China risks a debt deflation loop but could avoid a lost decade if it plays its cards right, Morgan Stanley says

China's economy fell into deflation the past quarter, and falling prices could get worse, Morgan Stanley said.

REUTERS/Kim Kyung-Hoon

• China's economy is at risk of falling into a debt-deflation loop, according to Morgan Stanley.
• That's a scenario where prices fall, debt rises, while economic growth stagnates.
• But policymakers could avoid that future if they keep interest rates below a key level.

China is potentially at risk of an economic catastrophe – but that could be avoided with the right policy moves, according to Morgan Stanley.

 In a recent podcast, the bank's chief Asia economist, Chetan Ahya, pointed to growing fears that China's economy could be headed toward the same outcome as Japan in the 1990s, with the nation being slammed by a decade of sluggish growth. That's because China is facing similar problems as Japan did several decades ago – but the nation could avoid falling down the same path so long as it makes the right policy decisions.

"China's policymakers will need to act forcefully. If they don't, the economy could fall into a debt deflation loop," Ahya warned, referring to a scenario where prices keep falling and debt keeps rising, while economic growth stagnates over the long term. 

Avoiding that future likely means China will have to keep real interest rates around two percentage points below real GDP growth, Ahya said, as that will keep the economy growing faster than the interest accrued on its debt. The Bank of Japan, by comparison, failed to keep interest rates low enough in the 90s, which caused debt burdens to spiral and helped push its economy into stagnation. 

China's real interest rates are already below the real GDP growth rate, with the central bankers slashing rates again last week after batch of weak economic data in July. But once the economy starts to recover, policymakers tend to return to hawkish monetary policy prematurely, Ahya said, which is one of the risks that still lies ahead for the country.

"While China's real interest rates are below real GDP growth currently, we still see the risk that policymakers will not take up reflationary policies to sustain the rates minus growth gap, which keeps the risk of China falling into the debt deflation loop alive," he added.

Experts have been sounding the alarm on China's economy for months, with the nation posting a so-far disappointing economic recovery since coming out of its pandemic lockdowns. Since lifting COVID-19 restrictions, demand has struggled to pick up, causing prices to slip into deflation last quarter for the first time in two years. 

The country is also being weighed down by a boatload of distressed real estate debt, as well as an aging population, which could hurt future productivity. That trifecta of obstacles means it could be possible that China's economy could do even worse than Japan did in the 90s, according to Nobel laureate Paul Krugman.

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