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Saturday, June 11, 2005

Cyclical Deflation Coming?

Sometimes it is easy to forget that there is such a thing as a business cycle. At the same time it is never easy to determine where exactly we are in the cycle. Europe and Japan don't help here, since ongoing economic problems make the trend line relatively flat (in the eurozone case) and growth fairly volatile (the Japanese one). Beyond this there are the Anglo-saxon economies (US, UK, Australia) and China. All of these have had strong - above par - growth in rcent years, but at the Anglo Saxon end inflation and interest rates have been low by historic standards. So what will happen when things finally slow down. Andy Xie has little doubt, we will get a bout of cyclically induced deflation:

The Anglo-Saxon consumer debt and Chinese overcapacity will likely become the main factors in causing cyclical deflation as the current cycle turns down. Ironically, Anglo-Saxon consumer debt would mainly exert deflationary pressure on its trading partners. Because these economies have huge current account deficits, they could export deflation through currency depreciation. Cutting interest rates is effective in pushing down currencies for economies with current account deficits, as foreign investors are less willing to buy their assets.

The economies with big current account surpluses and export exposure to these Anglo-Saxon economies would be at more risk of experiencing some cyclical deflation. Most Asian economies fall into this category. In addition, they compete against China. As China’s overcapacities push down its domestic prices, their export prices could follow.

China may be most vulnerable to cyclical deflation. It faces overcapacity in manufacturing, infrastructure, and property in addition to the risk of declining property prices. It is still too early to calculate accurately China’s overcapacity. What we know is that China’s fixed investment has risen from US$343 billion in 1998 to an estimated US$1 trillion in 2005.

I broadly agree with this picture. It is very difficult to see with any degree of certainty the evolution of the Chinese economy, but the UK is clearly already slowing down, and it seems clear that when the housing market finally peaks the US will follow, that in itself will initiate a chain reaction in China which is heavily dependant on exports to these destinations. The UK for example had a trade deficit with China in 2004 of 13.6 billion euro ($16.5 billion approx). At the same time Chinese import penetration in the eurozone is growing significantly, and there will be increasing political pressures to reduce the growing negative balance here.

When the inevitable slowdown comes, disinflation pressure in the Anglo Saxon world will be strong. This may, as Xie speculates, produce downward pressure on the dollar and the pound, but since there are definite limits to the ability of the euro to rise, the outcome is far from clear. By this stage the renminbi may be floating, but were this to be the case it would only fuel further the excess capacity driven price deflation inside China. All in all, Xie's conclusions seem inescapable.

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