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China Perspectives series is a monthly discussion on the latest credit market and economic developments from China with experts from both within and outside of Fitch Ratings.
Welcome to China Perspectives, a podcast on economic and credit developments in China featuring experts from within and outside of Ratings. My name is Jeremy Zook, lead China sovereign analyst at Fitch Ratings. In today's episode, we will be discussing how significant are the deflationary risks in the Chinese economy and whether the government's plans for monetary and fiscal stimulus might be able to mitigate some of these deflationary pressures. This issue will have significant implications for China's medium term growth prospects as well as its ability to manage its high level of economy wide leverage. To discuss this critical and and timely issue, we are privileged to have with us today doctor David Wong.
Speaker 1:David is currently a professor in Virginia Tech's department of economics. Prior to that, he served as the head of Asia ex Japan economics and chief economist for the region at Credit Suisse. Before joining Credit Suisse, David was an economist in the research department of the IMF, and David also brings with him a breadth of financial industry experience as he was a researcher for BlackRock's multi asset solutions team after starting his career as an analyst at Morgan Stanley. David holds a PhD in economics from Stanford University and received his undergraduate from the University of Chicago. Thank Thank you for joining us today, David, and welcome to the podcast.
Speaker 2:Thank you for having me, Jeremy. It's it's always good to to be invited.
Speaker 1:To set the stage before we get into the discussion on on deflation in specific, I I thought it would be helpful to just get your views on the current state of China's economy and and how you're seeing growth prospects at the moment.
Speaker 2:Okay. I will start with a more kind of medium to long term assessment and then move on to the more current and top coat discussions. I apologize if this is a repeat for some of our more China focused audience. My assessment of the Chinese economy is that it is in a decelerating phase to its growth potential. Alright?
Speaker 2:This is mostly due to the fact that the investment driven model that China has been utilizing for the last three decades is getting towards the end of its effectiveness. By here, I meant specifically to investments to the more traditional sectors such as infrastructure or traditional infrastructure at least, and then construction related, real estate related investment. On top of that, you have labor input in China is gonna face a at a reverse, like, that's inevitable decline, right, due to the aging demographic and also the fact that the overall population is shrinking. And it seems that the authorities and the trading population either don't have the desire or they don't have or they have the authorities have the desire to turn this around, but the policies might not be very effective in convincing young Chinese couples to have more children. And even if they're successful, right, it will be at least sixteen years before these children can actually reach working age and start to replenish the diminishing workforce.
Speaker 2:So that already took care of two of the major inputs in macroeconomic or to macroeconomic growth, labor and capital. On top of that, and this is where I do think that China adds a opportunity, is that they can compensate for the decline labor force by boosting labor productivity, and that can be achieved, at least in theory, by boosting overall productivity or technological advancement. And at least from a policy perspective, I do know that the China it does appear that the Chinese authorities are focusing on that. But whether they can be successful in terms of making the breakthroughs, I think that's a very sector by sector or sector specific. We cannot make a blank statement saying China will make technological advancement on all the fronts that they want to make advancements, and but there will be at least some sectors that can make breakthroughs.
Speaker 2:So I'm not a pure pessimist in this case. Case. Now moving towards the more current assessment, I do think that China faces a underemployment and even, you know, high unemployment, especially among its young, which ironically is the fraction of the population or the portion of the population that should have the highest marginal propensity to consume. So when young people are either unemployed or underemployed, they tend to consume less, and I think this is reflected in the more higher frequency data that we have observed out of China recently. And that means if demand if household demand or overall consumption demand is weak, China will continue to face inflationary pressure, and that has been grabbing headlines for quite some time.
Speaker 2:I will stop there and see if you have which direction you want to talk more in detail.
Speaker 1:Yeah. I I think building on what you just ended with, I mean, as you said, there's been a lot of coverage of China's deflationary risks. I mean, we've seen CPI inflation hovering at just over, you know, zero percent for most of the last year. And I I think quite importantly, the the GDP deflator has been in negative territory for five quarters, and we'll get the GDP numbers shortly. And and it could be six straight quarters of of a negative deflator.
