China’s deflation problem
While western policymakers grapple with high inflation in the wake of the pandemic China faces a growing threat from falling prices.
The ending of China’s lockdown late last year was widely expected to ignite a surge in demand which would fuel inflation much as had happened in the west since 2021. Instead, demand has faltered and inflation has fallen with Chinese consumer prices unchanged in the last year. At a similar stage in their post-lockdown recoveries, the US and the EU were posting accelerating inflation of over 5.0%. Chinese producer price inflation, a measure of materials and utility prices, has fallen by 5.4% in the last year, the most rapid decline in seven years.
Increasingly the concern is that China could succumb to a period of excessively low inflation or falling prices. This has been Japan’s experience since the early 1990s, a period that has become synonymous with sluggish growth and stagnating or falling asset prices. Chinese policymakers recognise the threat. Earlier this month Yin Jianfeng, deputy director-general of the National Institution for Finance and Development, a state-affiliated think tank, said that China is showing evidence of the “Japan disease”.
When China lifted its zero-COVID restrictions at the end of last year, few would have anticipated this outcome. Many observers expected a sharp rebound in activity, with demand so strong that it would drive global commodity prices higher. Instead, China's recovery has been plagued by weak domestic demand, evidenced by slowing consumer spending and a slump in private investment, a very different experience from that seen in the west.
A major difference between China’s response to the pandemic and the west’s lies in China’s zero-COVID policy. It placed China’s population under draconian restrictions but without the substantial financial transfers made to affected households in the US and Europe. Rather than supporting incomes and jobs, Beijing's fiscal stimulus was channelled towards infrastructure spending and businesses. As a result, Chinese households that had experienced the fruits of decades of growth were exposed to job insecurity and a loss of income, many for the first time.
This has reverberated through the real estate market that was already facing problems in the form of excess capacity and over-leveraged developers. In the absence of western-style support for households, consumers have battened down the hatches and are avoiding major new commitments. The Chinese housing market has weakened, with new home sales and new development plummeting in the last year. Sharply higher youth unemployment, now at over 21%, has added to the difficulties facing the household sector. The joblessness rate for cities is just 5.0%, as measured by China’s statistics authorities. The Chinese government blames high rates of youth unemployment on the unwillingness of young graduates to take less skilled jobs. Certainly there appears to be a mismatch between the rising supply of graduates and the number of higher-paid jobs on offer from larger companies.
Unsurprisingly, consumers have become more cautious and are prioritising saving and paying off debts over spending.
Caution is also the watchword in the corporate sector. Chinese factories that expanded to meet surging western demand in 2021 and 2022 are facing flagging export demand. Domestic consumers have not filled the gap, leaving some businesses with excess inventories that they have tried to shift by cutting prices (China’s electric vehicle makers have marked down prices for this reason and also in response to Tesla’s price cuts).
Private businesses are also concerned about regulation and weak demand, in the domestic and international markets. The sprawling technology sector is still smarting from a domestic regulatory crackdown aimed at promoting “common prosperity”. Many firms face greater trade frictions and scrutiny in Western markets and US export restrictions. The business counterpart to the defensive positioning of consumers is the way in which Chinese corporates are cutting investment spending to build cash balances.
The fact that lower interest rates have failed to stimulate spending and borrowing is a particular cause for concern. The worry is that China could slip into a 'liquidity trap', similar to Japan's experience in the ‘90s and noughties, where interest rate cuts failed to spur borrowing and spending. China's property sector seems closest to exhibiting these symptoms. Despite significant monetary easing the market remains in the doldrums.
Chinese policymakers will work hard to prevent a sharp adjustment in the housing market. Property accounts for a significant share of household wealth and a crash could threaten social stability. This was evident in the mass protests against developers of unfinished homes last year. The government has the capacity for, and past experience of, aggressive market interventions. During the Asian financial crisis in 1998, Shanghai made home purchases income tax deductible, providing targeted fiscal support to the property market.
China’s Academy of Social Sciences, a state-sponsored think tank, wants to go further, and has called for the introduction of a comprehensive fiscal stimulus package, including direct transfers to low-income households to boost consumption. As one of the least indebted governments in the world, China has headroom to borrow to fund a stimulus programme in the same way western governments did during the pandemic.
Even without such measures to boost demand, inflation is expected to edge higher in the coming months due to the low base set by last year's prices. And despite weak demand, China is on track to meet the government's 5% growth target this year.
This exposes the limitations of comparisons with Japan. Even if Chinese growth slowed to 3% in the medium term, it would be a multiple of the 1% average growth that Japan mustered in its decades-long liquidity trap. China has absorbed the lessons of Japan’s deflation and has the tools to avoid a similar outcome.
With a rapidly ageing population and a shrinking workforce, China's growth rate has slowed from the dizzying double-digit rates seen in the ‘90s and noughties. Navigating the path from the investment-driven, rapid growth phase to a slower, consumption-dependent model was always going to be tricky. Further debt-financed stimulus could help China negotiate the latest turn. So far, policymakers seem unwilling to steer in that direction.
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