Peter Zeihan: Deflation could be final straw for the China economy

Peter Zeihan is a prominent geopolitical consultant. To learn more about Peter, visit the Zeihan on Geopolitics website.

China has never really recovered from COVID, whereas nearly every other country in the world – once the opening finally happened and the end of the epidemic was declared – we saw an explosion in consumption as people tried to get back to some version of their life which generated a lot of inflation.

We’ve not seen that in China. Growth is actually lower now than it was over the course of the last two years when they were supposedly under complete lockdown. Consumption is down imports and exports both dropped in July compared to a year earlier by double digits of percentages.

This is normally the sort of stuff you only see out of a country like say Ukraine or Russia when a war starts and this is happening when the Chinese are supposedly getting back to normal. Now a lot has gone down since the opening chapters of COVID in China which date back to the fourth quarter of 2019, but something to remember is that we saw a demographic bomb go off in China before COVID, going back to as early as 2017 the demographics really turned negative.

From 2017 to 2021 the birthrate dropped by about 40 percent and even in the months before COVID we saw new car sales (which are the quintessential indication that your population is up and coming and feels confident about its future and can spend a lot of money) going negative and they’ve never really recovered.

So now after COVID we’ve had all of these trends with four, five, six years behind them and as they’re manifesting in a more ‘normal’ environment the numbers are really really really bad.

The very very short version is that most of the consumption of a modern system happens when you’re in your 20s and your 30s, when you’re buying cars and raising kids and building homes.

But because of the One Child Policy, China doesn’t have much of a generation in that cohort at all, and since the One Child Policy is now over 40 years old, we’ve had a full generation of people who’ve not had kids and that is manifesting in the data.

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China economy: Deflation data paints even bleaker picture

So, the above, you cold say is problem one.

Problem two is deflation.

Chinese consumer price index (CPI) data for July 2023 revealed the country experienced deflation for the first time in two years. The CPI dropped 0.3% year-on-year in July.

In the United States, in Europe, in most of the developing world, COVID reopening was accompanied by a huge burst of inflation. People were trying to consume again to get back to some version of their normal lives and over the last two to three years their consumption patterns had changed.

Instead of buying cars or homes, they were buying computers and phones in order to adapt to their new reality. Well, now they’re shifting back and supply chains take about 18 months to catch up.

In the United States it has been 18 months since the last state to reopen (California) did so. So, we’re seeing inflation incrementally drop as it has been for the last year.

This is broadly what you should expect in China. But things are going in the opposite direction. The consumption boom never happened so supply chains never had to adjust.

But what has happened is people are less confident in their future so they’re consuming less and we’re seeing mounting trade Wars out of Europe, Japan, the United States, and increasingly secondary States like the Koreans joining in.

That means the Chinese have fewer places to send stuff, so what’s happening is product that was normally produced for export from China is now being locked up within the Chinese system at the same time that the population is purchasing less. You have an oversupply of goods and an under demand both at home and abroad.

As all those extra goods prices go down, you get deflation. Now short bursts of deflation are no big deal so I don’t want to overstate what’s happening here – it’s only one month of data at present, but this is what you would expect when you’re at the beginning of a deflationary spiral that’s caused by a fundamental mismatch between supply and demand which is where we are going with deglobalization and the Chinese demographic trends which are now well past the point of no return.

China economy deflation lessons from Japan?

The last country to face a major deflation burst was Japan. It started in the late 1990s and lasted for 20-25 years. You could argue that it might be over now because of their COVID reversion of demand – that might be over optimistic, but the issue is once those prices start to drop because of that mismatch between supply and demand it’s devilishly hard to adjust because normally you would do one of two things.

Number one – you could reduce supply, but that means closing productive capacity which means people lose their jobs, which means they spend less, which means that mismatch persists.

Or you can increase demand, usually with Government stimulus. This might not work in China and not just because of the huge demographic bomb that’s going off, the Chinese economic system isn’t really based on exports or consumption, it’s based on investment.

Mass borrowing in order to build industrial plant infrastructure has generated the vast majority of China’s economic growth going back 40 years. But you can only do that for so long, eventually you don’t need any more bridges or any more factories and I would argue the Chinese reached that point before COIVD and so again there’s been this three to four year lag between reality and the data.

Finally, the point is more spending probably isn’t going to help the marginal outcome.

The amount of growth they get for every yuan spent has been dropping steadily for 40 years and now it’s in far less than one-to-one, so it really doesn’t matter how much more fuel and how much cheap capital the Chinese pump into the system.

It’s never going to generate more economic activity than what it costs to put it in the first place.

This is what happened in Japan in the late 1990s and the early 2000s. They had reached the point where their economic model couldn’t run any longer. They were getting basically negative income on their investments and they had 20 to 25 years of deflation.

However, the advantage that the Japanese had going into this is they already had a global supply chain, they already had global allies, they had an option for offshoring some of their manufacturing incrementally, they had strong demand out of the United States, they had a good political relationship with the United States, and most of all they were already rich.

The average Chinese citizen today (in inflation index terms) compared to the average Japanese citizen in the year 2000 has an income that’s something like a quarter or a fifth what it is.

In China, they’re getting old and they’re getting into a permanent recession and a deflationary spiral long before they got rich and this can end in any number of horrible ways.

Potential for “horrible outcomes” for the China economy

So, again with one month of data I do not want to overplay this, but I’ve been watching for something like this for several years now and in the post-COVID environment we’re seeing the data belatedly match up with where demographics and geopolitical trends suggest that it should have been years ago.

If this proves to be the actual story, as opposed to a blip in the data you’re going to see this get significantly worse in a relatively short period of time because we have years of compressed damage that is now bursting out all at once and because the political system in China is basically down to one man.

The capacity of the Chinese state to come up with a creative solution is almost zero and even in Japan where they were willing to talk about this publicly and had alliances, it still took a generation to pull out of this.

This article is an edited transcript from Peter Zeihan’s recent video titled ‘The Chinese Slide Into Deflation (The Final Straw?)’. Subscribe to Peter Zeihan on YouTube here.