Speaker 1:So how significant do you see, yeah, some of these near term risks around deflation? And then what are kind of the the key drivers of these deflationary pressures? I mean, are are these coming from just weak demand or too much investment in the supply side, or is it a combination kind of of both those factors?
Speaker 2:Well, thank you, Jeremy, for presenting the answer already in your question. And as many economists will or as a typical economist in this case, the answer is always a combination of both supply and demand. Right? Yet, I think what you're really after is that, do I think that it's more due to demand weakness or more due to so, like, we have to do a decomposition. Right?
Speaker 2:And I would say that right now, the key risk deflationary risk that I see that China is facing, a, it's more it's gonna be more persistent. It's not gonna gonna be a transitory or near term risk alone. It has I do think that it will be a ongoing source of risk. For now, I think the dominant factor is still the demand side. We have essentially, when household demand has been weak, we have households had experienced negative wealth effects from both the correction in the housing market and, at least until recently, some underwhelming performance in the equities in the Chinese stock market.
Speaker 2:So those two negative wealth effects naturally already depresses would be leading the permanent income hypothesis. Right? Naturally, would depress household demand. And when household are cautious about making major consumptions or make major purchases, that translates into deflationary pressure at least in the near term. Now for this to turn around, we need households to see potential like, have expectations of increased wage growth or accelerating wage growth.
Speaker 2:And with the labor market the way it is, again, you know, I understand that's the official unemployment rate does not look too alarming. Of course, among the young people, they that's a different story. But there I do think that China faces a meaningful issue of underemployment. So, yes, you you have a job, but you're not working to your full capacity, or you're being employed at a job that you're not gonna realize your highest marginal productivity, and it's you know, you're not gonna realize the highest wage, and then that translates into some pessimism by the households, and they need they, in turn, become more cautious and decide to save more. So that lowers the marginal propensity to consume by, you know, across the board.
Speaker 2:And consequently, that, I think, is the key source of deflation or key driver of deflation or deflation pressure currently faced by China.
Speaker 1:Yeah. I mean, you raised very good points around kind of the, yeah, relatively subdued household confidence. I mean, yeah, I guess in terms of your expectations, is this a very medium term challenge for for China to deal with?
Speaker 2:I do think it is a medium and even long term challenge, and this goes back to my earlier assessment or summary of how can China come out of this bunk, if you will. Right? And it is whether or not they can truly boost labor productivity while facing a because I I kept on going back to productivity because we believe in an efficient labor market, productivity should be translated to wage. So there should be a very strong correlation, if not, causation between labor productivity to wage growth. And for and wage growth to happen without if the corresponding labor product could be, that would not be sustainable.
Speaker 2:That type of wage growth wouldn't be sustainable. For us to have to boost consumer demand, we need to, one way or another, increase the lifetime earning expectation or overall lifetime wealth accumulation expectation of the household. And the more most organic way to do so is to boost labor productivity by the channel that I just described. And the so but the a the ability to boost labor productivity is no longer a high probability event or it's at least it's not guaranteed because that directly links to the fact that you need technological breakthrough. You need a increase in your total factor productivity growth.
Speaker 2:We don't know if China I mean, China is making a serious effort to make these technological breakthroughs. And if successful, then they can grow their way out of the problem. That being said, there is no guarantee that China will be successful in making these technological breakthrough. And even if there is a guarantee, there will also be distributional issues because not everyone or the gain, the productivity gain, the labor productivity gain from the boost in technological advancement won't be benefiting the entire spectrum of the labor force. Some of the older generation labor force, they are, despite construction due to legacy or his historical issues, less educated, and they might not be able to participate in or benefit from the breakthrough in technological advance.
Speaker 2:I will stop.
Speaker 1:Yeah. So and you raise very, very interesting points. And before we turn to the the the near term policy response that we've seen kind of in in recent weeks, I just wanna ask, you know, one further question there. I mean, so the the government has been, of course, very focused on boosting what it calls new productive forces and, trying to advance in some of these other industries. I mean, what's your assessment on the the ability there in in those areas to boost product labor productivity as as you're discussing?
