Big trouble in little China: Currency deflation is worse than the Brexit vote

While economic media focuses its attention on the fallout of Britain’s recent decision to leave the European Union, another concerning situation is brewing across the Pacific. China, the world’s second largest economy, is facing some serious challenges in the near-to-mid future that could pose even more danger to the US economy and the world. China’s difficulties are two-fold. First, they face a serious deflation problem that’s dragging down the rest of the world’s economies. Second, they have s snowballing debt crisis that threatens to bury future growth.

Typically, central banks fight deflation, or a decline in prices relative to the value of the currency, with a variety of tools. They can do this by increasing the availability of credit, lowering interest rates, or purchasing bonds and securities on the open market. Governments have similar tools, like increased spending, lower taxes, and increased borrowing. Neither the People’s Bank of China nor the Chinese government have taken these steps to the extent their economic situation demands.

Practically, this means prices for commodities and labor in China are lower, which allows it to export goods at a higher rate. This increased export exerts a similar deflationary pressure on markets which buy their goods. China’s economy remains afloat due to a positive balance of trade; more money comes in for their goods than they lose due to deflation. The rest of the world absorbs the cost of this practice.

For a comparison of the seriousness of this problem, the S&P 500 dropped just over 5% in the immediate wake of the Brexit vote. In August of 2015, after the People’s Bank of China refused to take action to fight deflation, the S&P 500 dropped more than 12%.

Beyond the immediate problems of deflation, China also has a serious debt crisis looming. Typically, when American media outlets talk about debt to China, they refer to the amount the US owes the Chinese government. However, the Chinese economy is also financed by debt, to a far greater degree. China’s public and private debt reflects more than 3.5 times its GDP. For reference, Greece’s debt to GDP ratio was 1.75 at the height of their financial crisis.

As the Chinese debt has increased, more of it has gone to manage existing debt. This is a worrisome pattern for economists, who see that as a sign of pending default. Such a default would be catastrophic for the Chinese economy, resulting in an evaporation of as much as 7% of its GDP.

Investors should be cautious about the potential for a collapse in China. Until international monetary organizations can reach a consensus with the Chinese government and central bank about lending practices and steps to curb deflation, investors should take care. Just like crossing the street, before making any investment decision, it pays to look both ways.

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