China’s headline consumer price index fell by 0.3% year-on-year in July to register deflation for the first time in two years. This figure raised concerns that falling prices would lead consumers to delay spending in an already weakening economy. However, in our view, the data is not a harbinger for prolonged deflation.
Weak pork and energy prices were mainly responsible for the decline in headline CPI. The fall nevertheless comes as spending by consumers and businesses softens in an economy hamstrung by a flagging property market and laded with debt (that Beijing has committed to reducing). Producer prices have been falling for longer amid declines in energy, metals and chemicals prices as domestic, but also foreign, demand weakens.
Deflation conditions not met
Why do we think deflation will be relatively short-lived? Looking at the economic fundamentals, lasting deflation requires several conditions:
- Monetary contraction – i.e., a decline in money supply due to monetary tightening. We believe this is not the case in China. Data shows that various measures of money supply are in expansion territory (see Exhibit 2), with M2 broad money supply growing at double-digit rates. The growth rate has been slowing, however.
- Demand destruction – outside of exports, we do not see worrying signs of significantly flagging demand. Income growth is slowing, but not contracting. After a weak spell, consumer demand is recovering, mostly for domestic services and tourism; holiday prices jumped by over 10% YoY in July, for example. Non-food prices were unchanged from last year’s level in July, rebounding from -0.6% YoY in June. Youth unemployment is high, but in our view overall labour market conditions are not dire.
- Persistent loss of confidence. This is partially true in China, mainly because of the after-effects of the government’s zero-Covid policy and a persistently bad property market. We believe it is too early to assume that confidence will remain low, however. More assertive policy easing by Beijing in the coming months could stabilise the property market and bolster public confidence, reviving private sector spending and investment. The precondition is that Beijing acts quickly and decisively to shore up economic activity and business and consumer confidence before the current pessimism becomes entrenched and hits growth more heavily.
- Increase in the real value of debt. This is a long-term factor. We are seeing this to some extent as the debt ratio rises when inflation falls. We believe Beijing is aware of the debt problem. Indeed, the government has been addressing it for a number of years through economically good and bad times.
Is there more to come from Beijing?
Beijing has taken steps to support growth, but it has not unleashed the kind of monetary and fiscal stimulus seen during past downturns. There have been no cash handouts to consumers like those that fueled post-pandemic recoveries in the US and elsewhere. Debt-laden local governments do not have the fiscal space to boost spending themselves.
However, given Beijing’s resolve to shore up the economy and reduce the debt in the system, we believe it is unlikely that China will fall into a debt-deflation spiral. Its post-Covid economic recovery is fragile, but in our view, the problems are mainly cyclical and can be resolved effectively by a more aggressive fiscal expansion facilitated by calibrated monetary easing.