Speaker 2:Sure. So I do think that China so let's start with the good news, or at least where I'm more optimistic. Right? And then, of course, I have to given that I'm a two hands economist, like many, I then have to talk about where I'm less optimistic. Right?
Speaker 2:So I do think that in the sphere of renewable energy or essentially grain manufacturing, such as solar panel, such as electric vehicles, the adoption of green tech or energy efficient technologies by households, by businesses, I am very optimistic. I think that if anyone were to make any the the Chinese are at the frontier. And if anyone were to make a breakthrough in that sphere, as likely to be China as anyone as any country, if not more. Right? So that space, I am quite optimistic.
Speaker 2:That being said, that, of course, will have restricted benefit for in terms of its boosting labor product to be only for certain components of the of the labor force. In contrast, I am particularly cautious. Right? I wanna use my words very carefully. Right?
Speaker 2:I'm very cautious on the outlook of China's ability to make meaningful breakthroughs in the semiconductor space. And this is due to the fact that China has been making an effort to become more self reliant on in that sector, not as a recent effort. Sure. Recently, we have heard more about it, but this is a multi decade. Like, a it's at least a twenty year effort.
Speaker 2:And so far, they have had very little to show for. And that suggests to me that perhaps there's some misalignment in how resources are being distributed in that sector. There's some issue with how research is being conducted in that sector that is just not inducing to break. Now I am a economist by training. I am not an engineer.
Speaker 2:That boat has sailed the moment that my parents sent me to UChicago rather than MIT. But I and so I don't know much about engineering, like computer, all that, but I do like to think that as The Economist, I know a thing or two about incentives and the incentive structure. And why I know this is that if we were to look at the data from, ironically, tracked by the US Department of Education and look at the majors or the graduates from the disciplines that are related to making breakthrough in computer science, alright, computer science majors, computer engineering, even chemical engineering. Right? Like, they're very relevant for breakthrough in semiconductor space.
Speaker 2:For every one person who decides to be employed by China after they graduate, there are nine people stays in The US or seven or eight or nine people. So the ratio, it's eight to one or nine to one. So from a labor or talent input perspective, there is really no catching up here. So the trainee really needs to, you know, pull off a miracle for me to be proven wrong or to say or for me to change my mind on my assessment on that on the semiconductor space. In contrast, if you look at, say, battery making or electricity storage, heat pump.
Speaker 2:Right? The relevant graduates actually are more willing to go to China, and then the the they can and they they can tell me exactly, okay, at which level, what type of incentive can I receive, at which the city government, the provincial government, you know, and maybe even for the very talented from the central government? But it's very clearly delineated, so they know what can they get into, and consequently, they they're happy to, you know, take their talent and realize a higher labor productivity by returning to China. So that's why I'm more optimistic in that space. I will stop there.
Speaker 1:Yeah. I guess turning now towards, you know, some of the the near term policy measures that the government has rolled out and is in the process of formulating. Over the past several weeks, I mean, we've seen quite a what seems to be a shift in the government's approach to both monetary and fiscal policy. I guess in your view, I mean, some people have called this kind of a a whatever it takes moment where the authorities have have really come to understand sort of the the challenge the economic challenges. I mean, what's your view on sort of the the current policy making environment in in China when it comes to addressing these economic growth and deflationary risks?
Speaker 2:So first, I wanna be clear that I don't think that this is the whatever it takes moment. Right? And I know that sometimes the market get ahead of itself, and they like to see things that are not there. For me to change my mind or make the statement that personally, I want to I I'm happy to stand and say, this is the whatever it takes moment. I need to see fiscal measures that are targeted to households direct.
