William Pesek Jr.

Anyone notice how quickly "overheating" has been dropped from investors' China lexicon? In the annals of word-disappearance cases, it merits a mention.

"Not long ago, overheating was all anyone could talk about," says John Chan, managing consultant at Shanghai-based China Streetsmart Inc. "Now, fears of China getting too hot rarely come up."

Give credit where it's due: Chinese officials seem to be pulling off an orderly deflating of their nation's economic bubble. Along with this year's deftly handled 2.1 percent revaluation of the yuan, the feat suggests leaders in Beijing know what they are doing.

The risk is that China may be flirting with the opposite of overheating: deflation.

Sound like a reach? Not to economists such as Andy Xie of Morgan Stanley. He's eyeing a scenario in which Asia's No. 2 economy experiences falling prices as soon as next year. The reason: overcapacity. China is still producing too much cement, aluminum, textiles and other goods. It's also constructing too many factories, buildings and resorts.

Deflation Looms

Officials in Beijing have used administrative measures to reduce overinvestment. Doing it slowly to achieve a soft landing means capacity growth remains high, causing an oversupply even when China's annual growth of more than 9 percent slows.

Cutting interest rates may even worsen deflationary pressure by encouraging capacity growth regardless of corporate profitability. As Hong Kong-based Xie explains, "plentiful liquidity keeps interest rates low and, hence, sustains the on- going investment projects and funds new investments in bottleneck areas."

Pushing China toward deflation is a high savings rate. While Americans save too little, Chinese save too much. It's structural in nature, with roots in the baby boom of the 1950s and 1960s and the baby bust in the 1980s and 1990s.

China needs to get consumers to spend more. To do that, Xie argues the government should privatize state-owned assets, shift fiscal expenditures away from investment and modernize pension, health-care and education systems.

Oversupply

The specter of falling Chinese prices runs counter to most views of the world's sexiest economy. China ended five years of deflation in 2004 by stimulating investments in real estate, automobile manufacturing, power generation and elsewhere. And it worked; inflation climbed as high as 2.3 percent in the first six months of 2005.

"We can't go on stimulating the economy this way as this method will inevitably lead to oversupply, which in turn will take us back to deflation," says Justin Yifu Lin, a Beijing- based professor at Peking University and a government adviser. Lin thinks China could slip back into deflation by the end of the year or early 2006.

All this could have important economic implications. For one thing, it suggests Chinese currency revaluations may be smaller than investors and the Bush administration would like. Deflationary pressures and a weaker Japanese yen may leave Beijing even more reluctant to let the yuan rise.

"A common figure cited for another move, 20 to 25 percent, would be devastating to China," Robert Mundell, a Columbia University economics professor who won the Nobel prize in 1999, said in Busan, South Korea recently. "It would cause deflation, cut economic growth, cut off foreign direct investment and would destabilize Asia."

Commodity Impact

Economists on the ground in Shanghai such as Stephen Green of Standard Chartered Bank say Chinese officials are concerned that a rising yuan "might derail economic growth."

For another, it means China's trade surplus may increase even more as Chinese companies seek to increase exports. Also, a shift toward deflation might cool global commodity markets.

The steel industry, Xie says, "is facing serious overcapacity. Iron prices are strong as long as the steels keep producing. When some are forced to close down due to low prices, iron prices could decline."

Deflation is hardly a universal prediction. In a report earlier this month, strategists at Bank of America downplayed the risk. While the rate of inflation has been slowing, other barometers of price and money suggest the slide won't continue, they said.

No Crisis

Would Chinese deflation be a crisis? Not necessarily, so long as it doesn't get out of control. Besides, such a trend wouldn't be the cause of China's problems, but a symptom of its failure to create a healthy consumer market.

There is, of course, a nightmare scenario. In it, investment in China plunges, exposing huge industrial overcapacity. Consumption collapses as workers lose jobs. Trade frictions worsen with the U.S. as Chinese companies scramble to export more. China's central bank is unable to restore confidence among consumers, executives and investors.

Or the opposite might happen: deflation compels China to upgrade its economy, improving the business environment and increasing government efficiency. In other words, deflation drives positive change, much as it has in Japan.

Risks emanating from China haven't gone away, though they might be more about falling prices than rising ones. And that would have consequences far beyond China's borders.

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