What China's persistent deflation means for the world

China's spiral into deflation is proving hard to fix. Prices in the world's second-biggest economy have fallen for six consecutive quarters, and if they fall for one more quarter, the run would equal a record deflationary streak set in the Asian Financial Crisis in the late 1990s.

Policymakers have pledged to do more to shore up growth and ease price declines, using some of their most direct language in years, as Beijing braces for a trade war with Donald Trump's return to the White House. The US president-elect has vowed to impose a 60% tariff on Chinese exports that would decimate bilateral trade.

What is deflation?

The term describes a situation in which prices for goods and services fall across the economy. It's not to be confused with disinflation, which signifies prices are still rising, though more slowly. That's what's happening in the US, where annual price growth has slowed significantly since mid-2022.

Why is China in deflation?

Prices rocketed in the US and other big economies when they reopened after the Covid-19 pandemic, as pent-up demand coincided with shortages in the supply of many goods. Predictions the same would happen in China proved to be wrong. Consumer spending power is weak and a real estate slump has dented confidence, holding people back from buying big-ticket items.

A tightening of regulations on high-paying industries from tech to finance has led to lay-offs and salary cuts, further dampening the appetite for spending. A policy push to develop manufacturing and high-tech goods led to increased production, but demand for the goods has been weak, forcing businesses to mark down prices.

What's so bad about falling prices?

Cheaper prices look good for consumers at first, but that doesn't necessarily mean people will start spending again. In fact, they might hold off from buying expensive items in the hope that prices will fall further. That would depress economic activity even more, putting pressure on incomes, which could result in another dip in spending and further price cuts in a downward spiral.

Deflation also raises the level of "real," or inflation-adjusted, interest rates in the economy. Higher debt servicing costs make it harder for businesses to invest, which in turn crimps demand, inducing more deflation. Some economists believe such "debt deflation" can trigger recessions or depressions as people default on their loans and banks are undermined.

Why is China's deflation hard to fix?

Beijing responded to past bouts of deflation with forceful monetary easing and big fiscal stimulus measures. Since the pandemic, the government has approached stimulus with more caution, wary of piling too much debt onto the economy.

Policymakers are reluctant to go back to the old playbook of building infrastructure and engineering a property boom, since President Xi Jinping is determined to shift the economy toward new growth drivers such as advanced technologies. As a result, stimulus measures have been relatively restrained, and investors remain somewhat pessimistic over the economic outlook. In a sign of the gloom, 10-year government bond yields have fallen to a record low.

Top officials led by Xi vowed to raise the fiscal deficit target, while signaling an increase in public borrowing and spending following a two-day meeting in December of the Central Economic Work Conference.

What has China done, and what was the impact?

The People's Bank of China has cut interest rates several times over the past two years to boost demand. Officials have been trying to turn around the property market by relaxing purchase restrictions and lowering down payment ratios as well as mortgage rates.

Banks were told to extend more credit to developers so they can finish stalled projects, while local governments were urged to buy unsold apartments and convert them to public housing. While policymakers have refrained from handing out cash to consumers, they have subsidized purchases of cars and home appliances, and extended aid to low-income families as well as students.

A broad stimulus plan rolled out from late September included a $1.4 trillion program to help local governments deal with their debt. The measures helped the economy to improve in recent months but aren't seen by economists as enough to reverse the downward trend in prices, as the housing market remains weak and confidence is still low.

How does China measure deflation?

There are three main gauges. Most-cited is the consumer price index, which reflects changes across a range of goods and services bought by households. It weakened to a five-month low in November. The producer price index measures changes in industrial products sold by manufacturers and has been in contraction for more than two years. A gross domestic product deflator is calculated using the difference between the economy's nominal and inflation-adjusted growth. It provides the broadest measure of prices across the economy, and is in its longest deflationary streak this century.

What products are seeing the biggest price falls?

Transport has been the biggest drag on consumer prices lately, driven mostly by falling car and gasoline prices. Carmakers including BYD Co. have asked suppliers to cut prices, signaling an intensified price war in China's auto market. For the broader economy, real estate and manufacturing are the sectors that recorded the deepest contraction in prices in the first three quarters of 2024, based on an industry-level gross domestic product deflator calculated by Bloomberg. A persistent property bubble has led to a housing inventory glut, while the government's support for manufacturing — from cheap loans to favorable tax policies — has increased the supply of goods that consumers are hesitant to purchase.

What are the concerns from Trump's tariff plans?

Trump threatened during his election campaign to impose 60% tariffs on Chinese goods, and recently vowed to impose additional 10% tariffs on all imports from China as soon as he takes office next month. Uncertainty around a potential second trade war has dimmed prospects for China's export growth next year. This could take the wind out of the sector that has contributed to almost a quarter of the country's economic expansion so far in 2024. Weakened overseas demand will make it even harder for manufacturers to raise prices at home, which could add to the deflationary pressure.

What does it all mean for foreign investors?

Investors in Chinese equities are exposed to deflation-related declines in the earnings of some Chinese companies. Overseas makers of premium cars and luxury brands have seen sales crater in China as consumers tightened purse strings. The bond market has been a big winner, as low-risk government notes became more attractive on expectations of aggressive interest rate cuts by the People's Bank of China. Deflation in China could also potentially reduce inflationary headwinds elsewhere in the global economy.