This dangerous spiral has two implications for policymaking. To prevent deflationary expectations from becoming entrenched, increasing the inflation rate through aggregate-demand stimulus becomes an urgent necessity. But relying solely on more public or private borrowing is best avoided in favour of aggressive monetary easing — including the monetisation of debt (meaning the central bank purchases).
The Chinese economy is underperforming relative to its growth potential. Not only are investment and consumption demand weaker than hoped, but the country is facing the challenge of two Ds: deflation and debt. While consumer-price inflation is close to negative territory, producer-price inflation has already been negative for a year. At the same time, the private and public sectors have accumulated massive debts, owing to higher spending during the pandemic and the broader response to the easymoney conditions of previous years.
The two Ds are a toxic combination. By increasing the real (inflation-adjusted) value of existing debt, deflation makes it harder for firms to secure additional financing, thereby raising the prospect of bankruptcies — a trend that is already discernible in China. Moreover, once the combination of debt and deflation becomes entrenched, it can generate a vicious cycle whereby lower demand leads to lower investment, lower output, lower income and thus even lower demand.
