The "d" word is weighing heavily on the global economy several weeks into 2016, and in fact how China sorts out its industrial deflation crisis is likely to be the single greatest economic story for the whole year - as it will largely determine the timing, direction, and magnitude of fluctuations of prices of virtually every asset class on every major equity, debt, and commodity exchange worldwide. It has become imperative for anyone concerned about the markets to get a realistic overall picture of the Chinese deflation problem and where it is likely headed.
Cautious optimism is warranted at this time; the doom-and-gloom of the China bears is largely a reflection of their "free market fundamentalism" - that is, their deep skepticism of the communist political system. If one instead takes the view that this autocratic system is still essentially sound, then one can be considerably more sanguine about China's prospects in 2016 - even while allowing for repeated bouts of China-induced global market volatility throughout the year.
To begin with, China's present crisis was a long time in the making, and contrary to what the pessimists seem to suggest, it has not caught Beijing unprepared or by surprise. Today's unfolding troubles were quite clearly in view when the fifth-generation leadership of Xi Jinping and Li Keqiang assumed power in 2013. Xi's signature anti-corruption campaign has actually been a prelude to and preparation for the difficult reforms of the state-owned enterprise (SOE) sector that many expect to finally get off the ground this year and next, because the success of these reforms is primarily a matter of the central government's authority to bring to heel the party's vested interests in local governments and the SOE power hierarchy.
SOEs are at the heart of the Chinese industrial deflation that began quite some time ago - late 2011 and early 2012 - but that only became a major global risk in earnest in mid-2015. The present crisis has its roots in the early-2009, $586 billion stimulus package unveiled by Beijing to rescue China from the global financial meltdown: the bulk of this massive spending was in the form of ultra-cheap loans by state-owned banks to SOEs in the heavy, infrastructure-related industrial production sector. Over three years, 2009-2012, this made China the engine of the world economy: it accounted for nearly two-fifths of global GDP increase as its factories pumped out massive quantities of industrial commodities like steel, other industrial metals, cement, glass, plastics, chemicals, etc. in a frenzy to saturate the entire country with roads, railroads, ports, airports, telecom networks, energy and power systems, water and gas supply and management systems, skyscrapers, high-rises, apartment complexes, new homes, public transit systems, shopping malls and commercial centers, and so on.
This was a boom of an unprecedented combination of speed and scale - the largest Keynesian pump-priming operation in human history. Prior to the 2007-2009 financial crisis, China had already exhibited what many feared to be a rapid over-investment in commercial and residential real estate, which led to its stock market crash of late 2007 and early 2008; but the 2009 stimulus demonstrated that this was a mere warm-up for the true infrastructure and investment splurge driven by the seemingly bottomless pockets of the communist party state, which now became the savior of the global economy and especially the darling of commodity-producing countries, regions, and corporations, which now enjoyed unprecedented export volumes of their resources at elevated prices.
By late 2012, when Xi Jinping ascended to party leadership, it was clear that all was not as well as the torrid GDP growth figures made it seem. Images of "ghost cities" throughout the country now became emblematic of the obvious fact that a lot of money had been wasted on unprofitable, commercially unsound investments - even as more were still being made. The explosion in credit throughout the economy - that is, debt - had begun to spiral out of control with the alarming rise of a massive "shadow banking" sector of officially unauthorized, high-risk and high-interest financing entities. Real estate prices had vaulted into the stratosphere, especially in first-tier cities and regions, but in many second and third-tier areas the sticker prices were utterly unsupported by actual market demand, and there was now a glut of idle or badly underutilized infrastructure and construction in virtually every province, which cast a darkening cloud of overcapacity and deflation over the heavy industrial sector. As of early 2012, China's producer price index (PPI) had already slipped into negative territory - it has only sunk deeper in the red since.
In January 2013, the city of Beijing was walloped by an "Airpocalypse" of catastrophic smog which revealed the extent of the wasteful overproduction plaguing its surrounding coal-burning industrial enterprises. This was followed in June by a credit crunch engineered by Chinese authorities in response to the US Federal Reserve's announcement that it would end quantitative easing (QE) to support the US economy, which triggered a so-called "taper tantrum" in emerging markets worldwide; owing to their disproportionate share of financing from the banking sector, the SOEs were heavily impacted. Then in July, Xi Jinping began his anti-corruption campaign that has already lasted far longer than most observers expected, and this put local governments and SOEs squarely in the target sights of the newly empowered graft-busting bureaucrats.
Thus, by the time Xi unveiled his ambitious economic policy agenda in November 2013, a new era had already begun for the bloated state-owned enterprise sector: as the officially approved SOE reform goals indicated, they would still be central to the Chinese economy, but now had to respond to market demand, i.e. they could no longer do their "business as usual" of sucking up vast sums of cheap financing from state banks to pour into large investments which typically prioritize the self-enrichment and self-empowerment of their own ensconced power and patronage structures over the wider public good.
