Deflation is the key to understanding China's economy this year, despite rosy growth announcements as Chinese officials try to improve perceptions and attract investment.

At Davos this week, Premier Li Qiang announced that the economy grew by 5.2% in 2023, hitting Beijing's target. But he failed to point out that this came on the back of serious deflation, with the slew of Q4 data out in the past couple of days confirming the dire state of China's economy. 

As expected, the Q4 GDP release showed another quarter in which the GDP deflator fell, the longest slide since the Asian Financial Crisis. It declined by an average of 1.4% in Q2-Q4 last year, compared with 1.3% in 1998-99 when it fell for seven straight quarters.

In the mid-to-late 1990s China had to deal with a serious debt problem, much like now. But then it was on the cusp of entry into the World Trade Organisation, and the subsequent exploding growth helped the debt shrink away rapidly.

This time around, China is in the midst of the Great Decoupling, with foreign capital pulling out of the country, US tech restrictions impeding China's technological development and Chinese exports and capital not welcome in the West anymore. 

Deflation is set to persist this year and strong growth is unlikely to help shrink China's bad debt away. 

Premier Li also praised the government for not having sought "short-term growth while accumulating long-term risk." True, just throwing money at the economy without structural change would not have been beneficial. But while China has been transforming the production side of its economy, it has neglected the demand side. The leadership in Beijing seems incapable of instituting the structural changes that would help it fuel a consumer-led recovery. 

Instead, Beijing appears more amenable now to a credit-fueled stimulus, although this is unlikely to yield the results it hopes to achieve. Both fiscal and monetary support are on the cards. 

Policymakers are mulling over the issuance of another Rmb1trn tranche of "special treasury bonds", likely in the second half of this year. These bonds sit outside of the normal budget, but we also expect this year's fiscal deficit ratio to be raised as well. 

In "China Issues New Financing for Old Debts" we wrote that Enodo "expects more tolerance for debt financing in the coming fiscal year". We also explained that the extra Rmb1trn treasury bonds approved in Q4 last year after the authorities' unusual mid-year increase in the budget deficit target would be managed under the category of "special treasury bonds". 

China has only issued "special treasury bonds" on two occasions before Covid: in 1998 and in 2007. Since then it has in essence done so two times, and now likely a third, underscoring the severity of the economic situation. (The 2017 and 2022 issuance were to refinance the bonds issued in 2007.)

More monetary policy easing is also on the way as indicated by a change in the wording of the central bank's monetary targets. 

At its annual work conference earlier this month, the PBoC vowed to promote the"scale of total social financing (TSF) and money supply (M2) to match the expected  goals of economic growth and price level". In the past, the policy wording moved from M2 growth targets, to M2 and TSF growth targets, to matching the growth of M2 and TSF to nominal GDP growth since 2019.

The inclusion of a price level goal in the policy guidance for the first time shows that the authorities acknowledge the urgency of tackling deflationary pressures. 

The new language also implies that the PBoC is keen to lower real borrowing costs. 

We expect cuts not only in the banks' reserve requirement ratio in order to facilitate the their bad debt-clean-up, but also more declines across the alphabet soup of China's multitude of rates in order to boost feeble credit demand. We intend to do more digging here in order to understand fully the implications of this change.

Conclusion

Chinese officials are likely to fall back on the solution they know best: credit-fueled stimulus, to help create the growth that is so important to attracting investors. But this model for growth only doubles-down on the issues that have dogged the economy for years: overcapacity, low returns on investment and ballooning debt.

Meanwhile, Beijing has proven far less adept at stimulating more demand from its 1.4bn people, the true engine of growth for the vast country.

Enodo Economics expects deflationary pressures to continue, affecting not just China but its trading partners in 2024.