Emerging Asia: The ill wind of deflation

Price shifts are often early harbingers of global change. The first inkling the British had of the 13th century Mongol invasions of Europe, for instance, was a spike in the price of fish at the east coast port of Harwich. Baltic fishing fleets had stopped sailing after their crews were redirected to fight the invaders, thus cutting the supply of fish to one of England’s biggest markets.

The current economic convulsions emanating from the East are very different, but they do signal changes that imperil global fortunes. Deflation, a prolonged decline in the price of products, is flowing like a draught of cold air from Asia’s powerhouse economies and casting a chill over Japan and Europe, while also endangering the United States’ efforts to sustain a recovery.

Although aggregate falling prices may sound benign for consumers, they are in fact feared by economic policymakers because they erode corporate profits and force companies to cut jobs, sapping overall demand.

Deflation was blamed for turning the 1929 US stock market crash into the Great Depression. Fears that a downward price spiral might follow the 2008/09 financial crisis was a key impetus behind the decision of Mr Ben Bernanke, then chairman of the US Federal Reserve, to unleash quantitative easing (QE) — the monetary policy that has dominated the world’s economic cycle ever since.

For these reasons, evidence of a deepening deflationary spiral in Asia — sparked by manufacturing overcapacity, an evaporation of trade demand and anaemic productivity — is a major cause for concern. That anxiety is amplified because of the structural nature of the problem. That it is taking place just as the European Union and Japan are slipping back into deflation while the US is struggling with weak corporate earnings makes Asia’s falling prices a pivotal issue.

“There is a chance that we are moving towards global deflation,” says Mr Alberto Gallo, head of European macro credit research at RBS, the bank. “We have overleveraged everywhere and, instead of reducing capacity, we are creating a prolonged state of industrial overcapacity that is driving down prices. China is the biggest example.”

The threat of a worldwide slide into deflation also worries Mr Michael Power, strategist at Investec, an asset management company. He sees declining prices as the result of a fundamental imbalance between an excess of supply from Asia and a dearth of demand from the West. “In economic terms, prices are falling because the coordinated supply out of Asia is overwhelming the West’s best efforts to pump up demand via the likes of QE,” Mr Power says.

The nightmare deflationary scenario is that falling prices in Asia continue to cut corporate profits, prompting mass redundancies and reducing consumer demand.

The drag that this imposes on global demand may then intensify, depressing feeble economic growth in Europe and Japan and damping dynamism in the US. Aspects of this scenario are already in place.

Producer price deflation

Key to Asia’s problem is the particular type of deflation that it is afflicted by. The issue is not with consumer prices; these are still buoyant in most of the region’s shops. Instead, it lies with producer prices — the amount that factories, mines, farms and other producers can charge for the commodities or manufactured products and components that they sell.

The producer price index is at its lowest average point for six years in the 10 largest economies in Asia (excluding Japan), according to Morgan Stanley. Only Indonesia among the 10 is experiencing any producer price inflation, while South Korea, Taiwan and Singapore have been in a deflationary funk for around three years.

China has notched up 42 straight months of falling producer prices, making it the only large economy other than Japan in the 1990s to show such a persistent deflationary trend, according to Mr Chetan Ahya, chief Asia economist at Morgan Stanley.

Overall, China’s producer prices are down a cumulative 10.8 per cent from their recent peak in 2011. The speed at which prices are falling is a cause for alarm. As recently as August last year, the producer price index for commodities was showing only a 1.1 per cent drop; this August the decline was 12.8 per cent. Even a country such as India, with an otherwise robust economy, has slipped into producer price deflation over the past year.

Nor is Asia’s deflation solely the result of the global slide in commodity prices. Pernicious effects are also evident from the decline in the price of manufactured products and components, which fell on average by 4.4 per cent year on year in August in the region’s 10 leading economies (excluding Japan).

Chinese industrial companies suffered an 8.8 per cent year-on-year decline in their profits in August, the largest drop since records began in 2011. Elsewhere in Asia, the trend is repeated, with both sales and earnings for the region’s top-listed companies declining in the second quarter of the year, said Morgan Stanley.

Some of the corporate fallout is eye-catching. Longmay, a large Chinese coal company, said last week it was laying off 100,000 workers in a “life and death” struggle to rescue a bleeding balance sheet. Mr Wang Zhikui, its chairman, said Longmay had run up huge losses during the first eight months of the year and was closing coking coal mines and selling off assets to meet debt repayments.

Caterpillar, the American heavy-equipment maker, generates 60 per cent of its pre-tax profits outside the US, mostly in emerging markets. But it has had to close 20 manufacturing facilities since 2012 and cut 31,000 jobs. It announced last month that 2016 was likely to mark an unprecedented fourth year of falling sales.

Another equipment company, the state-owned China National Erzhong Group, which makes smelting and forging equipment, defaulted on interest payments last month after a local court accepted a restructuring request from one of its creditors.

