currently standing at 26%, but the incremental contribution of exports to GDP's 7.8% growth in 1H 02 reached 45%. And it is poised to rise further in 2H. Along with FDI and government spending, they drive the Chinese economy higher. In the first three quarters of 2002, utilized FDI amounts to USD41.2bn, up 22.4% YoY. Surging FDI is related to global manufacturers replacing productions elsewhere for exports as well as targeting the huge Chinese market. China's labor supply curve is nearly horizontal, meaning close to unlimited supply. Its labor force is seven times the total of Japan and the Tiger economies, but commanding only one eighth of the latter's salary. Moreover, China pays close attention to technology transfers and IT products have increasing shares in exports. Rising investments and technology unleash the huge productivity potential of China's labor force. The annual productivity gains are estimated to be 4%+, higher than that of the US. Even if the global economy is in a slump, the replacement factor for manufacturing alone can keep China's economy growing. The more uncertain the global economic outlook is, the more attractive China's cost advantage will be, and more incentives for the manufacturing sector to relocate to China. In this sense, China's growth could be independent of the global economic cycle. The price benefits originated from this structural change, especially the vast improvements in productivity, should be deemed positive.

The real problem, however, lies in the insufficient demands to absorb the extra supply brought by improved productivity. In China, rural population is estimated to be 70% of the total. The huge gap between the urban and rural income levels limits the scale of internal demands. In 2001, for example, urban per capita income was RMB9218, close to four times that of the rural area. In the past five years, the growth in urban income has matched or exceeded GDP growth while the growth in rural income lagged consistently behind GDP growth. The still low per capita income, along with even lower rural income, curb domestic demands. Even in the cities, off-post workers receive only meagre incomes, which is another income distribution problem. This is no doubt a worrisome issue on China's deflation.

Imports and exchange rates also play an important part in shaping China's price level. Imports are the other active part in China's foreign trade, ranging from raw materials to parts and components. Its growth rate closely follows that of exports. Since the Asian financial crisis in 1997, RMB has become a strong currency as Asian countries sharply devaluated their currencies against the dollar and Japan pursued a weak Yen policy. With pan Asia trade heating up, China is importing more deflation through the trading channel. The WTO access also results in greater market opening and lower import tariffs, putting more downward pressure on prices. Accordingly, China can set even lower prices on goods in both the export and domestic markets, adding more deflationary pressure.

Is China "exporting" deflation globally?

On the surface, China commands the pricing power in the export market with its infinite supply of labor, super low cost and increasing productivity. Therefore it is argued that during globalization, it exports deflation through the trading channel. But the phenomenon masks the important fact that it is the global disinflation/deflation trend that ultimately benefits China and makes it an attractive location for manufacturing. Moreover, China is not fully capable of setting the retail prices in import countries to successfully export deflation. The China factor cannot dominate the overall price level of import countries because its influence is only partial and limited. The accusation of China exporting deflation globally has obviously been overstated case.

Foreign direct investments have always been a stable source for China's growth. In 2001, utilized FDI set a record at USD46.9bn. That was because after withstanding shocks from the 1997 Asian financial crisis, the 1998 Russian and LTCM crises, the 1999-2000 stock market bubbles and the ensuing recession, China has found new growth engines. The prospects of China's WTO access also expedited investment inflows. It is estimated that in 2002, FDI will set a new record. All these point to the fact that as the global economy received multiple shocks, consumers grew more price sensitive and their pricing power grew stronger, which set the global disinflation/deflation trend. Under such circumstances, China's cost advantage becomes more prominent, resulting in more manufacturers relocating to China in order to reduce costs. In other words, it is the global disinflation/deflation that created the China factor to put pressure on commodity prices. By relocating to China, the manufacturing sector can lower costs by 20% to 30%, which in turn exerts further downward pressure on pricing, forming a cycle.

In recent years, China's total exports and its share in global trade and manufacturing exports have all increased significantly. China has become the leading manufacturer in goods such as camera, air conditioner, and TV, etc. But overall, China still has to work its way through before being named a world plant. In terms of industrial production, China is ranked fourth in the world behind the US, Japan and Germany, and the gap is still large. A major portion of manufacturing goods are for the ever-increasing domestic market instead of for export. The made-in-China goods still account for a small portion of the world exports. Statistics from the World Trade Organization show that in 2001, Chinese manufactured goods exports only accounted for 5.3% of the total. And a large proportion was parts, components and capital goods that would not directly affect consumer price. Therefore, putting the blame on China for global deflation is obviously exaggerating.

Furthermore, the China factor can only influence the factory price and the FOB price. It cannot directly impact the transfer price and retail price set by the importing countries. Therefore the deflationary pressure originated from it can only reach certain segment of the goods export channel. Take the US as an example, because of the complex middleman distribution system, the US consumers may have to pay many times more than the factory price of China-made products. China's competitive pricing is only partially transferred to consumers with the majority becoming profits for various distributors. This explains why the China factor has only very limited effect on import pricing.

