Deflation: China’s latest export has gathered strength

China can withstand the pricking of a debt-financed property market bubble if it takes the right set of policy actions.
China can withstand the pricking of a debt-financed property market bubble if it takes the right set of policy actions.


  • Goods prices are softening while those of services harden in a global situation that’s unprecedented.

There is a strong (deflationary) gust blowing from the East. Last month, Chinese consumer prices fell at their fastest rate in 15 years. For the first time since the Global Financial Crisis (GFC) of 2008-09, China’s CPI fell 0.8% year-on-year (y-o-y). The Chinese economy is in the midst of a long and significant property sector implosion and a dramatic decline in stock prices. It has been over six months since China lapsed into consumer-price deflation and producer prices have been in decline for 16 straight months.

These indicators point to a significant risk of prolonged deflation in China. In addition to its property sector slump and stock market downturn, there is a dramatic loss of investor confidence and a decline in consumer demand, even as exports weakened. This economic situation, characterized by excess supply, insufficient demand, debt-induced financial stress and politics-based economic decision-making, does not augur well for any easy solutions.

Ironically, this deflationary wind is gathering strength at a time when neighbouring country Japan’s Nikkei Index has finally eclipsed its peak from 34 years ago. A strong earnings report from US based chipmaker Nvidia allowed the Nikkei 225 to rise above that long forgotten 39,000 peak-level. The intervening three decades in the Japanese economy have been characterized by deflation and recessionary conditions. Japan’s core CPI reached 3.1% in 2023, its highest level in 41 years. For the first time in decades, the Japanese central bank is contemplating normalizing interest rates. China will be wary of falling into the same abyss that Japan did after the collapse in its stock market and real estate bubbles in 1989.

Unlike Japan’s, China’s economy is well diversified, and its fiscal pockets are deep. China can withstand the pricking of a debt-financed property market bubble if it takes the right set of policy actions. Some analysts believe that its CPI will become mildly positive once the lunar new year period is over, even though it will remain well short of the official 3% y-o-y target. China’s best bet will be to directly stimulate consumer spending. In a year that marks the 75th year of the People’s Republic, the first Politburo meeting of 2024 had a marked focus on political control and party discipline. Despite a deteriorating economy, economic actions will be delayed for later in the year. China’s annual party congress, where it usually announces economic policy, will be held in March. Some policy action could come then or more likely at the not-yet-scheduled Third Plenum postponed from last year. Look for consumer tax incentives or some outright ‘helicopter money’ for households to kick-start the economy. Interest rate relief or liquidity measures are unlikely to be a big component, as this will only feed China’s addiction to fixed asset formation. A drip feed of new bond issuances may continue this year to modestly add liquidity to the system.

Differing inflation paths of the two largest economies are a headache for central banks around the world. Some developing countries (including India) and all developed countries of the West have had to deal with inflation rather than deflation. Central Banks, led by the US Federal Reserve, have raised rates for two straight years before putting their policies on pause. The Australian and New Zealand central banks are signalling that they are closer to raising rates again than cutting them. Fed fund futures in the US signal a 60% chance of reduction in June, leaving room for it to retain its pause or increase rates further.

The nub of the issue is sectoral rather than geographical. The post-pandemic world of goods has moved from excess demand to excess supply, and from inflation to deflation. Semiconductors are a case in point; from a very tight supply chain in 2020 to a glut in commoditized memory and processor chips. In contrast, the services sector in the developed world has been beset with labour market issues, demand surges and staff shortages, and has not recovered from the disruption caused by the pandemic. The Bureau of Labor Statistics (BLS) that reports the components of US inflation shows that hospital services, physician services, owners’ equivalent rent, motor insurance and airline services are the biggest contributors to core inflation. These are not impacted by cross-border exchange and have therefore remained immune to deflationary winds from China.

Other emerging markets, like India, are somewhere in between, with easing food and energy price pressures, but some residual pressure in services.

This situation of global deflation in goods prices with inflation in services (sector-wise), and with the American and Chinese economies making a zig-zag pattern (geography-wise), is unprecedented in modern economic history. Monetary and fiscal policy on both sides of the Pacific Ocean must be careful to restrain one side while not pushing the other over the edge. Even under normal circumstances, interest rates are blunt instruments. In this context, they may no longer be useful at all. The US and other developed countries need prudential policies that specifically tackle labour market frictions, while China needs liquidity policies aimed directly at consumers. We might otherwise end up with stagflation in the West and a deflationary recession in China. Not a good cocktail for any country.

P.S.: “When the facts change, I change my mind, what do you do, sir?" asked John Maynard Keynes.

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