China may have a perfect deflationary frame!

Just a quick post!

In an October 29 blog post I talked about risks posed by outsized debt financed gross fixed capital investment binges and high savings rates.   I wanted to refer to this with respect to deflationary risks in East Asian economies, per a rather good piece by Ambrose Evans Pritchard in the Telegraph.

Strictly speaking:

Price x quantity = output, and output more or less = national income.

A decline in price for a given quantity = a fall in nominal income…and a rise in the real value of debt and debt servicing costs. A fall in price for a given quantity more or less = a fall in income and prices may need to adjust, all other things remaining equal, to prevent a decline in real consumption.   A rise in the real value of debt may force a partial default in debt and a decline in asset values…this may also impact demand if part of expenditure is drawn from assets or if individuals have target asset accumulations.

But here we are assuming a level of stability in GDP components that we do not have in China!

Reduced expenditure at a given price leads to a fall in income and a fall in nominal demand in the next period. This may well be reinforced by individuals delaying expenditure decisions in expectation of lower future prices…itself leading to a decline in income and hence demand.

What might initiate a fall in price though…well a fall in demand, quite clearly, and what might cause a fall in demand…prior excess demand possibly funded by debt which may also have been predicated on rising asset prices (collateral) as in the US prior to 2007…

Prior excess demand in China is in good part a function of gross fixed capital investment expenditure.  A decline in debt financed capital investment expenditure is not necessarily a problem if investment is productive and capable of generating output and income and consumption focussed loan and investment growth itself. 

But what if capital investment is not sufficiently productive and what if a good part of savings from incomes from capital investment remains asset focussed?  

Well we have a structure able to produce more than demand is able to satisfy and we have a de facto net present value loss of capital asset value.  Funny, in this scenario we do not even start off from a position where the economy is capable of naturally generating both demand and output from its own organic dynamics.  We start off from a structure that is incapable of generating the output required to fund the consumption needed to keep output stable, let alone growing.

As with Ambrose Evans-Pritchard’s article, a decline in international currencies creates an additional demand shock that may precipitate a deflationary crisis itself. 

Leave a Reply