Deflation in China is severe, reaching 3.5 percent in May compared to May of 1998. All told, prices have been falling ever since October 1997.
Since deflation is highly debilitating in its effects on the economy (high real interest rates, depressed earnings), Chinese economic leaders are certainly right in having assigned the fight against it the highest priority. What's troubling us, however, are the types of measures being instituted to combat it. They range from the desperate to the ridiculous and clearly signify the extent to which economic reform momentum has been lost. Officials are now content with treating the symptoms rather than the root causes of China's current malaise.
What brought on the present deflationary spiral is not that difficult to discern. When economic growth started slowing in the second half of 1997 as the result of the impact of the Asian crisis, initial decisions were made to slow state-enterprise and other reform efforts for fear of socially and politically destabilizing rapid unemployment growth. Ever increasing amounts of deficit spending came to be relied on to support growth of industrial output to attain a quite arbitrary 8 percent GDP growth goal for 1998 - and the glut in unsaleable consumer goods was on. The simple reason: the unproductive state-owned enterprises that then vice-premier Zhu Rongji had vowed to subject to market discipline and cut off from easy credit if they failed to reform now had gotten a new lease of life and started producing tons and tons of junk, largely unsaleable at any price, to meet planned growth targets. Consumers saw through the fraud and decided en masse to put their money into savings accounts rather than buy substandard products. More subtly (and ironically), oversaving instead of spending was also prompted by loss of confidence in the economy as reforms were slowed with the avowed goal to protect jobs.
Initially, the government attempted to cope with the problem through the dual-purpose measure of successive lowering of interest rates - to provide growth stimulus while simultaneously making saving less attractive. But as deflation had now set in, real rates remained nearly unchanged and the overall effect remained negligible.
Next, earlier this year, came the attempt to generate a bull market on the Shanghai and Shenzen stock exchanges and tempt consumers to shift their savings there. That worked for a while; but market gains have since slowed along with markets consolidation in the rest of East Asia. Neither has the imposition of minimum prices in some industries done much to mitigate deflation, nor, of course, does it in any significant way address the more basic issue of the wide and widening supply-demand gap.
Then, on Wednesday, came the latest measure and quite astonishing variant on supply-side economics: the ban - effective September 1 - on new undertakings in the production of anything from VCD players to toothpaste, from air conditioners and refrigerators to sweets and apple juice, and from microwave ovens and bicycles to plastic bags, salt, and alcohol. And that, naturally, won't make much of a dent either, though it clearly exposes the level of desparation now reached.
All of this smacks badly of old-style command-economy manipulation and more than a thousand rumors and reports attributed to questionable sources prove that indeed Premier Zhu and his team of market reformers have now been sidelined and economic policy control has passed to conservative planned economy advocates. This bodes ill for China and has every chance of ushering in a period of Brezhnev-style stagnation that marked the final phase of Soviet socalism. Regrettably, under these circumstances one has to conclude that things now will have to get a whole lot worse in China before there is a realistic chance for improvement.
The next move the conservative apparatchiks will try as all else fails is currency devaluation. In earlier editorials, we have both forecast and advocated that. But it can have a positive effect and restore some real growth momentum only when accompanied by the key task now foresworn - decisive state-enterprise reform.