China’s Inflation Problem: The Risk of Deflation

China has a unique problem amidst the global fight to control rising inflation; its inflation is too low. According to reports, consumer prices in China rose only by 0.7% in March compared to the previous year, and factory gate prices fell for the sixth consecutive month. While other major economies such as the United States, European Union, and the United Kingdom are struggling to bring down inflation that is slashing living standards, China is trying to do the opposite.

Despite the People’s Bank of China (PBOC) cutting interest rates and pumping cash into the financial system to boost the economy and the removal of strict Covid control measures late last year, prices are stagnating or falling in China. The uncertainty over the economy means that Chinese households continue to save money rather than spending it, and companies are hesitant to make new investments, which could lead to a tailspin of falling prices and wages from which the economy may struggle to recover.

The broad money supply in China has increased by a record high of $5.6 trillion in the past 15 months, and the PBOC has been trying to encourage people to spend by boosting banking liquidity through various policy tools such as open market operations and lowering reserve requirement ratios. However, consumers are hoarding cash at a record rate, and much of the new bank lending has gone to local governments that used it to repay their high levels of debt.

The combination of price declines and unprecedented money supply in the economy has fueled talks of deflation, a sustained and broad decline in general price levels for goods and services over a period of time. Deflation is bad for the economy because, in such an environment, consumers and companies may put off spending in anticipation of prices falling further, which would only exacerbate economic problems.

Japan’s stagnant economy struggled with deflation for two decades, and its officials have only recently succeeded in starting to reverse the trend. There is concern that China is headed in the same direction, with a top government think tank, the Chinese Academy of Social Sciences (CASS), describing the current economic situation in China as falling into recession territory due to the personal balance sheet issue and the collapse of the willingness to use credit by various subjects in the entire economic system.

Yu Yongding, a former director of the Institute of World Economics and Politics at the CASS, admits that the economy is facing deflationary pressure. He called attention to deflation as entirely correct, citing insufficient aggregate demand as a prominent problem facing the economy. Former central bank advisor Li Daokui, meanwhile, has urged Beijing to give cash handouts to consumers to stoke demand, a measure adopted by many major economies such as the United States and Australia but rarely used by China’s central government.

The PBOC, on the other hand, has dismissed talk of deflation and defended its current policies, stating that there is no basis for long-term deflation or inflation. They believe that as financially supportive policies take effect, consumer demand will warm up, and price increases will likely return to average levels in the second half of this year.

In conclusion, while the rest of the world is struggling to control rising inflation, China’s low inflation rate poses a unique challenge to its economy. Deflation could be detrimental to the country, leading to falling prices, wages, and investments, making it challenging for the economy to recover. The Chinese government needs to find ways to encourage consumer spending, possibly through cash handouts, to increase aggregate demand and prevent a deflationary spiral.