China may see mild deflation as its credit bubble deflates and money supply growth slows

In the years since the Global Financial Crisis (GFC), China experienced an exceptional credit surge in three waves, raising many eyebrows over the resulting credit bubble. However, in the past year, this surge has slowed down substantially. As China’s credit bubble deflates, it is likely that China will experience mild deflation in coming two years.

Sep 26, 2017 | John Greenwood

The first two waves
The first credit bubble following the GFC was after the Chinese authorities announced a CNY 4 trillion “fiscal stimulus” program in November 2008, increasing the quantity of credit in the economy massively and financing the program through the banking system. This led to a 25% rate of growth of bank credit and M2 (money supply) over the period from January 2009 to July 2010.

Following this initial increase, there was a second wave of credit expansion when Chinese companies shifted from domestic borrowing to foreign borrowing from 2010 to 2014. Taking advantage of the low borrowing cost of foreign currencies and investing the proceeds in steadily appreciating RMB (renminbi), Chinese companies gradually increased their foreign currency debt until it peaked at US$677 billion in 2014 Q2. This was a classic carry-trade: to take advantage of the appreciating RMB between June 2010 and mid-2014 by borrowing low yielding US dollar or Hong Kong dollar and holding the proceeds in appreciating and higher yielding CNY (onshore RMB) or CNH (offshore RMB). At the same time nonmainland residents and foreign companies took advantage of the appreciating RMB to rapidly increase their holdings of RMB deposits in 2010-11 and 2013-14 until the RMB peaked in 2014 when the value of foreign-held deposits also topped out at US$503 billion.

However, after the RMB peaked in 2014 and started depreciating, it no longer made sense to continue to finance such borrowing with appreciating foreign currencies. Foreign currency borrowing fell to US$299 billion in 2016 Q1 as Chinese entities repaid US dollars and other credit borrowed from abroad, and the offshore RMB (CNH) market shrank significantly as foreign RMB deposits also declined to US$363 billion in 2017 Q1.

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