One Chinese yuan bill lying on top of a US dollar bill.

One Chinese yuan bill lying on top of a US dollar bill.Getty Images

  • China’s economy risks falling into a vicious cycle of debt and deflation, said economist Shang-Jin Wei.

  • To avoid that, the central bank could launch an aggressive bond-buying campaign, he wrote in Project Syndicate.

  • While that could also weaken the value of the yuan, “it is a price worth paying,” Wei added.

China’s economy risks falling into a vicious cycle of debt and deflation, but avoiding that trap may require letting the yuan lose value, said economist Shang-Jin Wei.

Writing in Project Syndicate, the former chief economist at the Asian Development Bank noted that consumer prices recently fell into negative territory, and producers have been experiencing deflation for a year. Meanwhile, the public and private sectors have racked up big debts after pandemic-related spending binges and easy-money policies.

“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,” Wei said. “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.”

While Beijing has unveiled a series of steps to try to stimulate the economy, the People’s Bank of China has yet to inject a massive amount of liquidity, he said.

The central bank could embark on a quantitative easing campaign similar to bond-buying sprees that the Federal Reserve and other monetary authorities launched after the 2008 financial crash, he added.

“China needs the ‘whatever it takes’ approach that the European Central Bank pursued a decade ago when it, too, was facing a debt-deflation spiral,” Wei said. “The PBOC should publicly declare a strategy to monetize a big portion of government debt and to incentivize more private-equity investment.”

But aggressive quantitative easing would likely weaken the yuan, which has already lost about 5% against the US dollar over the past year.

That’s a key concern for China’s leadership as further depreciation could lead to more capital flight, Wei said. In fact, Beijing has been scrambling to boost the yuan, while foreign investors dump Chinese stocks at a record pace.

“But if the price of saving the economy from entrenched deflation is a weaker renminbi, it is a price worth paying – and could even serve as a useful adjustment mechanism by boosting foreign demand for Chinese products,” Wei said. “Rather than trying to manage the exchange rate, which would artificially justify an expectation of depreciation, Chinese authorities should leave such adjustments to market forces.”

Read the original article on Business Insider

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