Speaker 2:That for me is the definition with a threshold for a whatever it takes moment by the Chinese authority. However so that already means that the monetary there are natural limitations to what monetary policy can accomplish. And on that end, I think for China to turn things around, especially in terms of households' confidence or consumer sentiment, monetary policy alone cannot do it, and monetary policy in the overall package is playing a supporting role. The amount of fiscal policy or fiscal support, we still lack details, but my suspicion is that the authorities will still lean more towards the investment side of fiscal policy support rather than direct transfer payments to the households in the form and the scope that we have seen in many Western or more advanced economies. That, you know, US being a a good example.
Speaker 2:We know that Canada also helicopter money. The reason that I'm somewhat hesitant to say that to make the forecast that the Chinese will make direct households wide scale household wealth transfers are twofold. One is that the fiscal room is somewhat limited. China has spent a lot of their fiscal space and used up quite a bit of the ammunition during the pandemic. Vaccine, lockdowns cannot be cheap.
Speaker 2:We know that for sure. So quite naturally and the rebound coming out of the out of the pandemic was well, we know for a fact now all that it was underwhelming in the sense that it was below expectations. It was a healthy rebound. Right? They I think the year after trying to grow by 5.1% coming out of the lockdown, but many people were anticipating or many of my peers at the time were anticipating, you know, six close to 6% rebound.
Speaker 2:So that's a one percentage to GDP. So fiscal space is somewhat limited. But even if we abstract away from that and say that China is willing to borrow or somehow I am wrong with my assessment of China's fiscal space, and they come up with fiscal package. They come up with the fiscal. Right?
Speaker 2:And they're willing to spend it. There's this another issue, which is that they have trouble making that distribution. It's a kind of a infrastructure insufficiency. Right? So let me be very explicit about what I mean.
Speaker 2:In The US, when money was being sent out, right, there is the IRS. There is a already established infrastructure that keeps track of who should be receiving the money, right, through income, megas. And, sure, not everyone in The US pays federal income tax, but the overwhelming majority of them still file federal income tax. And you add that to some veteran affairs, so there's already institutional structure that help you to make sure that the check will get to your proctored. China, despite all the advancement and all the we're we're living we're living under the impression that China's technological advancement in terms of connecting households or, know, their ability to track where you are is so overwhelming.
Speaker 2:But, really, China's maybe 20 to 30% of Chinese households actually file income tax because the rest of them don't really make enough to the threshold to even bought. And that 20 to 30% of households are probably not the households that you want to receive transfer payments because another set of data points show that or survey show that 20% of Chinese households tend to control, you know, 70 to 80% of Chinese savings. Now I'm not saying that two twenty percents are exactly overlapping or they're identical, but I think the degree of overlap is probably pretty strong. So that means if you go through the taxation system, you won't be able to get money to the right hand. So that raised the question that already narrow that naturally limits the scale of how much you can do.
Speaker 2:Now, sure, we know that part of China, Hong Kong had tried this very successful. Right? But they weren't making much discrimination based on income. All they said back then was saying, show me your resident ID card. They register on this system, and all they do is to say, are you a permanent resident versus, say, you're, you know, just a not permanent resident, and then you get different amounts.
Speaker 2:Logistically, it's much easier, and Hong Kong only have 7,000,000 people, and then clearly not all 7,000,000 of them will be receiving payments because only the working age adults. There are certain restrictions, like filters. Right? I shouldn't say restrictions, filters, that helps narrow it down. How can you do that?
Speaker 2:And Hong Kong's tax system, it's pretty efficient. They you know, people do pretty much a lot of people file their taxes. Right? So they have their ways to get money to you. How will you do that to China?
Speaker 2:Will the local author do you leave it to the local authorities? And will the local authorities still want to do so? Because this is opening yourself up to criticism. Right? This is a task that can be easily manipulated.
Speaker 2:It can be very prone to error, not due to the fact that they want to to make mistakes. It's that you just are not given the right tools. So use the analogy of helicopter money. I am making the argument that even China has the money, they might not have the helicopter. So consequently, I think whatever I can see, the authorities can see it too.
Speaker 2:So that is why they might be hesitant, and I am assigning a low probability to the outcome of wide scale wealth transfer to the household. But, unfortunately, that's the dilemma here. Right? Without that tycoviscopes measure, it's more challenging for China to turn the household sentiment. Right?
