China heads for deflationary bust

This week's data from China continued to point to a rapid downturn, thanks to a slowing global economy and a deflating domestic credit and housing bubble. The annual rate of consumer price inflation dropped to a 29-month low of 2.2% in June.

Producer prices, which lead consumer prices, are falling by 2.1% a year. Annual export growth decelerated modestly in June but import growth halved to just 6.3% from May. Last week the central bank unexpectedly cut interest rates for the second time in a month.

What the commentators said

Chinese data are always dodgy, but the big trend is "abundantly clear", said FxPro.com. Economic growth has slowed much faster than expected in the first half of 2012. Demand in key sectors such as shipbuilding has "collapsed"; electricity production is barely positive; and construction 10% of GDP at the apex of the boom has "completely stalled". Overall annual growth is probably already down to around 6%.

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Especially worrying is the sharp decline in prices, which along with quickly receding money supply growth raises the spectre of a Japanese-style bout of deflation. A "deflationary spiral" is already visible in some sectors of the economy, said IHS Global Insight's Ren Xianfang.

For the economy as a whole, this would imply that the government would not be able to erode the debt load through inflation, said Robert Cookson on FT.com. Borrowers' assets would lose value while their debt loads and interest rates increase in real terms. The indebted private sector thus becomes even less inclined to spend, which reduces activity and prices further in a vicious circle.

The overcapacity created by the lending binge of 2008/2009 is evidently bearing down on prices. Many observers hope that the government can deliver more stimulus to ward off a hard landing, but this is unlikely. As Fxpro.com pointed out, China is basically going through the same credit bust as the developed world.

And as central banks and governments worldwide are learning, the multi-year deleveraging process is inescapable. "Both monetary and fiscal policy are rendered virtually helpless" while economies work off the hangover from a credit bubble.