China Officially Slips Into Deflation

The second-largest economy in the world is struggling to maintain growth, following the sharp slowdown of its post-pandemic recovery.

The National Bureau of Statistics (NBS) reported that the consumer price index (CPI) dropped 0.3% year-on-year in July, while the producer price index (PPI) fell 4.4%, its tenth consecutive monthly drop.

Why Is Deflation Bad?

With most of the rest of the G20 suffering from inflation, China's situation might seem enviable for citizens struggling with rising prices. But deflation brings a different set of problems.

Deflation means that the same amount of money can purchase more now than it did a year ago. While that sounds like a positive thing, it's a dynamic that risks becoming entrenched. If consumers believe their money will be worth more in the future, they will delay purchases. This, in turn, prompts producers to drop their prices to entice more buyers, which only causes deflation to get worse.

Just as inflation can become a vicious cycle, as wages are raised to compensate for lower spending power, so can deflation become self-fulfilling. And, like inflation, once the spiral has started, it can be hard to stop.

This is one of the reasons central banks target 2% inflation, so there is a buffer against the devastating impact of entrenched deflation and the recession it brings.

What Could The Consequences Be?

Deflation and recession are the nightmare scenario for an authoritarian regime like China's, in which the ruling party has made a tacit bargain with its citizens to swap democratic freedoms for economic prosperity.

China's economic story has been a remarkable one, with the rapid expansion of the middle classes as GDP growth averaged 9% from 1989 to this year (even taking into account negative growth during the pandemic). Per-capita income has quadrupled in the last 15 years.

The question for the CCP must be, when they can no longer deliver the same economic benefits, will the population of over 1 billion start to question whether the trade-off is still worth it? Youth unemployment, which is at a record high, is a particular concern.

For the rest of the world, there is another issue. China is a huge trading partner. As discounted goods hit the global markets, there could be the welcome effect of helping reduce inflation, particularly in countries where it remains stubbornly high (like the UK). But that could quickly turn sour, as reduced demand within China and a prolonged period of cheap exports drives other major economies towards recession too.

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