Deflation spiral is a major risk to China’s economy 

As the Western world struggles with higher-than-usual rates of inflation, China faces a very different problem. Potential price deflation could signal serious economic trouble in the future.

On Monday, official data showed that consumer prices in June had barely risen compared to a year earlier. Excluding the volatile food and energy sectors, inflation was still surprisingly low, at just 0.4% per year.

At the same time, China’s producer price index, which measures what manufacturers charge for their goods, showed a dramatic 5.4% year-over-year decline. 

This signal of wholesale price deflation appears to be the result of decreased demand, which bodes ill for Chinese manufacturers.

While lower prices may seem like good news for consumers, widespread declines can be very bad news for the broader economy. The United States and other advanced Western economies typically target an inflation rate of about 2% per year.

Very low inflation, or deflation – when prices begin to decline across the broad economy – can significantly hamper economic growth.

Low demand

“Deflation is a signal of weakness and lack of confidence in the economy,” Gary Jefferson, the Carl Marks Professor of International Trade and Finance at Brandeis University, told Voice of America. 

He said that it is often caused by low demand for goods and services and can have a number of negative effects, adding:

If people see prices are falling, then they may be more likely to delay their purchases, knowing that next week or next month, they can buy a car or a house at a lower price.

“And so it tends to further depress spending in the present in the expectation that a better deal could be had in the future,” Jefferson, who studies the Chinese economy, pointed out.

While it increases the purchasing power of a fixed amount of money, deflation also puts pressure on business profits. This can in turn push down wages and employment, as well as reduce the incentive to invest in further productive capacity.

Significantly for China, deflation also makes it more difficult for borrowers to service their debts, as the rising value of money makes fixed loan payments more expensive relative to the cost of other goods and services. 

Many Chinese businesses and local governments are carrying very high levels of debt, complicating their financial future as they face declining revenues.

The financial struggles of local governments are particularly relevant to the country’s current difficulties. In the past, they have served as a conduit for economic stimulus packages. 

Ian Hutchinson, a spokesperson for the Rhodium Group, an independent research organization, said in a statement emailed to VOA that is no longer a viable option for Beijing. He wrote:

Some recent research we did looking at the debt of local government financing vehicles showed that [LGFVs] alone hold over 59 trillion yuan [US$8.16 trillion] in interest-paying debt and payables – around 50% of China’s GDP.

“Those LGFVs are also facing a significant cash crunch – only around a fifth of them have enough cash on hand to pay their short-term obligations. So how does that relate to economic stimulus,” Hutchinson asked.

Government investment

“In the past, fiscal stimulus channeled through local government investment has been a key tool for Beijing to exert influence over the economy. Since these localities are struggling to make ends meet, they aren’t effective tools to juice the economy unless there’s a restructuring of their debt obligations,” he said.

Loren Brandt, the Noranda Chair Professor of Economics at the University of Toronto, told VOA that the outlook for China is consistent with a long-term trend that has seen the country’s economy weakening.

“We’ve seen a marked slowdown in the Chinese economy, and a lot of what has been underlying that decline has been anemic growth in productivity,” he said.

For several decades, China had enjoyed explosive productivity, boasting double-digit economic growth rates. But in recent years, productivity growth has sharply declined.

Brandt pointed out that this is clearly not just a result of China catching up with Western rivals and growing at the more sedate pace typical of advanced economies. He said:

Even if we just take the official numbers, per capita GDP in China is 20% of that of the United States.

“Other Asian economies that experienced booming growth from the mid-to-late 1900s and through today did not see a similar slowdown in productivity growth until they reached a level equal to between 40% and 50% of US productivity levels,” Brandt said.

“In China, this decline in GDP growth is happening much earlier in development. [It] suggests it’s something much more systematic. It’s likely related to internal [and] external policies in terms of how it relates to the rest of the world,” he added. 

Jefferson, of Brandeis, believes that Beijing will likely look to implement some sort of economic stimulus package to boost demand. However, he said, whether it will succeed is unclear.

In the past, the Chinese government has pushed stimulus programs focused on infrastructure investment, to the point where returns on further funding in the sector are sharply diminishing.

Human capital

An alternative, stimulus spending directed at individual households, is likely to run into the reality that consumer confidence in China is quite low, Jefferson said. This makes it less likely that investments in human capital, like graduate education, will be seen as worthwhile.

Should China continue to struggle with low inflation or even deflation, the impact will be felt in the US and worldwide, according to Jefferson, adding:

It’s a kind of double-edged issue for the rest of the world, in that deflation and diminished demand is going to reduce [Chinese] imports from the rest of the world.

“On the other hand, it will make Chinese exports somewhat more price stable or even [less expensive]. That could have some benefit to our effort here, in this country, to promote price stability,” he added.

This is an edited version of an article, republished courtesy of Voice of America. Read the original article here.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy of China Factor.