How Does China Face the Woes of Financial Deflation?

As the world grapples with soaring inflation levels, fueled by rising energy and food costs amid the war in Ukraine and the fallout of the coronavirus pandemic, China is confronting a different and equally perilous economic phenomenon: deflation.

For the third consecutive quarter of the year, prices in the domestic market have continued to plummet, eroding profits and consumer confidence.

The Chinese central bank has taken a series of steps to stem the price decline, such as cutting interest rates and injecting liquidity into the market, hoping to boost consumption and demand.

But the Chinese authorities have dismissed the notion that deflation is afflicting the world’s second-largest economy.

 

Financial Contraction

China is facing a steep drop in the prices of goods, from industrial materials to household staples, for the third consecutive quarter of the year.

The situation has drawn comparisons to Japan’s prolonged economic stagnation, which was marked by deflation and weak growth.

According to the National Bureau of Statistics of China, the producer price index, which measures the cost of goods at the factory gate, fell by 5.4% in June from a year earlier, the biggest decline since December 2015.

The index has been in negative territory for nine months in a row.

The consumer price index, which tracks the prices of goods and services purchased by households, remained unchanged in June from a year ago, meaning that there was no inflation or deflation.

The main factor that kept consumer prices stable was pork, a staple of the Chinese diet, which saw its prices drop by 7.2% year-on-year in June.

The falling prices reflect a slowdown in China’s economic growth, which has been hit by the coronavirus pandemic, trade tensions with the United States, and structural challenges such as debt and overcapacity.

Beijing reported that the country’s gross domestic product expanded by 6.3% year-on-year in the second quarter, below market expectations of 7.3%. The quarterly growth rate was also lower than the first quarter’s 2.2%.

These figures suggest that China is facing a risk of economic contraction or a decline in output and income.

However, some economists say that it is too early to declare a recession, which is typically defined as two consecutive quarters of negative growth.

Hong Hao, chief economist at Grow Investment Group, said: “We need to see broad and persistent price pressure before we can declare deflation. This is happening in the upstream sectors, and it normally takes two to four quarters to pass down.”

 

Beijing Denies

China’s government has dismissed the possibility of a looming financial crisis in the world’s second-largest economy, despite signs of slowing growth and rising debt.

Officials from the National Bureau of Statistics and the central bank insisted that China’s economic fundamentals were sound and that there was no risk of a contraction in the near future.

Fu Linghui, a spokesman for the statistics bureau, said at a press conference on July 19 that China’s consumer price index rose by 1.3 percent year-on-year, while its gross domestic product grew by 4.5 percent in the first quarter.

He also pointed to a relatively fast increase in the M2 money supply index, which expanded by 12.7 percent at the end of March.

“In general, there is no financial contraction in China,” Fu said.

Liu Guoqiang, a deputy governor of the People’s Bank of China, echoed Mr. Fu’s remarks, telling reporters: “At this time there is no deflation, and there will be no risk of deflation in the second half of the year.”

However, some analysts and economists have warned that China faces mounting challenges as it tries to balance its recovery from the coronavirus pandemic with its long-term structural reforms.

The country’s debt-to-GDP ratio surged to 285 percent last year, according to the Institute of International Finance, raising concerns about financial stability and asset bubbles.

In response, China’s central bank has adopted a more cautious monetary policy stance, cutting interest rates and injecting liquidity into the financial system to support growth.

In mid-June, the central bank announced that it would lower the interest rate on its one-year loans to financial institutions from 2.75 percent to 2.65 percent.

Some experts have also called for more fiscal stimulus measures to boost consumption and domestic demand.

Li Daokui, a prominent economist and former adviser to the central bank, proposed that Beijing should issue 500 billion yuan (about $70 billion) worth of vouchers to encourage spending.

According to Li, these vouchers will provide total spending worth one trillion yuan ($138.7 billion) and enable the government to generate revenues equivalent to 300 billion yuan ($41.8 billion) at least in taxes resulting from increased spending.

 

Why China?

As the prices of consumer goods keep falling in China, the world’s second-largest economy faces the threat of deflation, a phenomenon that can have severe consequences for economic growth and stability.

Deflation is the opposite of inflation, which occurs when prices rise over time. While lower prices may sound appealing to consumers, they can also signal a looming recession and a vicious cycle of lower spending and income.

A recent report by Forbes magazine explained how deflation can undermine an economy. When consumers expect prices to drop further, they postpone their purchases, hoping to get a better deal later.

But this reduces the demand for goods and services, which hurts the profits of producers and may force them to cut jobs and raise interest rates.

The deflationary pressure in China is partly due to the impact of the pandemic, which forced the government to impose strict lockdown measures that disrupted economic activity.

The Chinese economy has not fully recovered from that shock, according to some analysts.

David Kuo, an economist, said that zero inflation for consumer prices and sharper declines in producer prices in June indicate that China’s post-coronavirus recovery has lost more momentum.

He added that the decline in price momentum is a sign of weak demand that casts a shadow over growth prospects. The need for more stimulus from the People’s Bank of China is increasing.

CNN reported that the uncertainty about the economy may lead Chinese households to save more and spend less and businesses to be wary of investing in new projects.

This could create a downward spiral of prices and wages that would hamper the recovery of the Chinese economy.