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China Deflation and Market Implications

China has recently slipped into a period of deflation. This has raised concerns among economists and policymakers about the state of China’s economy and its implications for global trade. In this article, we will explore the concept of deflation, its impact on the Chinese economy, the reasons behind China’s deflation, and its implications for consumers and the global economy and the financial markets.

What is deflation and how does it affect China’s economy?

Definition of deflation

Deflation is a sustained decrease in the general price level of goods and services in an economy. It occurs when there is an imbalance between supply and demand, causing prices to fall. Deflation can have serious consequences for an economy, as it leads to a decline in consumer spending and investment, and can result in a deflationary spiral.

Impacts of deflation on the Chinese economy

China’s deflationary trend has significant implications for the country’s economy. Falling prices can lead to a decrease in consumer spending, as people delay purchases in anticipation of further price reductions. This, in turn, can slow down economic growth and hinder the country’s economic recovery. Additionally, deflation puts pressure on businesses, as they face declining profits and may be forced to cut costs, including cutting jobs and reducing investments.

An important aspect to this deflationary spiral are expectations. Falling prices of both goods and services could increase expectations of future falls in goods and services resulting in a deflation trap.

In fact, a recent article in the Financial Times by Sun Yu on August 6, 2023, looks at how the Chinese authorities were putting pressure on prominent economists not to mention terms such as deflation. This pressure covered brokerage analysist as well as researchers at universities and think-tanks. Thus, negative talk about deflation was prohibited by the Chinese authorities which shows a real concern about Chinese growth prospects.

Recent trends in China’s deflation

China’s Consumer Price Index (CPI) fell by 0.3%, marking the first time in almost two and a half years. On top of this the Producer Price Index fell by 4.4 percent in July.  However, core inflation rose by 0.8% from a year earlier.

This has sparked concerns among policymakers, who are closely monitoring the situation and taking measures to curb deflation.

Why has China slipped into deflation?

Factors contributing to China’s deflation

Several factors have contributed to China’s deflationary scenario. The ongoing pandemic has disrupted global supply chains and reduced demand for goods and services, leading to an oversupply in the market. Additionally, China’s economic slowdown and overcapacity in industries such as manufacturing and real estate have further fueled deflationary pressures. Furthermore, increased competition from other Asian economies and global uncertainties have also played a role in pushing prices down.

Effects of the pandemic on deflation in China

The pandemic has had a significant impact on China’s deflationary trend. The strict lockdown measures implemented to contain the spread of the virus have resulted in reduced economic activity and decreased demand for goods and services. This has led to a decline in prices, particularly in sectors heavily affected by the pandemic, such as tourism, hospitality, and retail.  It should be noted that the pandemic measures lasted for about three years and impacted business, especially small to medium sized ones heavily.

Government measures to curb deflation not enough

The Chinese government has recognized the risks of deflation and has taken steps to prevent further price declines. Beijing has implemented fiscal and monetary stimulus measures to boost demand and support economic recovery. However, these measures are a bit too late and not enough.

Both local and the central government were facing issues.  For example, the profitability of local government financing vehicles (LGFVs) are a drag on growth with high debt levels and earnings failing to cover costs and interest payments.  Combined with property woes, local governments in China are not in a good position and this puts pressure on the central government in terms of policy actions.

Several factors contributed to failed measures such as the the property sector crisis, negative geopolitical environment and overestimation regarding the post-pandemic spending.  Market players got the recovery wrong such as Goldman Sachs which forecasted a 46 percent rise in the near term. Obviously, this did not happen.

What are the implications of China’s deflation for Global Markets?

The implications for Europe are higher than for the US. That is because European companies rely more on exports to China. There are also indirect effects such as the curent real estate risk arising from a Country Garden liquidity crisis. If China cannot contain this, expect things to get worse in the future.

Effects of Chinese deflation on international trade

China’s deflationary trend can have significant implications for global trade. As China is one of the world’s largest exporters, falling prices can make its goods and services more competitive in international markets. This can lead to increased export volumes and put pressure on other countries’ producers, affecting their competitiveness and trade balance.

In addition, falling demand in China will impact global firms that rely to exports to China. This was mentioned earlir regarding European companies. Examples would be Italian luxury goods makers and German auto manufacturers.

Export implications of China’s deflationary trend

The deflationary trend in China can also have implications for other countries’ exports. If China’s falling prices result in decreased demand for imported goods, it can adversely affect exporting countries, especially those heavily reliant on the Chinese market. This can disrupt global supply chains and impact the overall stability of the global economy.

This would affect not only European companies but aslo major commodity exporters to China such as Australia and Brazil for example.

Effect on Financial Markets

Thus, investors should look at both direct and indirect affects of a slowing China. We believe this trend is not short-term and will continue over the mid to long-term to some extent due to geopolical factors, declining Chinese population and global fragmitation.

Thus at least for the short-term and to some extent the medium-term we are negative on China. The effect of the pandemic and failed measures to help the economy recovery can be seen in the chart of FXI, the Chinese ETF, and how fart it has fallen in the chart below:

Chinese ETF: FXI Price Chart