As advanced nations fight inflation, China grapples deflation, says Richard Koo
This dynamic is reminiscent of the 1990s, when Japan grappled with deflation while the rest of the world worried about inflation, said Richard Koo, Chief Economist at Nomura Research Institute.
- Future drop in fossil fuel demand is driving prices up to maintain supply.
- Large layoffs during the pandemic have led to a labor market reset and higher wages.
- China is facing multiple deflationary pressures after the asset bubble burst.
In the 1990s, Japan grappled with deflation in the aftermath of its asset price bubble burst, while the rest of the world worried about inflation. Over three decades later, this dynamic is playing out again, but this time with China. During his keynote address at Nomura Investment Forum Asia 2024, Richard Koo, Chief Economist at Nomura Research Institute, said that while many advanced countries combat inflation, China is fighting deflation.
While higher fossil fuel prices and increased wages are inflationary in the developed world, China is facing a balance sheet recession and a slump in its construction industry, which accounts for a fourth of its GDP.
Energy Prices
Fossil energy producers have operated on the certainty that demand for their product will always increase, and the uncertainty that drilling for oil and gas comes at a risk. Prior to 2021, when several countries passed laws banning the use of fossil fuels, the potential for significant rewards meant that they were willing to take this risk.
But this risk-reward combination is now being challenged. Countries like China and Europe have prohibited the sale of gasoline and diesel cars after 2035. New York City also now requires buildings to have air conditioners run on electricity rather than natural gas or oil. This means that demand for fossil fuel products could drop sharply by 2035, giving energy producers only 11 years to recover costs and reward shareholders.
This has changed the entire energy market landscape, with Saudi Arabia working with OPEC and Russia to keep oil prices high. These high prices will likely stay with us and energy prices are expected to remain inflationary for the foreseeable future.
Labor Market Reset
When the pandemic hit, countries with flexible labor markets like the US, Canada and the UK laid off large amounts of workers, with about 20 million people losing their jobs in the US alone. A year-and-a-half later when companies wanted to recall workers, many had relocated to different areas and industries making it difficult to find people with the same skill level. As a result, the labor supply curve, adjusted for skill level, shifted to the left, which meant companies had to pay more for workers with the same level of skills.
The reverse occurred in Japan and Italy where companies kept people on their payrolls, and had the necessary workers and skill levels to meet returning demand quickly. As a result, wage rises remained relatively muted, except for the hotel industry in Japan where workers had to be laid off and now wages are much higher.
In its latest Beige Book, the US Federal Reserve notes that things are beginning to normalize, as employers start to have bargaining power in the hiring process of workers. Yet, it will take another year or two for the market to completely normalize. Until then, it remains inflationary.
China
China is moving in the opposite direction to advanced countries. Like Japan 30 years ago, it is facing a balance sheet recession due to the bursting of its asset bubble, but unlike Japan, China could also see a recession in the construction industry, which accounts for 26% of its GDP. Other deflationary pressures include:
- Drawdown of corporate and household savings during Covid-19 lockdowns leading to balance sheet recession on the asset side
- Population decline starting in 2021 when the asset bubble burst
- Businesses reducing borrowings and investments from 2016 due to:
• Being stuck in the middle income trap, when the country is no longer the lowest-cost producer
• Regulatory tightening and uncertainty in real estate, finance, IT and educational sectors
• Geopolitical tensions with the West
With China’s economic slowdown likely to persist, we will continue to have a world where advanced countries combat inflation while China fights deflation for some time to come.
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