Case study of the US

The US is the largest goods importer in the world and China has replaced Japan as its largest source of trade deficits. Here we examine the impact of China's exports on the US price level and use it as a proxy to evaluate the argument of China exporting deflation globally.

There are many price indicators in the US, including PPI, core PPI, CPI, core CPI, GDP price deflator, PCEPI, etc. With the exception of PPI, all indicators show that in the first eight months of the year, the US inflation was growing at a 1.5-2.5% pace. The possibility of outright deflation is still remote because the rise in services price has more than offset the drop in goods price, which is just contrary to China's situation.

Take the GDP price indices for example, it is divided into three categories: goods, services and structures. The overall GDP-based price level would not have risen by 1.2% in the first half of 2002 had it not been for the 2.2% rise in the services price offsetting the 0.8% drop in goods price. The Wall Street Journal conducted a study in August showing that 30% of the CPI basket of goods registered price decline in 1H 02, and it was the rising services price that kept the general price level from falling. The China factor cannot possibly affect the US services price because on one hand, China's service sector growth is still at an early stage, on the other hand, globalization in services lags far behind the goods sector. Although China contributes most to the US trade deficits, it ranks fourth in the US imports market behind Canada, Mexico and Japan, and has a market share of only 9.3%. As a result, we can see that China can only affect part of the goods price in the US.

The US Labor Department compiles the Import Price Index series to gauge imported goods price. While lacking separate data on imports from China, it does have indices for Japan and the Newly Industrialized Countries, i.e. the Tiger economies. They all have fallen to the lowest level in ten years or more, signaling that the US is importing deflation from Asia, with China being only part of it. The real personal income in the US has been rising steadily even during the recession. If Chinese exports had made consumer products cheaper, then the living standards of the US consumers would increase accordingly, and the US may have entered into a hard-to-get low inflation growth period. It is only the collapse of the services market that can possibly bring down the services price and push the US into outright deflation. And even the strongest competition from China cannot yield such an outcome. The US situation has clearly demonstrated that the argument of China exporting deflation globally is incorrect.

Hong Kong's deflation is mainly internally induced

Hong Kong and the Mainland are only separated by a river. Its economic transformation emphasizes integration with the Mainland, especially the Pearl River Delta. Thus Hong Kong's price level is more directly impacted by the China factor. But is Hong Kong's deflation made in China?

Statistics show that the Mainland is an important supplier of Hong Kong's imports for local use, accounting for 13-14% in total. Since Hong Kong entered sustained deflation, unit import price from the Mainland has indeed been declining. But it must be pointed out that unit import prices from all other sources have been declining at even larger scales. Take last year's data as an example, unit import price from the Mainland decreased by 1.6%, with that from Japan, Taiwan and the US down by 4.1%, 6.0% and 2.2% respectively. The overall import price has dropped by 3.1%. In 1H 02, the trend continued. Therefore from the point of view of Hong Kong importing deflation, the Mainland is not the primary source.

Some believe that sagging property market has much to do with the rampant deflation. In CCPI, housing has a weighting of 29.91%. From 1998 to 2001, the housing index was down 15.6%. Multiplied by its weighting, it accounts for 4.65% of the cumulative price decline, roughly half of the decline in CCPI for the same period. If shops and office buildings are included, property deflation may account for 60%+ of the general price decline. But in any case, the Mainland should not be blamed for causing the property market slump. The economics theory of factor price equalization states that the property prices of Hong Kong and Shenzhen should converge on economic integration. In the factory and back office building market, this has already happened. But in the residential property market, the trend is much less prominent. Although more Hong Kong residents are purchasing properties in the north, they are mainly for vacation purpose. Few buyers will move the whole family across the border. The vacating effect on the residential property market should be limited. So far, it is the bursting of the property bubble, the oversupply and weak demands generated by dim economic prospects that led to the multiyear slump in the property market and the ensuing deflation.

It is justified to say that besides the still deflating property market, weak domestic demands also contribute to deflation. Personal consumption expenditures have been contracting at an alarming speed of 2% per annum from 1998 to 2001. Some view the loss of consumption to the north as part of the reason. Indeed, overseas expenditures by local residents surged to HKD80bn in the mid 1990s and has been staying around that level ever since, with most of the money being spent in the Pearl River Delta. As a result, discounts have to be offered by local merchants to attract consumers, again triggering deflation. But overseas spending by local residents accounts for only 10%+ of the total. Although the Mainland does contribute partially to the weak local demands, it is far from being the key player. The economic slump, dim employment, poor pay prospects, and the resulting loss of consumer confidence must all be accounted for as well.

To conclude, it is fair to state that although the economic integration between Hong Kong and the Mainland does have some effects, most of Hong Kong's deflation is internally induced. As the property market contributes most to the deflation, policies to stabilize the market are necessary. But more importantly, measures should be taken to promote economic growth, which in turn can strengthen the property market, stimulate demands and eventually stabilize the price level.