news

Yes, think about it this way: with inflation, you can improve the supply shortage with more investment (more deficit spending), or alleviate the supply chain in some ways.

However, deflation is a much more complicated problem to solve. For one, it is tied to insufficient demand, and this is itself an underlying symptom of a much deeper structural problem. The core issue here, for China at least, is wealth inequality. So more stimulus is only going to be a temporary fix without solving the core issue.

For corporations, a slump in the consumption demand drove many companies to engage in price wars to undercut their competitors, which further tapered off their already thin profit margin.

For example, the most recent data revealed that the total net profit for the top 18 Chinese automakers (which sold at least 15+ million vehicles) in 2024 combined was only about one third of Japan’s Honda’s net profit (which sold only 9 million vehicles).

Similarly, the total net profit for the top 4 steel manufacturers in China in 2024 combined was less than Nippon Steel’s net profit, which makes 17 times more profit per ton of steel ($98.22 profit/ton) than its Chinese counterparts ($5.87 profit/ton)!

This can only mean that the companies have less financial resources to pay wages, invest in expansion of productive capacity, as well as the ability to service their debt borrowed through commercial lending.

Thus, the increase in productive capacity has failed to translate into wage growth for the working people, and this directly impact the household sector.

For households, reduced or stagnating household income leads to increased debt leverage and even less spending. For homebuyers, they are paying a higher proportion of their income to pay off mortgage of a house that is decreasing in value. The deflation in asset prices also means that it has become more difficult to liquidate their asset, thus placing those households in even more precarious financial situation. Defaulting on mortgage means taking a severe hit on social credit score (similar to the US credit score) and being barred from many public services (exactly the meme people make fun of China’s social credit).

With deflation, it also makes debt (which were taken out at fixed nominal rate) more expensive to service. What you need to remember is that the amazing infrastructure building in China over the past 15 years was mostly financed through borrowing (first through the shadow banks, then after 2015 through direct issuance of municipal bonds), rather than through new money creation via the central government spending.

This also applies to the infamous 4 trillion yuan infrastructure stimulus back in 2008, where 1.18 trillion yuan was contributed by the central government (the rest by local governments). Because Article 29 of the Law on the People’s Bank of China explicitly forbids the central bank from purchasing government bonds, the 1.18 trillion yuan was financed through issuing bonds to the private sector. Therefore, nearly all of the infrastructure financing came from either borrowing from commercial banks, or taking from the yuan already circulating in the economy, instead of direct new money injection from the state.

As such, for local governments, whose tax revenues rely mainly on value-added tax followed by corporate income tax (industries profit is plunging), and whose non-tax revenues came predominantly from land premiums (property market price is plunging), deflation in both product prices and asset prices simultaneously deplete the local government revenues.

Land premiums comprise an average of ~35% across all local government revenues, with certain cities like Guangzhou (a key manufacturing hub that is now experiencing slowed export due to tariffs) reaching 40+%. This means that the local governments are now even more financially constrained to operate the public services and maintain infrastructure such as subways and rail roads. There has been cases of local governments delaying wage payments to their civil servants for months being reported now.

This is a complex crisis that requires the Chinese government to allow direct deficit spending in large quantities to raise the wages of the working people, as well as a complete revamp of the financing mechanisms that involve both the central and local governments so that they do not have to rely on borrowing from the commercial banks. Finally, how to resolve this over-ballooned local government debt crisis is particularly difficult because there are going to be winners and losers, and the ones that deserve the most punishment also happens to be the wealthiest cities contributing the largest GDP to the country, the ones that carry the national economy.

The problem is, who is going to buy all the stuff from all those huge investment package? When the problem is insufficient demand, pumping more goods into the economy will only intensity the deflationary spiral, leading to more businesses closing shop, more workers to be laid off and even less people can afford to spend money.

I am very well aware of the arguments from economists like Justin Lin Yifu and Meng Xiaosong that “the Chinese people aren’t poor, but they simply prefer to save because of the lack of confidence in the market.” Their solution is to increase investment to improve consumer confidence, hoping to unleash the money locked in the people’s savings in this manner.

However, this is also getting the sequence backwards for two reasons: people aren’t spending precisely because they aren’t positive about the economic outlook (at risk of becoming unemployed any time soon), and because of the wealth inequality caused by the government continuously transferring wealth to prevent the failing industries and the financial and property markets from imploding. Socializing the costs to prevent a nation-wide economic crisis.

Furthermore, as mentioned, these investments did not come from net new money creation (that is, new money being injected directly into people’s pockets). These investment packages also came from borrowing and bond issuance, which is why the Chinese government is hoping for the Fed to lower its key rate so the cost of borrowing will be cheaper for Chinese banks. As of today, the Fed continues to maintain the rate.

The only way you can resolve this crisis in full, is to directly confront the wealth inequality issue, and this requires structural and systemic changes.

Since the 1994 Tax-Sharing Reform was introduced, local governments were driven to find their own non-tax revenues, now that they are responsible for financing their own investments and provincial/municipal operating budgets. They found it in speculating land prices as a cheat code to quickly raise their GDP numbers.

However, the reckless investment in infrastructure and housing, without any careful planning at the national level, is now causing an oversupply of houses and the land prices falling. The local governments aka the landlords find themselves depleted of funds but still have to operate public services, servicing the huge amount of debt they had borrowed, and continue to inject subsidies to the industries, without which many of the companies would straight up go bankrupt. So, naturally, the wealth of the people have to be sacrificed to slow the plunging property market and save the local industries from imploding.

Once you understand all that, it will make sense why the amazing development and technological advances in China are paradoxically accompanied by stagnating wage growth, increase in working hours, increase in retirement age, and the average working people not enjoying the living standards of the world’s second largest economy (and soon to be the largest).