Deflation, a prolonged decline in the price of products, is flowing like a draught of cold air from Asia’s powerhouse economies and casting a chill over Japan and Europe, while also endangering US efforts to sustain a recovery.

Although aggregate falling prices may sound benign for consumers, they are in fact feared by economic policymakers because they erode corporate profits and force companies to cut jobs, sapping overall demand. Deflation was blamed for turning the 1929 US stock market crash into the Great Depression.

The evidence of a deepening deflationary spiral in Asia — sparked by manufacturing overcapacity, an evaporation of trade demand and anaemic productivity — is a major cause for concern. Just as the EU and Japan are slipping back into deflation while the US is struggling with weak corporate earnings, makes Asia’s falling prices a pivotal issue.

“There is a chance that we are moving towards global deflation,” says Alberto Gallo, head of European macro credit research at RBS, the bank. “We have overleveraged everywhere and, instead of reducing capacity, we are creating a prolonged state of industrial overcapacity that is driving down prices. China is the biggest example.”

The threat of a worldwide slide into deflation also worries Michael Power, strategist at Investec, an asset management company. He sees declining prices as the result of a fundamental imbalance between an excess of supply from Asia and a dearth of demand from the west. “In economic terms, prices are falling because the co-ordinated supply out of Asia is overwhelming the west’s best efforts to pump up demand via the likes of QE,” Mr Power says.

The nightmare deflationary scenario is that falling prices in Asia continue to cut corporate profits, prompting mass redundancies and reducing consumer demand. The drag that this imposes on global demand may then intensify, depressing feeble economic growth in Europe and Japan and damping dynamism in the US. Aspects of this scenario are already in place.

Key to Asia’s problem is the particular type of deflation that it is afflicted by. The issue is not with consumer prices; these are still buoyant in most of the region’s shops. Instead, it lies with producer prices — the amount that factories, mines, farms and other producers can charge for the commodities or manufactured products and components that they sell.

Weakening currency values against the dollar are failing to boost export performance. They are nevertheless driving down demand for imports, thus worsening the deflationary trend

The producer price index is at its lowest average point for six years in the 10 largest economies in Asia (excluding Japan), according to Morgan Stanley. Only Indonesia among the 10 is experiencing any producer price inflation, while South Korea, Taiwan and Singapore have been in a deflationary funk for around three years.

China has notched up 42 straight months of falling producer prices, making it the only large economy other than Japan in the 1990s to show such a persistent deflationary trend, according to Chetan Ahya, chief Asia economist at Morgan Stanley.

Overall, China’s producer prices are down a cumulative 10.8pc from their recent peak in 2011. The speed at which prices are dropping is a cause for alarm. As recently as August last year, the producer price index for commodities was showing only a 1.1pc drop; this August the decline was 12.8pc. Even a country such as India, with an otherwise robust economy, has slipped into producer price deflation over the past year.

Nor is Asia’s deflation solely the result of the global slide in commodity prices. Pernicious effects are also evident from the decline in the price of manufactured products and components, which fell on average by 4.4pc year on year in August in the region’s 10 leading economies (excluding Japan).

Chinese industrial companies suffered an 8.8pc year-on-year decline in their profits in August, the largest drop since records began in 2011. Elsewhere in Asia, the trend is repeated, with both sales and earnings for the region’s top listed companies declining in the second quarter of the year, according to Morgan Stanley. There have been a small but significant number of defaults on foreign currency bonds by emerging market borrowers this year — 16 in the first eight months, more than in all of 2014, according to Standard & Poor’s.

The drop in earnings across Asia is particularly serious with a huge overhang of corporate debt raising risks of a ‘balance sheet recession’, in which high debt service charges force companies to focus on saving rather than spending or investing, thus slowing growth.

Andrew Polk, senior economist at the Conference Board in Beijing, sees such a recession under way in China, especially among small producers.

The Institute of International Finance (IIF), an industry association, says that Asia — and in particular, China — has taken the lion’s share in a fivefold debt increase at non-financial corporations in emerging markets over the past decade. The total, it estimates, now stands at $23.7tn or 90pc of total emerging market gross domestic product.

“The speed in the build-up of debt has been staggering,” says Hung Tran, the IIF’s executive managing director. The impact of this burden allied to the deflationary spiral, which depresses returns on corporate investments, has exacerbated a net outflow of capital from emerging markets that the IIF estimates is likely to reach $540bn this year — the first time that net flows have been negative since emerging markets evolved as a concept in the late 1980s. Falling producer prices are diminishing corporate returns while debt repayments subtract from profits.

“Emerging markets should prepare for an increase in corporate failures,” said the IMF in its latest semi-annual Global Financial Stability report.

Classic theories of deflation, including that espoused in the so-called Bernanke doctrine, state that falling producer prices result from a collapse in aggregate demand. This leads, as Mr Bernanke said in 2002, to “a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers”.

However, in the case of Asia’s deflation at least, it appears likely that it is an excess of supply rather than insufficient demand that is the prime factor depressing producer prices.

If this is the case, then endless bouts of QE — or ‘QE infinity’ as Mr Gallo describes it — may be exacerbating rather than alleviating the problem of deflation by acting to prolong oversupply through providing cheap credit to companies.

“By itself, ‘QE infinity’ could be deflationary in the long run because it means that the issue of overcapacity is not resolved but dragged forward,” says Mr Gallo. “This could in turn result in both prolonged deflation and asset price bubbles at the same time.”

Mr Power points to crumbling barriers to entry in Asia’s manufacturing sector — driven by government incentives — as a reason for the persistent oversupply of products.

This ‘supply tsunami’, as Mr Power describes it, is crashing up against an Asian trade recession. Exports in the region have posted their worst performance since the 2008/09 crisis, falling 7.7pc in July to register a ninth consecutive month of year-on-year declines in dollar terms, according to data compiled by Capital Economics, the research firm.

Weakening currency values against the dollar are failing to boost export performance — as would normally be expected — but they are nevertheless driving down demand for imports, thus worsening the deflationary trend. A Financial Times study found that import volumes fell by an average of 0.5pc for every 1pc a currency depreciated against the dollar.

It is hard to see a silver lining at this stage of Asia’s deflationary period, with overcapacity still chronic, trade demand weakening, productivity anaemic and the global economy in poor shape.

Published in Dawn, Business & Finance weekly, October 12th, 2015

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