Wednesday, November 30, 2005


Deflationary Overcapacity Hangs Over Asia

Bloomberg reports that China is in a deflationary trap. "Anyone notice how quickly ``overheating'' has been dropped from investors' China lexicon? The risk is that China may be flirting with the opposite of overheating: deflation. Economist Andy Xie of Morgan Stanley (is) eyeing a scenario in which Asia's No. 2 economy experiences falling prices as soon as next year. The reason: overcapacity. China is still producing too much cement, aluminum, textiles and other goods. It's also constructing too many factories, buildings and resorts."

"Cutting interest rates may even worsen deflationary pressure by encouraging capacity growth regardless of corporate profitability. As Hong Kong-based Xie explains, 'plentiful liquidity keeps interest rates low and, hence, sustains the on-going investment projects and funds new investments in bottleneck areas.'"

"'We can't go on stimulating the economy this way as this method will inevitably lead to oversupply, which in turn will take us back to deflation,' says Justin Lin Yifu, a Beijing based professor at Peking University."

"All this could have important economic implications. For one thing, it suggests Chinese currency revaluations may be smaller than investors and the Bush administration would like. Deflationary pressures and a weaker Japanese yen may leave Beijing even more reluctant to let the yuan rise."

"Would Chinese deflation be a crisis? Not necessarily, so long as it doesn't get out of control. (In) nightmare scenario, investment in China plunges, exposing huge industrial overcapacity. Consumption collapses as workers lose jobs. Trade frictions worsen with the U.S. as Chinese companies scramble to export more. China's central bank is unable to restore confidence among consumers, executives and investors."

"Or the opposite might happen: deflation compels China to upgrade its economy, improving the business environment and increasing government efficiency. In other words, deflation drives positive change, much as it has in Japan."

The Economist checks in on the Japanese situation. "Short-run hopes about Japan’s economy may be a little too rosy. The cyclical recovery seems this autumn to have hit a soft patch..Crucially, it is no longer so clear that inflation will remain positive for months to come. For a start, the core consumer-price index for the Tokyo metropolitan area, which is released a month ahead of data for the rest of the country, fell unexpectedly sharply, by 0.3%, in the year to November. This weakness could soon be reflected in national figures."

"Even a benign inflationary environment would not end the (Bank of Japan's) conflict with the government. After all, Mr Koizumi’s administration is set on a reform path. And an ambitious programme of deregulation could well prove deflationary. The government, in other words, wants the central bank to offset some of the pain."

"So bet on the BoJ continuing with its super-loose policy for longer than it might feel comfortable with. At some point, the continuation carries the risk that bond markets take fright at signs of incipient inflation; if bond yields spike, that could cut off the recovery."

"It also carries risks for the yen, since, with both the Federal Reserve and the European Central Bank in a mood to raise rates, interest-rate differentials with the rest of the world are only likely to widen. But those are worries for tomorrow. For now, you have a cast-iron invitation in Japan’s asset markets to take unlimited risk with free money."

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