China inflation: no risk of deflationary spiral, but vigilance and caution needed at crucial juncture to avoid Japanification
- China’s consumer prices fell for the first time since 2021 in July, adding to deflation concerns, although factory-gate contraction narrowed last month
- Beijing denies it has entered a period of deflation, but analysts warn the situation must be handled correctly to avoid imitating Japan’s so-called lost-decade
China’s first drop in consumer inflation for more than two years has given Beijing the daunting task of fending off chronic deflationary pressure, testing its toolbox to avoid imitating Japan’s so-called lost-decade.
The consumer price Index (CPI) falling by 0.3 per cent from a year earlier follows a slew of disappointing economic indicators, with Beijing already balancing lacklustre domestic demand and mitigating against risks in the financial sector as well as local government debt.
A 1.7 per cent drop in food prices, year on year, was the major contributor to the headline inflation’s first fall since early 2021, while services prices rose by 1.2 per cent to the highest level in 17 months, indicating an uneven post-reopening economic recovery.
China’s producer price index (PPI), which reflects the prices that factories charge wholesalers for products, fell for the 10th month in a row after dropping by 4.4 per cent in July compared to a year earlier.
Beijing has repeatedly denied it has entered a period of deflation, which technically requires three consecutive monthly declines in consumer prices, while analysts at Capital Economics also said they were “sceptical that China was slipping into an extended period of deflation”.
But economists have warned that lingering low inflation would further discourage or delay investment or consumption, which are badly needed to reinvigorate growth momentum.
We are currently at a crucial juncture, and if we mishandle the situation, it could potentially evolve into a long-term issue
“We are currently at a crucial juncture, and if we mishandle the situation, it could potentially evolve into a long-term issue,” said Zhao Xijun, a finance professor at Renmin University in Beijing.
“We need to be vigilant, while exercising caution on the issue, and we must make every effort to resolve this problem.”
But China will be able to limit the extent of its period of low inflation with timely policy support to boost economic growth and offset deflationary pressures, added Zhao.
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Xu Tianchen, an economist with the Economist Intelligence Unit, also said China must respond with more proactive policies to prevent a lost decade, including increased spending by the central government, adjustments to the credit system and efforts to motivate entrepreneurs.
China’s headline CPI rose by 0.2 per cent sequentially from a drop of 0.2 per cent in June, and analysts said that despite the year-on-year slump, the month-on-month price changes have improved thanks to the summer spending boom, with travelling, entertainment and hospitality revenues all at high levels.
Core CPI inflation, excluding the volatile prices of food and energy, rebounded to the highest level so far this year, after rising by 0.5 per cent, while the services index rose by 0.8 per cent, month on month, up from the 0.1 per cent rise in June.
“The lack of a more pronounced rebound in services inflation following reopening underscores how underwhelming the domestic recovery has been,” added analysts at Capital Economics.
Officials said the impact of the high base from last year will fade and a rebound is expected to start in August, bringing CPI up to close to 1 per cent at the end of the year, but still far from the “around 3 per cent” target set by Beijing for 2023.
“We think [inflation] may pick up somewhat in the coming months as policy support results in a slight reacceleration in economic growth,” said Capital Economics.
Xu said the destocking process that has added downward pressure since the middle of 2022 may fade away towards the end of the year.
Higher inflation may come back when labour supply becomes tighter
“It’s likely that PPI is bottoming out as these two drivers reverse: destocking is about to give way to restocking in the fourth quarter, while commodity prices have held up following some supply-side changes,” said Xu.
Xu said the worst may be over for China, but that it may still face a long period of low inflation, which requires government support to stimulate the private sector.
“This is a result of a number of factors, including a drag on demand from deleveraging, a sizeable and ever growing manufacturing sector that is capable of absorbing any price shocks, and excess labour supply that will cap wage growth. Higher inflation may come back when labour supply becomes tighter,” he added.
“The deleveraging among housing developers and some local governments are exerting downward pressure on prices through lower demand.”
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Analysts also argued that reforms and more policy support are necessary, including an increase in public spending, interest rate and tax cuts, as well as a more well-rounded social security net to promote consumption.
China should aim to shift its focus to stimulate higher-level demand, such as employment, healthcare, education and comprehensive well-being, while expanding demand requires dispelling many concerns among society, added Zhao at Renmin University.
“For example, people seek higher-quality services for more secure retirement, yet there is currently a lack of satisfying facilities for elderly care, healthcare, leisure, and mental well-being,” he said.
“Even a proper nursing home is absent. The multitude of issues arising from a major flood in northern China highlights the inadequacies in water infrastructure and the security of mountainous residents’ livelihoods.”
