Lunar New Year: China's stock market can't escape falling prices

Chinese consumer prices fell 0.8 per cent in January from a year earlier, the steepest drop in fifteen years, and the country's stock markets enter the Year of the Dragon with little to celebrate. The economy is stuck in deflation. State-directed buying and bans on short selling cannot conjure corporate earnings out of nothing.

A rescue in all but name

The weeks before the holiday brought a scramble to stop the slide. Chinese shares had fallen for three years running, and in early February the main indices touched their lowest levels in about five years. Central Huijin, an arm of the sovereign wealth fund, said it was increasing its purchases of exchange-traded funds. The securities regulator tightened restrictions on short selling and on lending shares to short sellers, and its chairman was replaced. The central bank cut the reserve requirement ratio for banks by half a percentage point from 5 February, releasing liquidity. The measures produced a sharp bounce in the days before markets closed for the new year.

Falling prices, heavier debts

When factory-gate and consumer prices fall together, companies' nominal revenues shrink while the real cost of their debt rises. For China's heavily indebted corporate sector, that squeezes margins and pushes firms into defensive price wars. Share valuations cannot rise while companies have no pricing power.

The producer-price index has been falling for more than a year, and it dropped 2.5 per cent from a year earlier in January. Nominal growth tells the same story in aggregate. Last year China's real economy grew by 5.2 per cent, but nominal GDP grew by only 4.6 per cent, because the overall price level fell. It is nominal growth that pays salaries, services debts and generates profits, so investors who look only at the real growth headline overstate how well companies are doing.

The arithmetic of debt deflation

The mechanism was described by the American economist Irving Fisher in 1933. A company borrows a fixed amount of money. If the prices of the goods it sells fall, its revenue falls, but the debt does not. The burden of interest and principal rises relative to income, so firms cut costs, sell assets and lower prices further to raise cash, which pushes prices down again. China's corporate debt is among the highest in the world relative to the size of its economy, which makes it especially vulnerable to this loop.

For equity holders, the outcome is lower earnings and a higher risk premium. Companies with pricing power, such as those with strong brands or dominant market positions, can defend margins. Most Chinese industries, from steel to solar panels to electric vehicles, have too much capacity and too many competitors, so the price war falls on shareholders. Property developers and the local-government financing vehicles that depend on land sales are in a worse position still.

Deflation also pushes real interest rates up. With consumer prices falling, even the modest nominal rates set by the People's Bank of China translate into positive real borrowing costs, the opposite of what an economy with weak demand needs. The central bank has room to cut further, but each cut widens the gap with American rates and puts pressure on the yuan, which Beijing has been keen to keep stable. That constraint helps explain its preference for targeted measures, such as the reserve-requirement cut, over large reductions in benchmark rates. It also shifts the burden of reviving demand onto fiscal policy, where Beijing has so far moved in modest steps, such as the extra sovereign bond issuance approved in October.

A lesson from Tokyo

Japan tried something similar in the early 1990s. After its stockmarket bubble burst, the government directed public pension and postal savings money into shares, in what became known as price-keeping operations. The interventions produced temporary rallies but could not reverse the trend while deflation, bad debts and weak demand persisted. The Nikkei spent the following decades far below its 1989 peak. The lesson is that buying shares with public money can slow a fall but cannot create the profits that valuations depend on.

Winners and losers

The winners, such as they are, are holders of Chinese government bonds, whose yields have fallen as investors seek safety and expect further monetary easing. Consumers on fixed incomes gain purchasing power. Foreign buyers of Chinese exports benefit from cheaper goods, which is exporting deflation to the rest of the world. The losers are shareholders in cyclical companies, heavily indebted firms and households whose wealth is tied up in property, which continues to fall in value.

The case for a floor

The counterargument is that January's figure exaggerates. The new-year holiday fell in January last year and in February this year, which depresses the annual comparison for food and travel prices. Core inflation, which excludes food and energy, was barely positive rather than negative. Valuations are also low by historical standards, and the state has deep pockets to support the market. On this view, the worst may be over.

The calendar effect is real, and February's figures will look better. But the underlying trend of falling producer prices, weak nominal growth and a property market still in decline is not a holiday quirk. The indicators to watch are February's inflation figures, the targets announced at the National People's Congress in March, and whether Beijing announces measures to support household spending directly.

Beijing can prop up share prices for a while. Until it tackles the deflation eating into corporate cash flows, each rally it engineers is likely to fade, probably within weeks of the state buying slowing down.