While many economies worldwide are still dealing with unruly bouts of inflation, China has the opposite problem. The world’s largest economy is under a “deflationary cloud,” Albert Edwards, Société Générale’s always opinionated and often sardonic strategist explained in a Tuesday note.
That doesn’t sound like great news, but Edwards, who isn’t exactly known for his bullishess, sees a “silver lining” in China’s problems—the country might be able to “export” deflation to the West in a win-win scenario for both economies.
“China’s economy is sliding into deep deflation. Why is that good news? Well, the ‘West’ wants lower inflation, while China (and Japan) wants higher inflation. There is a deal to be done and maybe all parties can benefit,” he wrote.
In other words, Edwards wants the U.S. and China to go back to the 1990s and early 2000s, when the U.S. benefited from China’s growing role as the world’s (quite affordable) factory by importing trillions of dollars of cheap goods. But Edwards’ proposal comes with a warning, too: If the U.S. overshoots and imports too much deflation, it could kneecap its own economy and its so-far-successful rebound from the pandemic years.
Deflation vs. inflation
Inflation is a terrible economic disease. It acts as a regressive tax on consumers, curbing their purchasing power while simultaneously raising costs for businesses. But deflation can be just as bad, if not worse. When prices fall consistently, it shrinks companies’ profit margins, which can lead to job losses, fading economic growth, and act as a drag on consumer spending.
The best known example of this is Japan, which suffered through a “lost decade” in the 1990s due to deflation. Asset prices in everything from real estate to stocks tanked during this period, leading to a seemingly inescapable economic stagnation.
Now, with the Federal Reserve hiking interest rates to fight the hottest inflation in four decades, the People's Bank of China (PBOC) has run into its opposite. The impact from extended COVID lockdowns, combined with recent high-profile failures in the country’s debt-fueled real estate market and a drop in manufacturing as its trade partners adjust their supply chains, have collectively hindered China’s economic recovery in the past two years.
The “big surprise,” Edwards said, is that China’s long-forecast post-COVID economic rebound never panned out. “Without that rebound, China has had to grapple with excess debt, excess capacity and the consequent ever-deepening deflation, especially in consumer goods,” he noted.
View this interactive chart on Fortune.com
To his point, after flirting with deflation for over a year, China’s consumer price index sank 0.5% from a year ago in November and 0.2% in October. Export prices for cars, for example, fell 10% from a year ago last month, while hot rolled coils or thin steel sheets sank 14% from their March highs, according to China’s General Administration of Customs.
A tale of two economies
But the worst of times for China could be the best of times for Western nations with a few trade agreements and a currency devaluation, Edwards argued.
To collectively address their very different issues, the U.S. and Chinese economies might want to consider joining forces, Edwards said, adding that “policy makers” in the U.S. “surely must want to import some of China’s deflation?”
In his typical acerbic style, the strategist hinted at the idea that China could devalue its currency in order to “export” deflation to the West. By devaluing the Renminbi, something China does periodically, the nation could lower the price and increase the quantity of its exports. That would lead cheap goods to flood the market in the West, lowering U.S. inflation while simultaneously boosting Chinese economic growth and consumer prices.
“China’s deflation problem could be a welcome dis-inflationary restraint for the ‘West’. Prices of Chinese imports into the U.S. are already falling sharply, which will drag down U.S. goods prices and core CPI [inflation] with it,” Edwards wrote. “What’s not to like?”
The U.S.-China relationship has been a tense one in recent years, going back to President Donald Trump, who reversed a decade and a half of relatively free trade between the two nations by instituting tariffs, which China reciprocated. In the past year, the two nations have imposed tit-for-tat bans on the imports of chips, semiconductor equipment, and software critical for military use. Still, a trade deal that would enable China to export more goods to the U.S. would certainly help both nations. And if China devalued its currency, it could pay even more benefits, Edwards said.
“China perhaps needs to learn some lessons from Japan, i.e., devalue to export domestic deflation,” he wrote, noting that Japan has devalued its currency and increased foreign trade to avoid deflation in the past.
There’s already some evidence that China’s falling prices are leaving the country. The prices of roughly 70% of China's major exports have fallen this year in dollar terms, according to trade data released by China's General Administration of Customs last week, Nikkei first reported.
Still, ever the bear, Edwards offered a warning about importing Chinese deflation to the West—the U.S. should be wary of overdoing it in case the economy crashes and it receives a double dose of price decreases.
“The fly in the ointment might well be that, if a U.S. hard landing is imminent (reflected in weak money supply) and triggers a collapse in U.S. domestic inflation anyway, importing an extra slug of Chinese deflation would then be extremely unwelcome and throw the Fed into a tizzy,” he said, arguing the central bank would be forced to cut rates to boost growth and prices due to the ailing economy in this scenario.
