China risks falling into a vicious cycle of deflation and debt, Morgan Stanley economist says

• China's deflation pressures debt levels higher, which lowers consumer spending, Morgan Stanley's Chetan Ahya said.
• It's a dangerous "loop" that Beijing must break, he wrote in the Financial Times.
• But current policy has been too "hesitant," and needs to focus on stimulating consumption.

Officials in Beijing need to apply a more forceful approach in reversing deflation or risk worsening the problem, Chetan Ahya, Morgan Stanley's chief Asia economist, wrote for the Financial Times. 

While other foreign central banks are dealing with inflationary pressures, China is the only major economy where prices are falling. The country's gross domestic product deflator, which is the broadest measure of prices in a country, has contracted for two consecutive quarters, and now stands at -1.4%, he wrote.

When adjusted for deflation, China's real interest rates are pushed higher, meaning that debtors in the country are facing a higher debt burden. This wears down on corporate revenues and profits, forcing indebted firms to cut back. 

"If deflation continues to eat into these, companies will cut wage growth, creating a vicious 'loop' of even weaker aggregate demand and deflationary pressures," Ahya said.

In fact, the country's high debt environment can explain why it's facing deflation in the first place, he added — as China's indebted governments and property sector started spawning defaults, those affected began focusing on deleveraging their balance sheets.

"When you consider that the combined debt on these balance sheets accounts for about 100 per cent of GDP, it is hardly a surprise that demand and price pressures are as weak as they have been," Ahya said.

To break the loop, Beijing must lift aggregate demand in the country, and bring the GDP deflator to 2%-3% within the next two years. 

So far, current policy has been too "reactive and hesitant," Ahya said. This has included cutting interest rates, and offering stimulus through sovereign bond issuance, but no approach has been sufficient in arresting the headwinds Chinese consumers face.

Beijing is also too reliant on investment, which currently accounts for 42% of GDP. This method of economic reflation — such as by pumping money into China's real estate and infrastructure  —  offers only temporary support, Ahya said. 

Instead, policymakers need to stimulate consumption, such as by spending on education, healthcare, and housing. In doing so, Chinese consumers could be more open to expenditures elsewhere, utilizing their high household savings.

"A concerted shift to rebalance the economy towards consumption or a strong uplift in the global trade cycle appear to be the two key factors that could lead to a faster transition towards more healthy inflation environment," Ahya wrote.