Why China is flirting with deflation as the west battles rising prices


While central banks in developed countries wrestle with stubbornly high inflation, China has the opposite problem — the world’s second-largest economy is flirting with deflation.

Beijing revealed this week that consumer prices were flat in June compared with a year earlier while producer prices plunged at the fastest pace since 2016. That compares with a US inflation rate that hit 9.1 per cent in June last year and was at 3 per cent last month despite multiple interest rate increases by the Federal Reserve. Even Japan, once almost a byword for deflation, boasted a relatively racy inflation figure of 3.2 per cent in May. 

Developed economies were hit particularly hard by soaring energy and food prices as Russia launched its full-scale invasion of Ukraine last year, but price controls on energy in China shielded it from the worst of those fluctuations. Instead, the country is at risk of deflation because of low consumer demand and private investment as the economy emerges from draconian zero-Covid controls, economists said.

With China poised to unveil its second-quarter gross domestic product figures on Monday, economists will be closely watching for clues about the underlying health of the economy and what policymakers might do to keep the country’s post-Covid recovery on track.

“The main point is that . . . domestic demand is really weak and that explains the very negative sentiment,” said Alicia Garcia Herrero, chief Asia-Pacific economist at Natixis.

Why is China bucking the global inflationary trend?

China was the last large economy to fully emerge from the pandemic, throwing off its Covid-19 controls in December last year.

Like other countries, China sought to counter the pandemic’s negative economic effects by keeping monetary and fiscal policy accommodative. In 2020, the government issued bonds worth Rmb1tn ($140bn), ran a fiscal deficit of 3.6 per cent of GDP and cut policy interest rates by 30 basis points. In 2022, it channelled another Rmb1.4tn in “quasi-fiscal funding” through state banks, according to Citi research. It also allowed greater local government bond issuances and cut rates by another 20bp.

Beijing’s fiscal stimulus, however, was mostly channelled to areas such as infrastructure spending and businesses in the form of tax reductions, cuts to compulsory social security payments on salaries and other measures aimed at preventing job losses.

The US, by contrast, launched a much grander fiscal and monetary stimulus plan, with American consumers receiving part of the bounty in direct payments and jobless benefits.

The US and other western countries also suffered supply-side constraints as people left the workforce and supply chains were disrupted. In China, the world’s factory, there were fewer supply chain problems. Chinese citizens were locked up for longer in their homes and businesses closed, leading to greater unemployment and deep damage to household balance sheets. The property collapse also hit commodity prices, reducing producer price inflation.

At the same time, many local governments emerged from the pandemic drowning in debt. The private sector was left with overcapacity and, sensing the weak consumer demand, an unwillingness to invest.

“China is on the brink of a self-fulfilling ‘confidence trap’ as the initial reopening impulse starts to fade,” Citi analysts wrote in a recent note.

What could deflation mean for China?

The danger for policymakers is if the deflationary trend becomes entrenched in consumer and business expectations, analysts said. Companies will further hold back investment as profits dry up while consumers will spend less as they worry about their job security and further falls in property prices.

There is evidence that the property sector, after stabilising early in the year, is again on a downward track. Transaction volume by floor space contracted 19.2 per cent year on year in June from a decline of 3.5 per cent in May, Nomura said based on a sample of 330 cities covered by the data service Wind.

Economists warned of further potential weakness in consumer prices. Even though China’s headline inflation rate was flat in June, core inflation — which strips out volatile food and energy prices — declined 0.1 per cent compared with a month earlier, “which could point to a loss of momentum in the consumption recovery”, HSBC said. Food prices also remain volatile: falling pork prices, for instance, affected consumer prices in June as strong supply met weak demand. 

While inflation is expected to rise slightly in the coming months because of a low base effect, many analysts said the government needed to step in with more support for the economy to anchor expectations.

“Further policy easing on housing and infrastructure, which could arrive in the coming weeks, will be crucial to stabilise aggregate demand,” Morgan Stanley analysts wrote in a research note.

What help is on the way?

Almost on cue after the release of weak consumer price data this week, the government extended a package of credit-related measures for developers aimed at arresting the fall in housing prices.

The government has already reduced policy interest rates by 10bp this year, and many expect further cuts in the third quarter to sustain credit growth. Analysts are awaiting a meeting of the Communist party’s ruling body, the politburo, this month and expect more measures.

Most of them anticipated any support to be more incremental — Beijing lacks the fiscal room and perhaps the inclination to launch the “bazooka” stimulus packages of the past. But there is a consensus even among some former government officials that more needs to be done.

Former finance minister Lou Jiwei said the government should expand this year’s fiscal deficit by Rmb1.5tn-Rmb2tn in order to provide subsidies to small and medium-sized enterprises. The measures, along with the removal of restrictions related to mortgages and homebuying, were needed “to bring economic recovery back on a more solid track”, state media quoted him as saying.

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