Pay Attention: Deflation Looms in China

飞雪寒冰

Deflation risks have yet to abate, China's foreign trade statistics indicate. Anatomizing China's 6.1 percent GDP growth rate for the first quarter, 4.3 percentage points of that amount was driven by final domestic consumption and 2 percentage points by investment, while net exports dragged down growth by 0.2 percentage points.

It seems changes in export trade are playing only a minor role. But this probably underestimates the weight of the external sector for China. It's easy to understand that China, as an export-oriented economy, would produce less as a result of depressed external demand. But this is not the whole story. As trade shrinks, businesses also can be expected to pull back from building up inventory, or even halt their investing in fixed capital.

Therefore, falling trade's impact on inventory investment and the disposable incomes of workers and households also should be taken into account to better interpret implications for the overall economy. We have found total trade to be a reliable leading indicator for GDP.

To begin with, export's role as an engine for China's growth is likely to soften. Although one needs to deduct imports from exports before calculating GDP, it makes more sense to refer to total trade (exports plus imports) to assess China's economic health, given its economic structure.

Looking only at China's first quarter trade surplus, which was 53.6 percent higher than in the same period 2008, one could form a false impression that net exports are still powerful tonic for China’s economic growth. In contrast, total trade fell by 24.9 percent in the first quarter due to a 19.7 percent decline in exports and an even sharper decline in imports, down 30.9 percent.

On one hand, it's not difficult to see that export weakness will remain for awhile. Just look at the recent Canton Fair, China’s most important trade fair, where fewer foreign buyers participated this year and export contracts diminished 20.8 percent in value.

飞雪寒冰

Among the 10 largest buying countries at the fair, orders from the European Union, Japan, Australia and the United States declined 38.6 percent, 36.5 percent, 11.2 percent and 4.9 percent, respectively. Although some emerging markets including Argentina, India and the ASEAN nations signed more contracts with Chinese exporters this year, their business could not offset sliding contracts with other major partners such as Russia and Brazil. Apparently, there is little hope for a rebound in time for the next fair this coming fall.

On the other hand, a sharp decline in imports bodes ill for future gross demand, reflecting less investment in inventory either due to fewer orders in the processing trades, or less consumption.

In fact, imports have been sympathetic to exports during the ups and downs of this cycle; imports have always led exports by approximately one month. This is because factories import materials or equipment according to their expectations of how many products they would be able to sell later, abroad or at home.

We also found that trade shares a similar trend with foreign direct investment. In the first quarter 2009, foreign investors set up only 4,554 new companies in China, down 34 percent from a year ago, and realized foreign direct investment decreased 20 percent. Notably, investments from China's two, major sources declined in value in March from the level of 12 months earlier: Investments from the United States declined 42.8 percent, and investments from European Union countries fell 12.6 percent. The number of new companies launched by U.S. and EU investors also fell by 38.7 percent and 21 percent, respectively.

Again, we expect foreign capital inflow to slide further. An important reason for foreign investors to invest in China is to utilize the low costs here and produce price-competitive exports. Without enough confidence in seeing an economic recovery within a year, it is no wonder foreign companies cut back on their investments in China. Meanwhile, the decline in new company set-ups is very likely to lead to a future decline in capital inflows.

Both fall-offs in trade and foreign direct investment would serve to ease pressure for appreciation of the yuan, reducing China’s attractiveness for interest arbitrage. Therefore, the "hot money" previously rushing into China for higher returns might head the other way. We have seen evidence of the current account surplus taking as much as 96 percent of the total surplus, reflecting a lack of momentum for capital inflow and an increasing chance that a capital account deficit will emerge. Besides, as growth in foreign exchange reserves slows or perhaps turns negative, China's central bank would no longer need to buy large amounts of foreign exchange from banks to prevent the yuan from appreciating too quickly. The current excess liquidity in the banking system might change as a result.

飞雪寒冰

Another implication of falling trade is future negative growth for inventory investment. This would undermine the driving force of fixed capital investment. Indeed, inventory buildup was suspended roughly at the same time as trade growth turned negative in November 2008. According to the National Statistics Bureau, domestic companies cleared 44.8 billion yuan worth of previously stocked materials in November, which was followed over the following three months by destocking of products valued at 33.11 billion yuan. The direct result is shrinking industrial value added, partly offsetting the government's stimulus package, which invests heavily in fixed capital.

Finally, China's labor costs, as well as land and capital costs, probably would continue to decline along with trade. As businesses get more hesitant about inputs with these factors due to concerns about future profitability, we might see these costs decline.

Each of these aspects point to a greater danger of deflation, which would dampen China's recovery. It may be too early to cheer for the government's enormous investment in infrastructure, since a truly promising up-tick in domestic demand has yet to appear.