How bad is the macro situation in China?

It’s a crucial question. For China, yes, but for the whole world too, and not just because China was a global economic linchpin in too many respects to quickly enumerate.

The Party derives much of its legitimacy from the continual improvement in the overall quality of life for the Chinese people. It’s not exactly “consent of the governed,” but the populace tolerates one-party authoritarianism in part because standards of living have steadily improved.

Recall the chart below from August’s Monthly Letter. In 1980, nearly everyone in China (more than nine in 10 Chinese) lived in extreme poverty. As of 1990, that share was still tragically high, at almost three quarters, but over the last two decades, extreme poverty in China virtually disappeared, falling from 46% when the country entered the WTO to less than 1% today.

If the Chinese economy stops delivering for everyday people and domestic discontent grows, it’s not clear how far the Party might go (or what means they may resort to) in an effort to tamp down domestic dissent or deflect. In other words: The economic situation in China is a macro concern, but it’s a geopolitical concern too.

With that in mind, Morgan Stanley on Monday noted that while the monthly YoY CPI prints make headlines (China’s recorded three consecutive negative prints, the longest stretch since 2009), it’s the deflator that matters most, and not just because it’s flattering the GDP numbers.

“The GDP deflator for China has been in outright deflation, and we are now tracking a mere 0.1% for 2024 as a whole,” strategists and analysts led by Seth Carpenter wrote, calling the deflator a “better measure than consumer prices because consumption is a smaller share of GDP in China than most other economies and this deflator is more closely tied to corporate earnings at all stages of production.” As the figure below shows, we’re witnessing the longest stretch of deflation in China in decades.

Morgan Stanley went on to cite a “soft start to 2024” as evidenced by a variety of leading indicators and noted that the deflator is “now tracking a mere 0.1% for 2024 as a whole.”

I’ve argued, repeatedly, that China needs fiscal measures, not monetary tinkering. Last week, when PBoC boss Pan Gongshen pre-announced an RRR cut, I wrote that because the move “works on the credit supply side,” it doesn’t address the problem. Again: China needs fiscal stimulus.

Apropos, Carpenter and co. cautioned that “falling inflation, and particularly deflation, makes monetary policy less effective [and] with the rest of the world slowing and a desire to limit capital outflows, prospects for stimulating the economy by weakening the currency are also much more limited than in the past.”

But there’s a problem on the fiscal side too. As Carpenter wrote, citing the bank’s China team, the “local government funding vehicles [which] have been core to infrastructure spending” are now over-leveraged, which may necessitate “federal intervention to restructure the debt” if Beijing wants to ensure the efficient implementation of fiscal stimulus.

As for the equity plunge protection plan outlined by the media last week, Morgan Stanley seems skeptical. “Such support can only affect stock prices in the near-term and cannot stabilize earnings or stimulate growth,” the bank said.

I assume this is obvious, but the liquidation order for China Evergrande (issued Monday by a Hong Kong court) has the potential to deliver yet another blow to foreign investor sentiment. It’s not clear how the order will be received by Mainland courts. There’s no rule of law to speak of on the Mainland, and that fact is about to be thrown into stark relief.