Can China avoid a disastrous deflationary spiral?

At a time of slowing growth and massive corporate debts, a deflationary spiral would be China's worst nightmare. And the risk is mounting. The producer price index has been in negative territory for 39 straight months. The growth of the consumer price index (CPI) has also been falling steadily, from 6.5 per cent in July 2011 to 1.2 per cent in May. If experience is any indication, it will turn negative very soon.

In China's last protracted bout of deflation, from 1998 to 2002, persistent declines in prices were the result of monetary and fiscal tightening that began in 1993, compounded by the lack of exit mechanisms for failed enterprises. After peaking at 24 per cent in 1994, inflation began to decline in 1995. But GDP growth soon began deteriorating rapidly. In an effort to revive growth, Beijing loosened monetary and fiscal policy, beginning in November 1997. But it was too little too late. By 1998, when CPI inflation began to fall, producer prices had already been declining for eight months, and remained negative for 51 months, with CPI growth beginning to recover after 39 months.

An obvious lesson is that the government should have switched to loosening earlier, and more forcefully. But this experience also underscores the impotence of monetary policy in a deflationary environment.

Nonetheless, China eventually managed to rid itself of deflation. A decline in investment - together with closures, mergers and acquisitions - reduced overcapacity, clearing the way for a strong rebound in 2002. At the same time, expansionary fiscal policy increased effective demand.

Housing-market reforms in the late 1990s also fuelled fast growth in real estate investment, allowing development to become the most important contributor to growth.

The problem with the emergence of these new growth engines is that it enabled leaders to delay important structural reforms. As a result, China now faces many of the same challenges - beginning with overcapacity. At this point, the authorities could implement firm closures, mergers and acquisitions, and other structural measures. In theory, the long-term solution would be to pursue structural adjustments to improve how resources are allocated. But that would be slow and painful. Striking a balance will be a major challenge.

However, this time, China cannot absorb overcapacity by stimulating real estate investment and exports. The leaders must do what it takes to avoid falling into the debt-deflation trap, including pursuing structural reforms and adjustment.

China should brace for a period of deflation, which may be more protracted than the last one. But with the right approach, it can ensure that, this time, it recovers more sustainably.

Yu Yongding is a former president of the China Society of World Economics. Copyright: Project Syndicate