Speaker 2:Because we talk about the organic way, which is that you you can you can increase wage. We talked about that already. There's some a set of challenges, and that might take longer. The more immediate way is to just drop money, and then we have technological challenges. And then if you do the other more effective channels of infrastructure or whatnot, the investment channel, which China has proven repeatedly they're very good at.
Speaker 2:But we have we know that this time around, you know, that channel might not be as effective. I will stop it. Yeah. You you raised some very interesting points on on the logistics of this. I mean, yeah, China has never really tried any major consumption based stimulus before.
Speaker 2:So getting all
Speaker 1:the parts in place, suppose, is is quite an effort. I I guess one other, you know, thing to potential critique on sort of the consumption based stimulus is that households I mean, given that their confidence is still relatively weak, what's the probability that they just end up saving a lot of these transfers and the economic impact there isn't isn't as as large?
Speaker 2:That is a very fair critique, Jeremy, and that is why I think the authorities you know, for me to see a satisfied I'm not in a position to judge here. Right? But I I can evaluate as a economist. Right? You know, a effective combination of policy should include some way to boost household income either immediately or at least give them the expectation that income is on the right.
Speaker 2:Combine that with more spending on how to reduce from the authority side to reduce the household's desire for precautionary saving. And on top of that, you know, you support it with some investment related policy support and then to a lesser extent by the boost monitor policy, which China is already about. And that's how we can get ourselves all of this. Right? And China seems to be going in the reverse order.
Speaker 2:They have the monitor policy. They have, you know, the kind of the investment driven fiscal spending seems to be in place. They're gonna be local governments, some money to retire their debts, to buy some house, and sell housing. Right? But none of that translates into demand by the household.
Speaker 2:Right? So even if they give enough money to the local governments to buy up all the unsold inventory in the housing market, I don't quite see how that translates into greater demand by the end consumer because all these housing are supposedly meant to be sold to the household. So for the households to turn things around, they need to see that maybe a greater a more reliable pension, wider, cheaper health care, these can help. Right? But then given that China recently introduced the fact that they're gonna increase the retirement age, which means that they're gonna delay the age where you collect your pension.
Speaker 2:I rather I I do think that's the right policy, right, because it helps delaying the diminishing or the the shrinking of labor force. But it does have this side effect of it actually increases people's desire to to make more precautionary saving because they know they have to work for a lot. It also means that just because you retirement age is delayed, it's not guaranteed that you will have a job before you retire. That that means your probability of facing unemployment during your working age, now the working age is longer, it's also high just by construction. So that is I I guess I'll leave it there.
Speaker 1:Yeah. Very interesting points. I guess just putting all this together, given your views on sort of the policy challenges that the government has and some of the medium term growth headwinds, how do you kind of see the balance of risks that, you know, China perhaps falls into a more prolonged deflationary spiral? Is this quite a high risk at the moment?
Speaker 2:I do think it's a meaningful risk. It is not yet in my baseline outlook, but it's getting close. Right? So by baseline, it has to be greater than 50% probability, right, in terms of do I want to bet money on it. Right?
Speaker 2:I do think that China can always resort to even if they cannot solve the back, cannot get the helicopters in place, right, they can resort to running a bigger deficit and then monetize that and, you know, raising debt to pay for it and then monetize the debt or partially monetize the debt down the road. And that way, it would even if it doesn't turn around households, the end per se, it would mitigate the deflationary pressure. Right? So it's again, it's kinda interesting in the sense that you don't monetize your debt or you don't raise debt to pay for your fiscal. So say, let's under the condition that China is gonna go with a a meaningful fiscal stimulus.
Speaker 2:If you pay for it with that, then it mitigates some of your deflationary concerns, but it could lead to depreciation expectation of the RMB, and it doesn't necessarily mean that it will turn around your household again. You don't do the fiscal stimulus or you don't do enough of it or you don't want to monetize you don't want to use debt to pay for it, then not only do you have the deflationary risk and you have the ongoing weak weakness. Because if you're raise tax, people gonna increase their precautionary saving even more. Right? So you have both the deflationary risk and the kind of lackluster demand by household.
