China’s Economy – Nothing Is Going Right!

By Hema Senanayake –

It has been reported recently that nothing’s going right for China‘s economy at the moment. In China, prices are falling than rising. That is deflation is taking place. People are not buying, and entrepreneurs want to sell what they produce even by reducing prices. Chinese central bank cut interest rates to reverse the situation propping up demand and growth. In a normal situation this is not a big problem. That is deflation itself is not a big problem. But China reported another problem, a “debt disease” previously. This means that there is an accumulation of relatively huge debt in the non-financial corporation sector and in household sector together. In brief, in China there are two economic maladies at the moment; those are “debt-disease” coming first and subsequent deflation. If debt-disease and deflation stand-alone separately there will be a smaller problematic wave in the economy. But if the deflation is caused by debt-disease it usually creates a bigger wave like severe recession or even great depression, if not contained proactively. Therefore, in this brief essay I will explain two economic theories which will help to understand the said crisis.

Debt-disease came first. In China, it is not about public debt which means government debt. But it is about private sector credit which includes non-financial corporations and households. China had been doing excessively well in past couple of decades posting doble digit GDP growth. But recent economic theory intimates that it could see troubles mainly a debt-disease when the economy is approaching its maturity, having near full employment and reduce GDP growth to lower single digits. The theory explains as follows.

“After a period of economic activity, it does not need necessarily be a period of economic growth, if private consumers are not in significant debt, then the government could be filling something defined as “Economic System Gap” from a large amount of debt – and if both private consumer and the  government are not in significant debt, then the “Economic System Gap” is being filled either by credit issued to nonfinancial businesses or by margin debt which means that there should be a debt bubble in nonfinancial business sector or debt bubble in the stock market with heavy indebtedness of holders of stocks and derivatives or in both sectors. If none of the above is happening, then it must be an (immature) economy that is expanding by reinvesting the expanded capital and producer credit and mostly producing goods and services that do not satisfy the demand of immediate consumption. In all former scenarios except the last, the economic system may crash soon due to “over-indebtedness”, if systemic partial debt-deflation is not undertaken by design. In the latter case, the economy will fall into any one of the former scenarios as it grows. This is the general behavior of contemporary capitalist economic system.”

Now apply this theory to China. Chinese consumers and the government are not in significant debt. And previously nonfinancial businesses were having less debt. If this was the situation, then it should be a immature economy expanding by reinvesting the expanded capital and producer credit and mostly producing goods and services that do not satisfy the demand of immediate consumption. During this period, China had double digit GDP growth. Then recently it falls into a kind of mature economy, having near full employment and reducing GDP growth, while usable inventions and innovations are slowing down. Under this scenario, the economy should be in significant debt according to the theory. So, in China still consumers and the government are not in significant debt, but nonfinancial businesses debt has grown to over 158% of GDP where in Australia the same figure is around 62% according to 2022 data of Bank of International Settlement. This means that in a way China is currently having a debt-disease. If this is a stand-alone problem, it could trigger only a smaller disturbance in the economy. But it is not so. It seems, Chinese debt-disease has caused another malaise that is a “deflation.” 

Then another piece of theory of Irving Fisher explains as follows.

“When over-indebtedness stands alone, that is, does not lead to a fall of prices, in other words, when its tendency to do so is counteracted by inflationary forces (whether by accident or design), the resulting cycle will be far milder and far more regular. Likewise, when a deflation occurs from other than debt causes and without great volume of debt, the resulting evils are much less. It is the combination of both – the debt disease coming first, then precipitating the dollar disease – which works the greatest havoc.” (Fisher, 1933). In this quote, the dollar disease means deflation or fall of prices.

The above two pieces of economic theory explain the current Chinese economic crisis, and sincerely hope that Chinese authorities would act proactively before two malaises work greatest havoc and save the global economy.

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