March 4, 2003
Both China and Japan are experiencing deflation. In contrast to the Japanese economy, which is suffering a protracted downturn, however, China is enjoying high economic growth. As Japan's situation illustrates, economic activity generally slows down under deflationary pressures. Why does this not hold true for China?
There are many hypotheses regarding the causes of deflation in China. Let me list some of the most representative:
1) Insecurity. During the planned economy years, workers were guaranteed lifetime employment as well as benefits in the areas of medical care, housing and pensions. With the transition to a market economy, however, people have become vulnerable to the risk of losing their jobs, and with the addition of the anxieties of old age, they must cut down on consumption and save more.
2) Unequal distribution of income. The fruits of the economic growth of recent years have not been distributed equally. The gaps between the coastal and inland regions, and between the urban and rural areas, in particular, have widened, and Chinese society is bifurcating into the rich and the proletariat. Consumption has grown sluggish as a result.
3) Credit crunch. Despite the fact that the main players in the Chinese economy have shifted from state-owned enterprises to private firms, the four major state-owned banks still dominate the banking sector. Because they continue to lend mainly to state-owned enterprises, and private firms are facing funding shortages, potential investment opportunities are unrealized. Although authorities are urging state-owned banks to extend more credit to private enterprises, the credit crunch has remained unresolved, in part due to the fact that banks are shouldered with large amounts of non-performing loans.
4) Intensified competition. The planned economy in the past was a sellers' market, which manifested in shortage of supply and long lines of customers at stores. With the transition to a market economy gathering momentum, however, companies have begun to react swiftly to the needs of consumers, leading to the birth of a buyers' market where goods are abundant.
5) Rise in productivity. Industrialization is progressing rapidly in China, with the leverage supplied by market reforms. China has acquired the production and management techniques of foreign countries, especially by receiving foreign direct investment and processing trade. As a result, the country now has gained strong price competitiveness, particularly in the production of labor-intensive goods.
6) Excess labor. Because of the presence of large surplus of labor in rural areas, a rise in industrial productivity does not directly lead to an increase in wages. Furthermore, unemployment is also on the rise in urban areas, as a large percentage of the excess workforce at state-owned enterprises is laid off as a part of the reform process.
These hypotheses all attribute deflation in China to structural rather than cyclical factors. So long as prices are determined by the balance between supply and demand, however, it is beneficial for us to categorize these factors accordingly. Depicted in the diagrams below, demand side factors are represented by a shift of the demand curve to the left, while supply side factors are represented by a shift of the supply curve to the right. In China's case, the hypotheses based on insecurity, unequal income distribution and an ongoing credit crunch are factors on the demand side, while those related to intensified competition, rise in productivity and excess labor are supply side factors.
In reality, both demand factors and supply factors are at work at the same time, but the pattern of economic performance differs depending on which has the greater impact. Specifically, if demand factors have greater influence, the end product is bad deflation, where both output and prices fall. But when supply side factors dominate, the result is good deflation, where prices fall but output grows. Judging from the fact that the Chinese economy is growing fast while the Japanese economy is not, Japan seems to be suffering from bad deflation caused by dwindling demand, whereas China may be experiencing good deflation brought about by an increase in supply capacity. Thus if we attribute deflation in China mainly to factors on the supply side, rather than the demand side, we can solve the puzzle of why deflation and high economic growth can occur simultaneously.
Diagram Good deflation / Bad deflation
How about the interaction between the two economies? To consider the impact of the China factor on Japan's macroeconomic performance, it is again helpful to distinguish between good and bad deflation. The former results from cheaper imports from China that reduce the costs of production of Japanese manufacturers (a shift of Japan's supply curve to the right), and is accompanied by an expansion of Japanese output. The latter reflects a diversion of demand from Japanese products to Chinese products in both the Japanese market and international markets (a shift of demand curve facing Japan to the left), which reduces Japan's domestic production. Since the economic relations between and Japan and China can better be characterized as complementary rather than competitive, the China factor is likely to bring more good deflation than bad to Japan. Unfortunately it is not "good enough" to offset the bad deflation resulting from Japan's falling domestic demand.
Author, C.H. Kwan
Senior Fellow
Research Institute of Economy, Trade and Industry (RIETI)
Editor-in-Chief, Ichiro Araki
Director of Research
Research Institute of Economy, Trade and Industry (RIETI)
e-mail: araki-ichiro@rieti.go.jp
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The opinions expressed or implied in this paper are solely those of the author, and do not necessarily represent the views of the Ministry of Economy, Trade and Industry (METI), or of the Research Institute of Economy, Trade and Industry (RIETI).
