China Deflation: What Lies Ahead in 2023

China Deflation: What Lies Ahead in 2023

Deflation is a broad, ongoing drop in price levels within an economy. China has begun to experience stagnation, while the other major economies are combating stagflation (low growth-high inflation) with monetary tightening and fiscal adjustment.

In July, China announced “deflation“. This has been referred to as a “warning sign for the global economy” by prominent business newspapers in the West. We discuss how this can make monetary policy managers’ jobs more difficult and how it might skew previous accounts of global growth and regional financial stability.

Deflation is a broad, ongoing drop in price levels within an economy. China has begun to experience stagnation, while the other major economies are combating stagflation (low growth-high inflation) with monetary tightening and fiscal adjustment.

Following its strict Covid limits, the second-largest economy in the world first looked to recover quickly, but this has turned out to be untrue. Tepid consumer demand is present. With y-o-y declines of 0.3% and 4.4% in July, key indices—consumer price index (retail) and producer price index (factory gate)—it has slid into the deflationary zone. While PPI has decreased for ten consecutive months, the CPI hasn’t fallen since February 2021. The Chinese economy expanded by 6.3% in Q2 2023 compared to 4.5% in Q1, primarily due to the base effect.

Deflation increases a nation’s public debt, sparks anticipation of additional price declines, which prompts consumers to put off purchases, and causes demand to decline even more. Profits for businesses will suffer, which will result in job losses. All of these prospects and a decline in exports greatly influenced by the issues in the West are already apparent in China.

If nothing is done to stop it, the economy may decline, and the financial system may become unstable. Tax reductions, increased public expenditure, and monetary easing are the traditional economic remedies for deflation—an effective combination of all three. Beijing has so far disproved expectations of any such policy reaction. The central bank, the People’s Bank of China (PBoC), had said that “stability” would be its primary goal in 2023.

China has long been a global export powerhouse; its percentage of the global goods trade only increased from 13% in the year before the epidemic to 14.4% in 2022 because its exports were still expanding quickly relative to other countries. Additionally, it makes up 6.5% of all service exports worldwide. The immediate positive effect of China’s deflation is that its cheaper goods and services may assist in reducing inflation in importing nations.

However, this could quickly become a problem since it will hurt sectors in other nations and force them to reduce investment. Additionally, the world needs help to afford China’s import demand to decline. China is still a voracious consumer of raw materials and an essential industrial component.

Reduced imports of copper, mineral oils, iron ore, and cotton yarn from China are also a significant economic drag on India. Technological advances that lower costs can also result in deflation. Many experts are also puzzled by China’s arrogant response to deflation and low growth (by their standards). US President Joe Biden signed a decree prohibiting some US investments in sensitive technology in China on Wednesday, signalling a cautious approach to technological progress in that country.

These changes need to be understood in light of forecasts that China’s contribution to global trade expansion would halve within five years, and the company plans to diversify away from China (China Plus One) and towards nations like India.

In 2022, worldwide inflation was about 9% due to the Russia-Ukraine war and the post-Covid consumer demand rebound. The IMF anticipates a decline to 6.6% in 2023 and 4.3% in 2024, which are still higher than pre-pandemic levels. Because of the Fed’s rate-hike cycle, US inflation has been falling since it peaked in June 2022 at 9.1%.

Oil price increases resumed in early June after a two-month lull. Even though US inflation increased by 20 basis points from June to 3.2% in July, many economists still think the Fed is nearing the end of its cycle of rate increases. The US is anticipated to manage a gentle landing, with inflation returning to the targetted 2% in 2023, despite the continued uncertainties.

Deflation, characterized by a decrease in the general price level of goods and services, is the opposite of inflation. While the global economy has grappled chiefly with inflationary concerns over the last few decades, China is bucking the trend as it faces deflationary pressures in 2023. This article aims to shed light on the current economic environment in China, the causes of deflation, its potential impacts, and the road ahead for the Asian giant.

Recent data suggests a slowdown in China’s economic growth. The booming export-led growth, urban development, and mass-scale manufacturing that characterized China’s past are now becoming more balanced. The trade war with the United States, environmental constraints, and the country’s aspiration to pivot towards a consumption-driven growth model has, to some extent, dampened the previously unyielding economic momentum.

China’s meteoric rise as the “world’s factory” has led to massive investments in infrastructure and manufacturing capabilities. But as global demand has tapered, there’s now a significant overcapacity, leading to falling prices as producers compete for market share.

The credit-driven growth model that served China for decades has resulted in high corporate and local government debt. This debt burden is restraining new spending and investments.

China’s demographic challenge, driven by its former one-child policy, means a shrinking labour force and an increasing dependency ratio, reducing consumption and lower demand.

Innovations and efficiency improvements in sectors like automation and e-commerce drive down costs, which, while beneficial, can also exert deflationary pressures. When consumers expect prices to fall further, they might hold off on spending, leading to decreased demand and, potentially, price drops.

Deflation increases the actual value of debt. For a country with substantial debt levels, this can strain corporations and even lead to bankruptcies. Falling prices can erode corporate profitability, making them less likely to invest or hire and dampening economic growth.

The People’s Bank of China (PBOC) has reduced reserve requirement ratios and has cut interest rates to stimulate borrowing and investment. The government has increased public spending, focusing on infrastructure projects to spur demand. Efforts are being made to manage and restructure bad debts, especially in the shadow banking sector.

Recognizing the role of innovation in driving growth, policies are being formulated to support technological advancements and research.

China’s deflationary concerns are real, but the country’s resilience, vast resources, and adaptive policy-making should not be underestimated. If successful, the push towards a consumption-driven model can lead to sustainable long-term growth.

This trade deal, of which China is a part, could open new markets and stimulate export-driven growth. This ambitious global infrastructure project can create external demand for Chinese goods and services.

The spectre of deflation in China is a testament to the complex dynamics of a maturing economy. While challenges abound, China’s proactive approach and inherent strengths could navigate it through these economic headwinds. However, as with all economic forecasts, uncertainty remains, and only time will tell the whole story of China’s financial journey in 2023 and beyond.