Today's Business News
August 19, 1999

Fearing Deflation, China Orders a Ban on New Factories

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    BEIJING -- In a drastic move aimed at reversing a steady fall in prices, Chinese officials announced Wednesday that they would ban construction of any new factories that make a broad range of ordinary consumer items, from refrigerators and air conditioners to candy, apple juice and liquor.

    The ban also covers the construction of luxury hotels, apartment and office buildings, and department stores, which have also suffered sharp falls in prices for many months as the market has become glutted. In some Chinese cities, these buildings sit empty or barely used.

    By withholding approval for any new production lines, while allowing existing output to continue, officials apparently hope they can shackle China's deflation, a self-perpetuating spiral of falling prices and falling demand that has become a serious new economic threat in Asia's biggest country, where growth has started to falter.

    China's economic troubles are compounding just as modest revivals are happening elsewhere in Asia, where a severe financial crisis flared two years ago and sent shudders through markets around the world.

    Prices of consumer goods in China have fallen for 22 months in a row. While that is good news for Chinese consumers, fewer and fewer of them are buying. Instead deflation is causing many factory stockpiles to overflow, and forcing producers to suspend their output, even though most are required to keep paying the same number of workers.

    Deflation also is prompting price wars among many producers, a new phenomenon for Chinese officials that they find unsettling.

    "Producers have resorted to malicious competition by slashing prices drastically for survival," was how the official New China News Agency put it Wednesday as it announced the ban, which begins Sept. 1. How long the ban would last was not announced, and it was unclear if the ban was aimed at industries that produce goods for domestic consumption.

    It also was unclear how effectively the ban will be enforced. Although it applies to producers of consumers goods all over the country, such central directives are often quietly ignored.

    Still, economists expressed concern that the ban includes hidden dangers that could actually worsen the deflation problem.

    Nicholas Lardy, a senior fellow at the Brookings Institution in Washington who specializes in China, said the ban could aggravate the situation by forcing cutbacks in construction jobs.

    "It could mean less employment and more deflation," he said. "With fewer people working, demand will go down."

    In many industries, state regulators have imposed minimum prices to try to prevent producers from undercutting each other with price slashing. Meantime, financial authorities have authorized several interest rate reductions to spur consumption by lowering the cost of borrowing. But the success of that effort has been limited.

    Weak demand for consumer goods has grown out of a serious deterioration in consumer confidence. Many ordinary consumers fear that the economy will continue to weaken, and that it may lead to job losses and a reduction of welfare benefits, including pensions. So instead of spending their money they are saving it.

    Some Chinese economists have gently begun recommending that Beijing consider a devaluation of China's currency, the yuan. That would theoretically help stem deflation by raising the cost of imports and would stimulate the economy by raising foreign demand for China's exports, which have been falling. But a devaluation could have destabilizing effects in China and elsewhere in Asia by unnerving foreign investors and raising the cost to China of repaying foreign loans. It appears that the authorities remain unwilling to devalue the yuan for the time being, at least until they see if falling exports and prices can be controlled.

    "The yuan is unlikely to be devalued this year and early next year," Joe Lo, senior economist at Citibank in Hong Kong, told Reuters. "A devaluation can be an option if exports continue performing poorly and the economy is not improving after exhausting other measures."

    China's trade surplus in the first half of 1999 reached $8 billion, down from $22.5 billion a year earlier. Exports in the first half fell 4.6 percent while imports surged 16.6 percent. At the same time, foreign direct investment declined 9.2 percent to $18.6 billion.

    Government economists have said that if Beijing does decide to devalue its currency, it is likely to orchestrate a gradual process in several steps, unlike the last time it devalued in 1994, by 33 percent, in one step.

    For China's leaders, long afraid of inflation and the potential social disruption it could cause, deflation is a new phenomenon that few took seriously until recently. But it has continued for much longer than anyone expected, and now threatens to seriously undercut government projections that economic growth will reach 7 percent this year, compared with 7.8 per cent in 1998.

    "China doesn't need a cheaper currency," wrote Gilbert Choy, head of China research at Dresdner Kleinwort Benson Securities (Asia), in a recent report. "Chinese exports continue to gain market share in their major overseas markets. More important, the growth of exports is roughly in sync with the recovery of China's neighbors."

    Choy argues that because a substantial percentage of China's exports involve processing of imported materials, even a substantial devaluation is unlikely to strengthen exports by much.

    "The real solution is to have the central bank, the People's Bank of China, print money," Choy wrote. "The best way to give the economy a boost is to inject a massive dosage of wealth effect, changing the psychology of consumers to expect a rise in permanent income."

    Other economists recommend that Beijing continue to expand its issuing of treasury bonds to finance the setting up of a social safety net, including a nationwide social security system and a national medical insurance plan.

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