Is the U.S. economy about to experience a deflationary shock from abroad?
Is the U.S. economy about to experience a deflationary shock from abroad?
N apoleon famously said that when China wakes, the world will shudder. Now that China, the world’s second-largest economy and largest commodity consumer, is economically faltering, Napoleon, if he had been an economist, might have said that when the Chinese economy stumbles, the rest of the world will get a deflationary shock. The silver lining to such a shock is that it would help relieve the Federal Reserve and the European Central Bank from having to raise interest rates further to regain control of domestic inflation.
The truth of the matter is that the Chinese economy is now stumbling, and is likely to continue to stumble, as a result of deep problems in its property and credit-market sectors. Underlining those problems has been a wave of property-developer defaults over the past two years, including most notably that of Evergrande, the world’s most indebted property developer. Other indications of a property sector in deep crisis are China’s estimated 65 million unoccupied apartments, falling home prices, and emerging financial difficulties for local governments, which derive around 40 percent of their revenues from land sales.
Last year, President Xi’s economically disastrous zero-Covid policy exacerbated the property sector’s troubles by causing the country’s economic growth to slow to barely 3 percent, or to its second-slowest growth in more than 40 years. Now that the zero-Covid policy has ended, the Chinese economy’s response has been disappointing, as it struggles with the bursting of its housing and credit-market bubble. A number of high-frequency economic indicators (including declining retail sales, exports, and housing-market activity) suggest that the government’s modest 5 percent growth target for this year might be out of reach.
The very size of the Chinese property and credit-market bubble makes it all too likely that the country will experience a lost economic decade as Japan did in the 1990s. According to the Bank for International Settlements, China’s private debt has increased by more than 100 percent of GDP since 2008. This is a faster rate of increase than the ones that preceded Japan’s bleak 1990s and the U.S. Great Recession in 2008–09. Meanwhile, according to a study by Harvard’s Ken Rogoff, housing prices in relation to income in a number of major Chinese cities are higher than they are in London and New York.
China’s slowing economy is now already causing deflationary wage and price pressures in China, as underlined by the fact that Chinese producer prices have now fallen by over 10 percent over the past year. It has also resulted in a 7 percent depreciation of the Chinese yuan against the dollar since the start of the year, as the Chinese central bank is now cutting interest rates to support a faltering economy. One must expect further Chinese-currency depreciation, as the Chinese central bank takes further supportive action. For the U.S., this likely means significantly cheaper imports from China, the so-called world’s factory, as well as increased Chinese competition in world export markets.
Slower Chinese economic growth is also contributing to declining international commodity prices. Over the past year, international oil prices have declined by around 35 percent. Meanwhile, according to the World Bank, international commodity prices in general are expected to decline by more than 20 percent this year.
Over the past year, the Federal Reserve has raised interest rates at the fastest pace in decades and shrunk the size of its balance sheet in an aggressive manner. This has contributed to a contraction in the broad money supply, to increased indications of a slowing economy, and to considerable strains in the banking system. If those were not reason enough for the Fed to pause its interest-rate-hiking cycle, an impending deflationary shock to the U.S. economy from China should be.
It is encouraging that at its last Federal Open Market Committee meeting, the Fed decided to pause its interest-rate-hiking cycle. China’s troubling economic outlook would suggest that the Fed should be in no hurry to resume raising interest rates anytime soon.