China's prices are falling. Its currency could be next

Chinese consumer prices fell 0.3 per cent year-on-year in July, and the People's Bank of China now faces an awkward choice. Property distress and weak consumer confidence have crushed domestic price pressure. The textbook answer is to cut rates hard. Beijing's currency stands in the way.

Deflation arrives

July was the first month of falling consumer prices since early 2021, and the pressure further up the chain is heavier. Factory-gate prices fell 4.4 per cent from a year earlier, the tenth straight monthly decline. Economists have spent the year waiting for a post-lockdown consumer boom that never came. Households have instead saved, paid down mortgages early and avoided buying homes from developers they no longer trust to finish them.

The property slump is the core of it. Sales of new homes have fallen for two years, and Country Garden, once the country's largest private developer, missed coupon payments on its dollar bonds this month. Local governments that relied on land sales to fund themselves are cutting back. On 15 August the statistics bureau reported weak July figures for retail sales, industrial output and investment, and said it would stop publishing youth unemployment figures for the time being.

Protecting the yuan

Big rate cuts would widen the gap between yuan and dollar interest rates, encouraging capital to leave and pushing the currency down. To head off a rout, the PBoC has set its daily fixings on the strong side and told state banks to soak up dollars. Every effort to hold up the yuan leaves the central bank less room to revive the domestic economy.

The same day as the weak data, the central bank surprised markets by cutting its one-year medium-term lending rate by 15 basis points, to 2.5 per cent, and trimming its seven-day policy rate. The size of the move says as much as its direction. A cut of that order will barely register on borrowing costs for households that do not want to borrow, and it was accompanied by fresh signals that the authorities would lean against yuan weakness.

The trilemma at work

The squeeze is a textbook case of the trilemma: a country cannot run an independent monetary policy, fix its exchange rate and allow capital to move freely all at once. China has kept capital controls, which is what lets it attempt the first two. The controls are porous, however, and pressure builds through channels that are hard to close, including exporters who keep dollar earnings offshore rather than converting them, and households that shift savings abroad within their annual allowances.

The interest-rate gap is what drives those decisions. American ten-year yields rose above Chinese ones in April last year for the first time in more than a decade, and the gap has widened as the Federal Reserve raised its policy rate to 5.25 to 5.5 per cent. With the yuan already weaker than 7.2 per dollar, every Chinese rate cut increases the reward for holding dollars. The central bank has also raised the limit on how much companies may borrow abroad and cut the reserve requirement on banks' foreign-currency deposits last year, both measures designed to increase the supply of dollars onshore.

The 2015 warning

Beijing's caution has a clear source. In August 2015 the PBoC changed how it set the daily fixing, and the yuan fell sharply within days. Markets read the move as the start of a managed devaluation. Capital poured out, and China's foreign-exchange reserves, which had approached $4 trillion in 2014, fell to around $3 trillion by early 2017 as the authorities spent heavily to steady the currency and then tightened capital controls.

Officials who lived through that episode have little appetite for repeating it. Their lesson was that expectations of depreciation can become self-fulfilling, and that it is cheaper to lean against weakness early with fixings and bank guidance than to defend the currency after a rout has started. That lesson now dictates the pace of monetary easing.

Winners and losers abroad

A slowly weakening yuan and falling factory prices mean China exports deflation. Buyers of Chinese goods in America and Europe get cheaper imports, which helps central banks there fighting inflation. Manufacturers competing with China, from German machine-makers to South Korean and Taiwanese electronics firms, face sharper price competition. Commodity exporters, particularly iron-ore producers in Australia and Brazil, lose if Chinese construction keeps shrinking.

Inside China the losers are borrowers facing real interest rates that rise as prices fall, including local-government financing vehicles and property developers already struggling to service debt. Savers with cash in state banks gain in real terms, which is part of the reason households keep saving rather than spending.

The case against alarm

The strongest counterargument is that the July figure overstates the problem. Pork prices fell sharply from a year earlier, and last summer's high base flatters the decline. Core inflation, which strips out food and energy, rose 0.8 per cent in July, up slightly from June, and services prices are recovering as travel and dining pick up. China also runs a large current-account surplus and holds some $3 trillion of reserves, so a disorderly run on the currency is not imminent.

All true, but beside the point. Core inflation below one per cent is still far below the rate needed to ease real debt burdens, and the surplus does not help if the domestic policy response is capped by currency fears. The authorities can avoid a crisis and still fail to escape a slow deflationary drift.

What to watch

The monthly loan prime rate fixing, which sets benchmark lending rates, is the next signal of how far the PBoC will go. Beyond that, the spread between the daily fixing and market estimates will show how hard the central bank is defending the yuan. Property measures matter most of all: the Politburo said in July that housing policy would be adjusted, and concrete steps to support demand in the largest cities would do more for prices than another small rate cut.

Beijing is caught in a classic balance-of-payments bind. Anything big enough to beat deflation at home risks a run on the yuan, so rate cuts will probably stay small and prices will keep falling for a while yet, most likely into the end of the year, with indebted developers and local governments paying the highest real cost.