China’s dangerous deflation dynamic

When China’s economy belatedly reopened after the Covid-19 pandemic in December 2022, there were high hopes that it would at last bounce back and regain its pre-Covid-19 vigour. But

these expectations have not materialised.

Instead, what we see is an economy still mired in a property slump, with consumer confidence chronically weak, unemployment high, both domestic and foreign investment on the decline and stock markets perched at multi-year lows.

A particularly worrying sign is that deflation has set in. The latest data shows that in January, consumer prices declined by 0.8 per cent year on year, the fastest pace in 15 years, while producer prices were down for the 16th consecutive month, falling by 2.5 per cent. Even the performance of the services sector, which was expected to rebound sharply post-Covid-19, has been lacklustre, with prices up only 0.5 per cent year on year. The persistent deflation is a major cause of China’s current economic malaise. Deflation leads consumers to defer purchases because they expect goods to become cheaper, and the resulting weak demand discourages investment. Deflation also increases real interest rates, which negatively affects credit demand, further hurting both consumption and investment, as well as economic growth.