China economy close to ‘vicious loop’ threatening Beijing with financial chaos

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China could face a “vicious loop” of spiralling economic decline as its gross domestic product deflator contracted over two consecutive quarters.

The issue has left Beijing’s GDP growth lagging behind at just 3.5 percent in the third quarter of 2023 – just over half of the United States’s 6.4 GDP growth.

Morgan Stanley’s top Asia economist Chetan Ahya warned that instances of deflation could wreak considerable havoc.

Ahya said: “A deflationary backdrop poses a few challenges.

“First, real rates after taking into account deflation will rise, increasing the burden on debtors. Second, even as debt growth slows, it will probably remain higher than nominal GDP growth.

“And so debt-to-GDP ratios will continue to climb. More crucially, a weaker GDP deflator negatively affects the trends in corporate revenues and profits.

“If deflation continues to eat into these, companies will cut wage growth, creating a vicious ‘loop’ of even weaker aggregate demand and deflationary pressures.”

China has been contending with slack demand, excess industrial capacity, weak consumer confidence and “certain risks and hidden problems”, according to a new report from the official Xinhua News Agency.

Moody’s Investor Service downgraded China’s sovereign debt rating as the country’s real estate crisis seeps into local governments and private financing.

It also downgraded ratings for some major Chinese banks and insurance companies.

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Writing in The Finacial Times, Ahya added: “The deflationary pressures in China stem from the deleveraging of the balance sheets of the property sector and local governments.

“When you consider that the combined debt on these balance sheets accounts for about 100 percent of GDP, it is hardly a surprise that demand and price pressures are as weak as they have been.”

Wholesale, or producer prices, have fallen year-on-year for all of 2023, dipping to a low of minus 5.4 percent in June.

Consumer price inflation has hovered near zero percent or below in annual terms since April.

The property sector, a major source of demand for any major economy, has stalled with dozens of developers defaulting on their debts and struggling to finish the apartments they promised to deliver.

In response, the government has eased borrowing rules and cut mortgage rates for first-time homebuyers while providing some tax relief measures for small businesses.

Late last month, it announced plans to issue 1 trillion yuan (£263,440 million) in bonds for infrastructure projects and disaster prevention, dipping deeper into deficit to try to nudge the economy into higher gear.

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