The hidden export from China: deflation

Trend: China will continue to export cheaper goods and drive up commodity prices.

Jim Jubak at MSN Money argues that China will produce and export more goods and consume more commodities in the near future, perhaps resulting in deflation. Excerpts below.

Source: MSN Money - The new risk from China: deflation - Jubak's Journal

Deflation effectively took Japan out of the global economy for more than a decade, slowing global growth and increasing global economic volatility. Serious deflation in China has the potential to be a lot more dangerous. At its least damaging, it would flood the world's markets with even cheaper Chinese goods. At the worst it could stall the Chinese economy, a major driver of global growth, and even send the country into one of its traditional periods of instability.

How did China get into this mess?

Start with an economy built around export growth and feed it with lots and lots of cheap money. And then ignore any signals that the rudimentary, somewhat free market might be sending you about overinvestment or overcapacity.

The result has been massive overcapacity in fixed assets.

Of course, this excess capacity hasn't ended plans to add even more capacity in these sectors.

Companies can raise money to build clearly unnecessary and unprofitable factories because all too many Chinese banks continue to make loans on the basis of political connections rather than market forecasts. Put a local entrepreneur and his local political patrons from the district government in the same room with a banker, and a loan pops out.

How do you make a profit if you're doing business in an industry with 100 million tons of spare capacity? Export, export, export -- to any international market that will buy your product. And cut your prices until the buyers can't resist. At home, cut prices and cut them again.

See how a system like this might produce both higher global prices for raw materials and lower prices for finished goods abroad and at home? Global commodity inflation and domestic price deflation.

Chinese consumers simply save too much and spend too little. The Chinese savings rate was about 40% of annual gross domestic product in 2005.

The Central Economic Work Conference held at the end of 2005 called "expansion of domestic demand" key to economic growth in 2006.

Easier said than done, especially when you look at why so many Chinese save so much and spend so little.

I don't have a lot of hope that the central authorities in Beijing will be able to implement the changes needed to make the average Chinese secure enough to spend more.

If the tide of protest keeps rising, if the repression gets more violent, you'll have a pretty good idea that the poorest of the Chinese are feeling the bite of deflation. The big danger is that the regime will feel so much pressure to restore order before the 2008 Beijing Olympics, meant as a national showcase, that it will resort to teaching the protesters some large-scale lesson like that imposed by the tanks of the Red Army in Tiananmen Square in 1989.