Can China Avoid Deflation?

BERLIN – In his speech at the 2015 World Economic Forum meeting in Davos, Chinese Premier Li Keqiang acknowledged that China’s economy is facing strong headwinds. Annual GDP growth in 2014 was 7.4%, the lowest rate since 1990. But, to stabilize economic growth, he pledged that China will “continue to pursue a proactive fiscal policy and a prudent monetary policy.”

China’s current economic slowdown was policy-induced. During the last two years, the government has tightened fiscal and monetary policy, in the hope of offsetting the adverse effects of the large stimulus package implemented in response to the 2008 global financial crisis. Li’s Davos speech was intended to signal that the Chinese government will not allow the growth rate to slip further.

China’s stimulus package was by far the world’s largest and most effectively implemented. It stabilized growth in China and moderated the global economic contraction. But it left in its wake some serious problems for the Chinese economy.

Most important, the country’s economy has become highly leveraged. Housing prices shot up, real-estate developers borrowed recklessly, and local governments became heavily indebted. As a result, broad money (M2) increased rapidly, and now stands at more than two times China’s GDP – one of the highest levels in the world.