It is thus incorrect to say that simply because virtually no SOEs have been outright allowed to fail, there has been no progress whatsoever on their reform. In the first place, Western-favored privatization has never been a realistic outcome for what remain essential pillars of the communist system; the real issue in China - ever since reform and opening began in the 1980s - has always been how to maximize efficiency and minimize waste in the state-controlled foundation of the economy whose priority will never purport to be innovation or dynamism, anyway. As such, the best route for Beijing is the one it has already embarked on: mild "supply-side" reforms focused on consolidation of redundant enterprises and capacity, which of course strikes Western market fundamentalists as monopoly promotion, but which actually closely mirrors the actual (as opposed to idealized) situation of oligopoly that exists in various industries even in developed OECD markets.
In the more strictly economic sense, the SOEs have already been largely contained, even if they haven't been downsized. With crushing deflation taking hold from 2013 on, their real cost of borrowing remained high because the People's Bank of China (PBOC) was initially stingy with interest rate and reserve requirement ratio (RRR) cuts that would ease their steadily increasing liquidity strains. It wasn't until the second half of 2014, when the yuan shot up in tandem with the dollar against other currencies (a turn spurred by a combination of crashing oil prices and the end of QE in the US economy), that the central bank aggressively eased domestic monetary policy - which hasn't so much given the SOEs a boost as simply prevented them from sinking even deeper into the deflationary trap.
As of 2016, though, the SOE reform odyssey is set for genuine takeoff forced by prevailing economic conditions. PPI has settled down close to minus-6 percent, with the situation particularly dire in the most overcapacity-plagued industries like coal and steel - these two have exhibited their first nominal output declines in decades in 2014 and 2015, respectively. China's industrial production figures now tell an unmistakable tale of divergence between real and nominal prices: while real production continues to expand around 6 percent on year, nominal output growth has plunged towards barely 1 percent. For a manufacturing country, this is the equivalent of oil dropping from $100 to $60 a barrel on the way to $40 and below.
On paper, the path out of the mess is quite clear, and China already seems on this road. The most bloated heavy industries are likely to suffer for maybe two more years with factory closings and mass layoffs, as many steel mills and coal mines are already experiencing. Mergers and consolidations of overcrowded industries, including shipbuilding, petrochemicals, energy, and heavy machinery, which began in earnest in 2015, will accelerate in 2016; at least in theory, this means that as early as 2017 these sectors will be leaner and meaner, and able to hold their own even in international markets with reduced state subsidies. Absent the possibility of outright privatization, private capital is being enticed to invest in SOEs nonetheless through joint ventures; different public-private partnership schemes are also in the cards to encourage greater input from and participation by non-state citizens and entities, to include possibly even management of enterprises. And overall, the central government seems to have a good handle on what needs to be done on a sector-by-sector basis: whilst some industries must radically shift towards profit-making, others (like healthcare and education) must cut costs and increase efficiency like nonprofits or NGOs.
But the real question which overhangs all these changes - and thus will determine whether they'll be deep and fundamental or merely superficial and cosmetic - is the nature of the state-run segment of the Chinese economy as a whole. Since it first established them in the 1950s, Beijing has relied on its sprawling state enterprises as the main levers of its practical day-to-day governance of the country. Even during reform and opening, it has only promoted profit-making and competition in the state sector as a means to facilitating such governance in a challenging new environment of global integration, never as an end in itself. Ultimately, because the state enterprises - from the massive centrally administered state banks to the local government-run factories and mines - are the principal means by which the communist party controls the nation's wealth and means of production, there are clear limits to what economic or even managerial reforms can achieve without political changes, as well.
In other words, in the final analysis it's hard to conceive of a central leadership in Beijing that's comfortable with relying more directly on the power of its citizenry - specifically, their enhanced purchasing power and greater capacity to supply tax revenues - than via the traditional intermediary of the state enterprise behemoth. The obvious implication of the reforms that Xi Jinping's regime has espoused is precisely this outcome, but thus far there is little of the overall substance of the execution of these reforms that points to a substantially lower profile for the state in the Chinese economy. Beijing clearly wants to have its cake and eat it, too - an impossibility in the long run.
And so, in all likelihood, we're about to witness another round of muddling through on China's part that could actually seem to work for a while - until the same underlying conundrum of the state sector resurfaces again, most likely in the form of yet another deflationary trap. China's per capita GDP could then be $15,000 as against today's $8,000. That level, in real terms, only elevates China to about the point where many economies have actually hit the dreaded "middle income trap": today it's at least 20 percent lower, indicating that China still has some relatively low-hanging fruit to pick in its economic journey that are likely to finally be exhausted over the coming decade of still relatively high investment and exports.
At that point, though, in perhaps the mid-2020s, Beijing will have a far more apparent choice between maintaining control at the risk of social stagnation vice loosening control at the risk of runaway social empowerment. We're not quite there yet, though we could actually reach that point far sooner if the global environment proves inhospitable to China's still heavily trade-dependent economy; either way, China's state enterprise conundrum is a chronic and recurring crisis that the communist regime may eventually find to be so intractable that playing it safe only increases its chances of becoming a long-term existential threat.
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