This article examines the current market turmoil in China, shedding light on the implications of a deflationary environment. As the world’s second-largest economy faces significant economic challenges, the consequences extend far beyond its borders.
A market panic is unfolding in the Far East, as buyers of Chinese stocks become increasingly rare. Even the Chinese government’s efforts to halt the market’s slide seem ineffectual.
On Monday, for instance, the Shanghai Composite Index plummeted nearly 9 percent, despite government-imposed bans on selling shares and aggressive interventions. Individuals opted to sell, undeterred by the government’s overt threats.
Ultimately, attempts by the government to stabilize the market are in vain. These interventions will not rectify the underlying imbalances. Years of cheap credit have led to significant market distortions and misallocations, with total collapse appearing to be the only plausible resolution.
According to a report from CNN, “The Chinese economic boom since the global financial crisis in 2008 has been fueled primarily by debt — with total debt levels exceeding those of the United States.” The surge in the stock market was largely a product of increasing debt levels used to finance stock purchases. Indeed, estimates suggest that around 35 percent of freely traded shares are acquired through borrowed money.
Moreover, China’s borrowing has extended beyond stocks to construction materials; between 2011 and 2014, the country consumed 6.6 gigatons of cement. For context, the U.S. used just 4.5 gigatons over the past century.
Liquidating Commodities and Mining Jobs
It is evident that China’s obsession with cement has far surpassed sustainable parameters. The return to economic reality will inevitably be painful, marked by substantial debt write-offs, managed defaults, and the liquidation of bankruptcies.
China’s scenario is fundamentally deflationary, starting with the Shanghai Composite Index but affecting much more.
As the world’s second-largest economy, and the largest according to purchasing power parity, a deflationary trend in China spells significant ramifications for the global economy.
This reality is best illustrated through trends in industrial commodity prices. Debt-driven growth in China created an artificial demand, prompting mining companies to ramp up their production. Now, that inflated demand has disappeared.
Per the World Bank’s Commodity Markets Outlook, “All major commodity price indices are projected to fall in 2015, chiefly due to excessive supply and, for industrial commodities, weak demand.” The result is plummeting prices and the loss of mining jobs.
The Wall Street Journal reports that major mining corporations are cutting jobs in response to protracted slowdowns in China and falling commodity prices. For example, Anglo American PLC announced plans to eliminate 53,000 jobs over several years, representing a drastic 35 percent workforce reduction.
Deflation with a Capital D
Job losses, mine closures, and a decline in commodity prices characterize the deflationary landscape—deflation with a capital D—and once it starts, it perpetuates itself.
The burden of existing debt magnifies during deflation. In a highly indebted economy like China’s, this poses a severe threat to the financial system. Prolonged deflation can trigger greater bankruptcy rates, a breakdown of capital markets, and a potential economic depression marked by soaring unemployment.
As deflation takes hold, a vicious cycle emerges: prices drop rapidly, spending declines, and personal, business, and government bankruptcies accelerate. This scenario sends ripples of fear through politicians and central bankers.
Central bankers favor inflation over deflation because it allows them to control the economy via interest rate adjustments and money supply contraction. In the face of deflation, their monetary tools become significantly less effective.
The typical response to deflation among central bankers is to pursue inflation. It is only a matter of time before the economic malaise stemming from China spreads to global markets. If you thought the responses to the financial crisis of 2008 were severe, brace yourself for what may come next.
Sincerely,
MN Gordon
for Economic Prism