Speaker 2:So neither of the outcome is desirable or ideal. Right? But we don't live in the I would rather world. Right? So in that sense, I think the authorities have a choice to make it that, do I at least want to get rid of the or mitigate the deflationary pressure the the deflationary pressure, or do I want to be physically disciplined?
Speaker 2:And I can see advantages and disadvantages to both arguments. Right? They wanna be physically disciplined and don't wanna increase their overall debt. They have deflationary issues. They are wanting to increase overall debt in a meaningful way.
Speaker 2:They don't have deflationary issues, but I guess some people argue that overpaying of debt in China is what gas into this space in the first right? Into the spy in the first place. So that's the catch 22 situation.
Speaker 1:Yeah. Yeah. It's it's certainly a very challenging policy trade off for the authorities. Just to end on that statement you made at at the very end. Yeah.
Speaker 1:In kind of this deflationary environment, I mean, China already has quite high leverage across its economy, particularly in LGFEs, in the property sector. How do you kind of assess the economic and financial sector risks given this quite high debt burden if deflationary pressures prove persistent?
Speaker 2:Well, clearly, we know all else being equal. Deflationary environment, it's less favorable to people who owe money. Right? Because you have to repay, and all of a sudden, when nominal amount did not change, you have and say, the nominal interest rate didn't change, a deflationary environment means you have to pay a higher real return for the money that you borrowed. And when you already borrowed that much money, that clearly becomes a fiscal burden in real in real space.
Speaker 2:Right? You know? That being said, I do think that if we're worried about, say, some of these, say, government debt at different levels or whatever, right, or the debt accumulated by the SOEs or issued by the SOEs and whatnot, I think there's always space for restructuring. Right? Essentially, the reframe ads, issuing new ones to refinance, or essentially a a swap.
Speaker 2:And there, you know, they can reprice the market. I'm not saying that they're gonna have to, you know, shave the I'm not here talking about restructuring the way of any wide scale default and then having the investors taking a major hit. What I mean is that you just issue new debt to require the old debt. Right? You just end up with the old debt.
Speaker 2:They could be trading at a discount already, and where they have the interest rate. The nominal interest rate was set in the environment back, say, you know, as recently as before the pandemic, that was only five years ago. Deflation wouldn't as big of a concern back then. Maybe I remember the wrong, but at least the way I remember that no one was really talking about deflation in China at the time. Right?
Speaker 2:So it was those nominal rates were interest rates were set back then. So you can always take you know, now the market environment has changed, you can always issue new ones with lower nominal rates and then hence lower real interest rates taking into account the fact that you're in the deflationary pressure. So and then you re you know, you tender for the old debt or you get tired of old debt, and you have the new debt in place. So I think that there are in that aspect, I am kind of in the somewhat more optimistic camp in the sense that there wouldn't be, like, wide scale defaults across China by local governments and whatnot. But will there be, say, like, true restructuring at some local governments?
Speaker 2:Yeah. Right? Because, you know, they each face their different fiscal constraints. We know that population is the key now, and China, there will be provinces and cities that are net losers out of in terms of population flow, and there will be cities and localities that are attract like, destinations for high quality labor, and then they don't have to I I wouldn't worry about their physical health as much.
Speaker 1:Thank you again, David, for for joining us today and and taking the time to share your insights with us. This was a very fascinating discussion. Covered a lot of ground here on on both the near term and and the medium to longer run challenges around deflationary risks. And as we discussed, of course, the policy response is is still evolving, so there's a lot to keep an eye on in in the coming months.
Speaker 2:Thank you for having me.
Speaker 1:You've been listening to, Fitch Ratings, China Perspective Podcast. To learn more about our ratings and research on China, you can visit us at fitchratings.com. Please subscribe to China Perspectives on iTunes, Spotify, or wherever you get your podcast. Take care until next time.