By Simon Bond

We have been banging on about deflation for longer than I care to remember. Interest rates are going lower (and staying lower for longer) there are impacts of technology on the inflation rate, the internet is the biggest deflationary force the world has ever seen, etc. Yes I know you’re sick of it too. Well it seems that now every time you turn on the television, read about markets on the internet, read a paper, or turn on the radio, all you hear is radio gaga. Freddie Mercury would be horrified. God rest his soul.

What I mean by this is now everyone's talking about deflation, you just can't get away from it. Everywhere you turn, deflation this, deflation that. So much so that I have grown very bored with their ‘me too’, copycat stuff. Do your own homework I say, stop looking at ours and copying across the desk. So I've decided to stop, to go the other way, to call the curtain down on these pessimistic poochers. Enough is enough.

So what now? Undoubtedly our mantra that "the millennials are just not buying what the boomers are selling" is still intact, and will remain so. But to be clear, the great transition is on. We have recently seen a watershed moment from the Chinese in Beijing’s decision to depart from using monetary stimulus toward an embrace of fiscal policies and a shift to supply-side structural reform. This is profound.

Recently, a very important article was published on the front page of the Communist Party’s mouthpiece, People’s Daily (May 9th issue), which was essentially an interview between the newspaper and an unnamed “authoritative figure” (believed to be Liu He, Vice Chairman of the National Development and Reform Commission [NDRC] and the chief of the General Office serving the Leading Group for Financial and Economic Affairs).

As President Xi once told news reporters, Liu is “very important” to him. In the 1960s, Liu and Xi went to the same high school and they became friends afterward. Liu is reportedly the “prime architect” of Xi’s economic plan and is sometimes dubbed by the western media as “China’s Larry Summers”, whom I personally believe is far ahead in his thinking than most.

The interview notes most likely were reviewed and approved by President Xi before appearing in People’s Daily. It represents a sea change in Beijing’s handling of the economy and although it garnered immense interest in Hong Kong, it amazingly received almost no attention in the West – people are obviously way too busy watching Donald Trump insult someone for television ratings.

Suffice to say, it represents one of the most important policy shifts in modern Chinese history. Beijing’s policy shift confirms the view that worldwide confidence in central banks is waning, as evidenced by the BOJ’s inability to weaken the yen, and that fiscal policy is going to be increasingly used as a lever for growth. Once again, China is leading the world in a major policy shift, as it did with its anti-corruption campaign in the Autumn of 2012 and efforts to lessen income and wealth inequality, which began in June 2009 and later spread to the rest of the world.

Beijing has prepared itself for an “L-shaped” recovery, implying that China’s GDP growth is likely to stay around 6%, or perhaps somewhat lower for several years at least, as they transition the economy to more consumption and services based. Just watch the growth in Chinese technology companies and the internet services economy.

“Comprehensively, China’s economic trend will be ‘L-shaped’, rather than ‘U-shaped’, and definitely not ‘V-shaped’. The ‘L-shaped’ economic trend will last for some time and will not end in a year or two. China is taking ‘one step back’ in order to take ‘two steps forward’. China has enough potential, great tenacity and lots of manoeuvring room. There won’t be a drastic decline in growth rates even in the absence of major economic stimulus.”

Supply-side structural reforms are being emphasised. “The central government has said that supply-side structural reform is China’s top-priority task for now and for the years to come. Worldwide, more and more countries have come to the realisation that structural reform is the fundamental solution to get out of their respective troubles. At the same time, local governments have also been taking proactive actions. Some provinces — such as Guangdong, Chongqing, Jiangsu, Zhejiang and Shanxi have released their supply-side structural reform plans. Many companies have taken substantial steps to rein-in capacity expansion.” Beijing is well attuned to the risks of excess leverage in promoting asset bubbles, and wants to avoid this outcome.

It is particularly interesting that the interview devoted several passages to the risks of excess leverage in the economy, which addresses one of the persistent risks that China watchers have cited. The following passage stands out; "As trees cannot grow to the sky, high leverage will inevitably result in high risk". If not handled well, high leverage will trigger a systemic financial crisis, resulting in negative economic growth and even wiping out household savings. It is neither possible, nor necessary, to stimulate growth by adding leverage.

The government will also spend more money on bolstering its basic social safety net, as well as training and education for laid-off workers in industries with excess capacity (unlike the U.S.). There was a noteworthy emphasis not just on shutting excess capacity, but on enabling a transition to other jobs for the many workers to be affected: “We should protect jobs instead of enterprises. We should set job/personnel relocation as the top priority when closing ‘zombie companies’ and shutting overcapacity. We should provide training for workers and transfer workers to suitable positions. For those who are laid-off and are unable to find new jobs, we should ensure that their basic needs are met.”

The government has decided not to use financial markets and hard assets (i.e. stocks, currencies, bonds, properties, etc.) as tools to bolster economic growth. Beijing has made it clear via this interview that it is leaving the markets to themselves, with minimal interference from the government. This stands in sharp contrast to what is happening in many other places, most notably the U.S., Europe and Japan, where government manipulation rules the day. We also learned that China is preparing for a rising tide of protectionism coming from the U.S. and E.U.

Just a few days ago, the European Parliament passed a resolution not to recognise China’s market economy status (MES), which came as no surprise to Beijing.

Several points are worth adding to put the article in proper perspective. First, the notion of supply-side reform has a different meaning in China as opposed to the U.S. It does not imply Reagan style tax cuts, but rather, cutting excess capacity while letting demand catch-up to reduced supply. This is important because it is excess capacity caused by mal-investment, largely by State-Owned Enterprises (SOEs) that has been responsible for much of the global deflationary pressure of the last two years. Hence, my change in stance.

Second, SOE reform has been talked about for years but never happened, largely because local governments did not listen to Beijing and feared the consequences of social unrest from layoffs due to shuttered plants. Beijing is now saying that local governments need to listen and follow its instructions, otherwise local government officials might lose their jobs.

Third, the coming round of reforms will have a much-improved safety-net, i.e., subsidies for laid-off workers and re-education and re-training programs — a very different scenario from the U.S., where laid-off workers were not able to replace their income. In this case, China learned from America’s mistakes, and those mistakes have caused the widespread feelings of anger in American society that presidential candidates, Donald Trump and Bernie Sanders, have been able to exploit.

And I believe them. You should too.