Such incidents are beginning to look like straws in the wind. There have been a small but significant number of defaults on foreign currency bonds by emerging market borrowers this year — 16 in the first eight months, more than in all of last year, according to Standard & Poor’s.

The drop in earnings across Asia is particularly serious with a huge overhang of corporate debt raising risks of a “balance sheet recession”, in which high debt service charges force companies to focus on saving rather than spending or investing, thus slowing growth.

Mr Andrew Polk, senior economist at the Conference Board in Beijing, sees such a recession under way in China, especially among small producers. The Institute of International Finance (IIF), an industry association, says that Asia — and in particular, China — has taken the lion’s share in a five-fold debt increase at non-financial corporations in emerging markets over the past decade.

The total, it estimates, now stands at US$23.7 trillion (S$33.5 trillion) or 90 per cent of total emerging market gross domestic product. “The speed in the build-up of debt has been staggering,” says Mr Hung Tran, the IIF’s executive managing director. “All the research shows that the speed of incurring debt plays a key role in the quality of that debt and in the subsequent crisis,” Mr Tran adds. “We do see an increasing burden on corporate borrowers to service that debt.”

The impact of this burden allied to the deflationary spiral, which depresses returns on corporate investments, has exacerbated a net outflow of capital from emerging markets that the IIF estimates is likely to reach US$540 billion this year — the first time that net flows have been negative since emerging markets evolved as a concept in the late 1980s.

The problem, in short, is that neither direct investors in plant and machinery or portfolio investors in stocks and bonds see emerging markets — and within that classification, Asia — as an attractive place to put their money right now. Falling producer prices are diminishing corporate returns while debt repayments subtract from profits.

The International Monetary Fund (IMF) warned last month that the stress on indebted corporations would intensify if the US Federal Reserve and other central banks tighten their monetary policy. The Fed is expected to increase US interest rates for the first time in a decade later this year or early in 2016.

“Emerging markets should prepare for an increase in corporate failures,” said the IMF in its latest semi-annual Global Financial Stability report.

Excess of supply as factor

Classic theories of deflation, including that espoused in the so-called Bernanke doctrine, state that falling producer prices result from a collapse in aggregate demand. This leads, as Mr Bernanke said in 2002, to “a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers”. This diagnosis led directly to the main US response to the threat of deflation; a reflation of demand by pumping liquidity into the economy via QE.

However, in the case of Asia’s deflation at least, it appears likely that it is an excess of supply rather than insufficient demand that is the prime factor depressing producer prices.

If this is the case, then endless bouts of QE — or “QE infinity” as Mr Gallo describes it — may be exacerbating rather than alleviating the problem of deflation by acting to prolong oversupply through providing cheap credit to companies.

“By itself, ‘QE infinity’ could be deflationary in the long run because it means that the issue of overcapacity is not resolved but dragged forward,” says Mr Gallo. “This could in turn result in both prolonged deflation and asset price bubbles at the same time.”

Mr Power points to crumbling barriers to entry in Asia’s manufacturing sector as a reason for the persistent oversupply of products. It has also been driven by government incentives — such as tax breaks, discounts on land purchases and other national policies — aimed at luring manufacturing investment across the region.

“Vietnam has secured Samsung’s new mega cellphone factory. Bangladesh is where lower-end textile manufacturing is migrating to. Cambodia and Indonesia are starting to win here too,” Mr Power says. “Meanwhile, India has launched its own ‘Make In India’ campaign and is already the leader in scooters and motorbikes.”

This “supply tsunami”, as Mr Power describes it, is crashing up against an Asian trade recession. Exports in the region have posted their worst performance since the 2008/09 crisis, falling 7.7 per cent in July to register a ninth consecutive month of year-on-year declines in dollar terms, according to data compiled by Capital Economics, the research firm.

The reason for the evaporation in Asian trade growth, however, is of more concern than the trend itself. Weakening currency values against the dollar are failing to boost export performance — as would normally be expected — but they are nevertheless driving down demand for imports, thus worsening the deflationary trend. A Financial Times study found that import volumes fell by an average of 0.5 per cent for every 1 per cent a currency depreciated against the dollar.

It is hard to see a silver lining at this stage of Asia’s deflationary period, with overcapacity still chronic, trade demand weakening, productivity anaemic and the global economy in poor shape. Mr Tran sees things in terms of historical multi-year cycles. The upward leg of a commodities supercycle, of which he identifies four since the 1890s, has tended to last around 20 years, while the downward legs have lasted 15 to 26 years, he says.

“We are in year four of the downward cycle,” he adds. “This is not a problem that can be turned around quickly.” FINANCIAL TIMES

ABOUT THE AUTHOR:

James Kynge and Jonathan Wheatley are The Financial Times’ Emerging Markets Editor and Deputy Emerging Markets Editor respectively.