China needs real growth that only a shift away from investments can deliver

The People's Bank of China has just cut interest rates again. It may support the stock market for a few days, but it won't reverse the deflationary trend in the economy. It won't even have much of an impact on lending rates. Political power, not market force, drives China's credit system.

China can only ease deflationary pressure by increasing the share of household disposable income in the economy. Short of that, stimulus measures will only worsen the situation. Monetary easing will merely prop up insolvent companies and prolong overcapacity-induced deflation. Fiscal subsidies for distressed businesses or local governments will lead to the same outcome.

In the long run, China must reform to remove the system bias for maximising investment. Fixed-asset investment should be reduced to one-third of gross domestic product, from half, and disposable household income increased from 40 per cent to 60 per cent. As long as investment is bigger than what the economy can sustain, bubbles, deflation and financial crises will continue to haunt the economy.

China experienced deflation between 1998 and 2003. Many experts learnt the wrong lesson from that. Instead of attributing its origin to the wild speculation and investment orgy between 1992 and 1994, they blamed the subsequent macro tightening to deal with the bubble. When inflation returned in 2004, the dominant view was to keep it going. The popular saying was that China's economy was easy to cool but hard to warm up.

Rampant monetary growth in China causes inflation now and deflation later. China's system is to allocate an increasing share of the money supply to investment; that is, a monetary boom functions as an inflation tax on labour to subsidise investment. The resulting overcapacity leads to lasting deflation.

When deflation hits, the policy of popular demand is to increase money supply. Alas, it works the other way round. China's financial system channels resources overwhelmingly into investment. Even lending to the household sector does so via property purchases. When overcapacity is the cause of deflation, prolonging it won't solve any problem.

Worse, the main borrowers in China, local governments and state-owned enterprises, don't really worry about paying back. They assume that the creditors would roll over the old debt. The worst hardship is fewer new loans. Hence, they don't worry about interest rates. Most private enterprises behave similarly. This gigantic moral hazard problem is the reason that interest rates are not declining much in spite of the intensifying deflationary pressure.