Falling prices in China might just be bad for everyone

While so many countries have spent the last year grappling with stubborn inflation, China is facing the opposite problem.

Indeed, in July prices actually fell by 0.3% compared to a year before.

While the term ‘deflation’ shouldn’t be officially coined until prices have fallen for three months in a row, there are now real fears that is where things are headed, and it is nonetheless a big moment for the world’s second largest economy.

You might think that falling prices might not be such a bad thing, indeed in the immediacy it can sometimes feel like a brief relief for households.

But deflation is actually a phenomenon that worries governments and central bankers even more than its opposite number, inflation.

Left to spiral, falling prices erode the profits of businesses, depress confidence, discourage investment and can ultimately lead to mass job losses and high unemployment.

If it were to take hold in a more long-term way it could wreak untold pain not just in China but around the world too.

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So, given much of the rest of the world is facing rising prices, why is China in such a different situation?

The causes are vast and complex, but the key factor is a post-pandemic dive in consumer activity and confidence.

At the height of the pandemic many Chinese businesses were doing extremely well. While millions were stuck at home there was high global demand for medical supplies, home working kit and other online goods.

But post reopening that foreign demand has fallen away and has not been replaced by a bounce back in domestic demand that the government had hoped for.

Indeed, the confidence of Chinese consumers has been seriously damaged by what they experienced in the pandemic.

Months of brutal lockdowns saw thousands of businesses close and family savings depleted, people just don’t have the belief that the next paycheck is guaranteed and are reining in their spending accordingly.

Too much ‘stuff’

The Chinese economy is also suffering from previous ‘over stimulus’. Huge subsidy packages in 2008 for example in the wake of the financial crash, as well as a culture of borrowing to invest, lead to a decade of mass production and construction.

The problem now is that the economy finds itself with too much ‘stuff’ in all sorts of areas, from properties to goods, and enormous debt burdens.

Add into the mix a crisis in the property market and the fact that a staggering one in five young people are unemployed and you have an economic challenge greater than China has faced for many years.

While many economists don’t believe a long term or deep deflation is inevitable, even a short-term dip could cause serious pain not just in China but around the world too.

And that is because the Chinese economy is so interlinked with global supply chains. Deflation would make Chinese goods increasingly cheap which would undercut millions of foreign companies, but there would also likely be a drop off in Chinese demand for foreign imports such as food, energy and raw materials. This would seriously hurt the balance sheets of countries like the UK.

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Be in no doubt, this is all of major concern to China’s leaders.

Indeed, in China’s one-party system economic success is a key pillar of legitimacy. Years of booming growth and development has meant people are more likely to accept increasing curbs on their political and civil freedoms. A potential situation where people feel they cannot get on in life poses a real challenge to the system.

While there have been small scale stimulus interventions in recent months, they have been largely targeted on key strategic sectors. A larger stimulus package would not only be fiscally difficult but also may not be desirable given that overly large stimulus is arguably part of the problem.

Many experts think small tweaks will be enough to right the situation and it’s worth remembering the Chinese economy is still growing, albeit sluggishly.

There are also other signs in the data that things are not all that gloomy. On a month-on-month basis prices actually grew by 0.2%, and Core CPI (the measure of inflation which removes more volatile factors such as energy) grew by 0.8%.

But nevertheless, there is no doubt this moment heralds a new period of jeopardy for an economy that for so many years has felt unstoppable.

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