What’s causing China’s deflation crisis?

China’s economy is teetering on the brink of a deflation crisis as its recovery from the pandemic stalls.

In stark contrast to much of the rest of the world, where rocketing inflation has driven up central bank rates, China’s Consumer Price Inflation (CPI) fell to zero in the year to June, down 5.4% compared with the same period 12 months ago. Factory gate prices also fell at the fastest pace since 2016 as demand for products slowed, signalling consumer prices may soon go into reverse.

“Inflation is painful” said Fortune, and it robs the whole of society – from postal workers to Wall Street bankers – while often impacting the most vulnerable. But deflation – where prices fall instead of rise – “might be even worse”, argued the magazine. “While falling prices can sound appealing, deflationary environments are terrible for growth.”

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What did the papers say?

The Chinese economy is “struggling under the weight of several challenges”, said Quartz. Hopes for a quick recovery from draconian zero-Covid restrictions have been “dashed”, said the news site, while interest rate hikes by central banks worldwide have “crimped consumer demand, weighing on Chinese exporters”. Tensions between Beijing and Washington have also affected activity, leading Western companies to increasingly shift investment away from China.

Domestically, efforts to boost consumer spending have proved insufficient, youth unemployment is at a record high, and the property market – long the driver of the Chinese economy – has entered a protracted slump.

A temporary period of deflation is “good news for households because it raises consumer buying power and helps keep interest rates down”, said The Telegraph. However, warned the paper, prolonged periods of falling prices “can suck economies into a low-growth trap where pay stagnates and companies are forced to cut jobs to cope with stagnating demand”.

Some believe the period of deflation will be relatively short-lived. Wang Qing, the chief macroeconomic analyst at Golden Credit Rating International, told Chinese news outlet The Paper that consumer inflation is expected to hit 2% by year-end, and “the risk of prolonged inflation is not high”.

Others are not sure. Low inflation and lacklustre growth mean analysts are now “sceptical” that Beijing will hit its economic growth target of “around 5%” for 2023, The Telegraph reported. The economy grew by just 3% in 2022: “one of the weakest rates in the country’s modern history”, said the paper.

“The pressure is on for the central government to steer the economy away from a deflationary spiral, which would sap growth and is often difficult to escape,” said Quartz.

What next?

Analysts cited by the Financial Times (FT) said they expected China’s central bank, the People’s Bank of China (PBoC), to reduce interest rates again, “adding to a round of cuts last month that many believe Beijing will have to supplement with fiscal stimulus policies”.

Further rate cuts could be supplemented by cutting banks’ reserve requirement ratio later this year. This would “release liquidity from the banking system as part of efforts to prop up the economy”, said the South China Morning Post.

Authorities have so far been reluctant to go further and turn on the “fiscal fire hose”, said Quartz over fears it will add to China’s already high debt-to-GDP levels.

Heron Lim at Moody’s Analytics said few were expecting a “bazooka”-style stimulus. “Despite the fact the economy is quite near deflation, it doesn’t look like the PBoC is looking at monetary stimulus of the kind the US Fed or European Central Bank would be doing”, he said in the FT.

But if the economy needs more of a push, “the central government will have to engineer it”, said The Economist.

The FT said Chinese economists are “urging the government to shift from its traditional form of stimulus – investing in big-ticket infrastructure projects – to targeting consumers”.

Unfortunately, according to The Economist, China’s fiscal authorities still seem to view such hand-outs as “frivolous or profligate”. If the government is going to spend or lend, “it wants to create a durable asset for its trouble”, said the magazine, which in practice, means any fiscal push is likely to entail more investment in green infrastructure, transport and other public assets favoured in China’s five-year plan.

“That would be an utterly unsurprising response to China’s year of surprises,” said The Economist.