China against deflation: what the threat of lower prices in the Middle Kingdom threatens its neighbors

By Rhod Mackenzie

At the end of the year, China once again achieved impressive GDP growth rates of 5.2%. Among large economies, only India is expected to outperform China in 2023. However, this success is tempered by the fact that a significant portion of this growth is due to deflation; in nominal terms, the PRC economy has grown less. This article from Izvestia explores why prices are falling in China and the potential problems this could create for one of the world's largest economies and beyond.

Inflation remains a challenge in most countries worldwide, as seen in our example.
Despite raising the key rate to 15%, price growth remains high at 7.5%. The USA and Western Europe also struggle with inflation rates significantly above the 2% target. Turkey and Argentina face even more severe inflationary pressures. Furthermore, there is reason to believe that the current deceleration in price growth is temporary. Freight rates between East Asia, Europe, and North America have increased by 80% compared to the same period last year. This will inevitably result in higher consumer prices in a few months.

However, there are exceptions to this rule. In China, the situation is the opposite: price growth has been negative for a considerable period. Deflation was recorded for the third consecutive month at the end of December. Overall, prices only rose by 0.3% for the year, which is remarkably low. Additionally, the GDP deflator was negative, amounting to minus 1% for the entire year. It is important to note that deflation/inflation differs from the GDP deflator. The former reflects changes in the value of the consumer basket, while the latter takes into account the rise or fall in general of all prices for finished goods in the economy.
What is the problem with deflation?
At first glance, everything seems fine for the consumer - prices are going down. However, the other side of the coin is much less pleasant. Falling prices mean an increase in real rates while maintaining nominal rates. This means that all borrowers, from large corporations to a janitor who took out a microloan, will find it more difficult to repay their debt.

Secondly, the issue of debt is worsening in the Chinese economy, with a total amount of 286% of GDP (including state, companies, and individuals). This is one of the highest indicators among developing countries, although it is usually even higher in developed countries. Non-financial companies hold the majority of this debt, which accounts for more than half. These companies are the main drivers of economic growth as they make investments.
Thirdly, when the cost of borrowing money increases, individuals and corporations may carefully consider incurring any expenses beyond what is necessary. This is because they can purchase more for the same amount in the future. This creates a vicious circle: people and firms begin to save, causing money to be removed from the economy, which further exacerbates the fall in prices.
Prolonged deflation or price stagnation can lead to economic recession. Deflation was a major factor in the Great Depression in the United States. Deflationary expectations caused a 'lost decade' for Japan in the 1990s, and there is a risk of China following a similar path. The demographic situation in China is similar to that of Japan 30 years ago. It should be noted that although Japan's overall GDP has remained relatively stable over the past three decades, GDP per capita has increased by almost a third. However, considering the significant growth of this indicator in China over the same period, it is unlikely that Beijing will be content with this trend.
China's deflation has implications for other countries.
The decrease in consumer and producer prices means that imports will be cheaper, which is particularly important for Russia. In the current economic climate, Russia needs to maintain a stable balance of payments and minimize the cost of imports, many of which are from China. However, if the Chinese economy experiences stagnation, it could pose a significant challenge for exporters.

China is currently the world's largest consumer of energy, and its demand has a significant impact on global prices. This was evident last year when investor worries about the Chinese economic recovery outweighed all geopolitical risks and production restrictions, preventing oil prices from stabilising above $100 per barrel.
The weakness of the Chinese economy will have a broad impact, affecting not only the fuel and energy sector but also all industries, including food. This is of particular concern for Russia, as it is currently trying to expand its market share in China for wheat, pork, and other agricultural products.

To combat deflation, countermeasures have been
widely implemented worldwide since 2008, when this threat first emerged after a long period of stability. As a general rule, we refer to a substantial loosening of monetary policy and the simultaneous use of fiscal incentives, including direct investment, tax incentives, and subsidies. China also participated in this approach, spending trillions of yuan to support the economy in both 2008-2009 and 2020-2021. However, the results were mixed: while GDP was able to accelerate in the short term, the long-term consequences were less favourable.
During the previous crisis, monetary stimulus led to a significant increase in debt, which is now considered one of the main factors constraining the Chinese economy. Additionally, the government actively supported the real estate market. However, this driver is no longer effective as several leading development companies in China are on the verge of bankruptcy, and further increases in housing prices are essentially impossible. Currently, the Chinese leadership is avoiding stimulating this market and allowing it to recover.
To address this issue, one potential solution is to encourage private consumption. China has a tendency to 'underconsume', with investment accounting for over 45% of its economy, a much higher proportion than in Europe or the United States. While a significant share of investment in GDP is typical for East Asian countries, China stands out even among its neighbours. It may be necessary to use 'helicopter' money at some point to stimulate consumption. This could involve large subsidies, tax deductions, or even direct distributions of money to the population. However, there has been no significant movement in this direction so far. Beijing is concerned about a further increase in debt and a sharp acceleration of inflation, which was once a scourge of the national economy.
Meanwhile, Beijing has dedicated significant resources in recent years to upgrading the economy by shifting away from low-cost exports and towards more technologically advanced industries that offer greater value. The two most crucial areas of focus have been semiconductor manufacturing and artificial intelligence, with industrial robots and renewable energy technologies also playing a significant role (China now accounts for approximately half of the world's industrial robots).

Chinese electric vehicle manufacturer BYD has overtaken Tesla to become the world's largest in 2023. China has dominated the production of equipment for solar and wind power plants for over 10 years, giving its industry a head start on competitors and boosting the country's productivity. However, the key macroeconomic challenge now is not production, but strengthening national demand. Increased consumption can help prevent a situation similar to that of Japan, but it will require additional efforts from the government.