China, the world’s second-largest economy, is facing a challenging year ahead as it grapples with deflationary pressures amid weak consumer demand and rising debt levels. Despite exceeding its 2023 growth target of 6%, the country’s economic outlook is clouded by uncertainties and risks.
One of the most worrying signs for China’s economy is the decline in consumer prices, which fell by 0.3% in July from a year earlier. This was the first time since February 2021 that the consumer price index (CPI), a measure of inflation, turned negative. Analysts said this reflects the sluggishness of domestic consumption, which has been hampered by the Covid-19 pandemic, natural disasters, and regulatory crackdowns on various sectors.
Deflation, or falling prices, can be harmful for the economy as it erodes profits, discourages spending, and increases the real burden of debt. China has a high level of debt, especially among local governments and state-owned enterprises, which could pose a threat to its financial stability and growth prospects. According to the International Monetary Fund, China’s total debt reached 266% of GDP in 2020, up from 246% in 2019.
Factory gate prices rise but fail to boost consumer demand
While consumer prices have fallen, producer prices, or the prices charged by manufacturers, have risen sharply. The producer price index (PPI), a measure of factory gate inflation, surged by 9% in July from a year earlier, the highest level since August 2008. This was mainly driven by the rising costs of raw materials, such as coal, iron ore, and oil, which have been affected by global supply disruptions and geopolitical tensions.
However, the increase in producer prices has not translated into higher consumer demand, as manufacturers have been reluctant to pass on the cost pressures to consumers, fearing that they would lose market share and customers. Instead, they have opted to absorb the costs by cutting profits, wages, and investment. This has created a divergence between the CPI and the PPI, which indicates a lack of demand-pull inflation and a weak transmission mechanism between the two price indices.
Government faces dilemma over stimulus measures
The deflationary challenge facing China’s economy has put the government in a dilemma over whether to adopt more stimulus measures to boost growth and demand. On one hand, the government has pledged to maintain a prudent monetary policy and a proactive fiscal policy, while avoiding excessive stimulus and debt accumulation. On the other hand, the government has also signaled its willingness to provide targeted support to key sectors and regions that are facing difficulties, such as small and medium-sized enterprises, the service sector, and the flood-hit areas.
The government’s policy stance reflects its balancing act between short-term stability and long-term reform, as well as its recognition of the limits and side effects of stimulus. Some analysts have argued that China needs to shift its focus from quantity to quality of growth, and from investment to consumption, in order to achieve a more sustainable and balanced development model. Others have warned that China cannot afford to ignore the deflationary risks and should take more proactive measures to stimulate demand and inflation expectations.
China’s economic recovery remains uneven and uncertain
China’s economic recovery from the Covid-19 shock has been remarkable, as it was the only major economy to register positive growth in 2020 and the first to bounce back to its pre-pandemic level of output in 2021. However, the recovery has also been uneven and uncertain, as different sectors and regions have experienced different degrees of recovery and resilience. Moreover, the recovery has been largely driven by exports and industrial production, while consumption and services have lagged behind.
China’s economic performance in the coming months will depend on a number of factors, such as the evolution of the pandemic, the pace of vaccination, the impact of the regulatory crackdowns, the external demand and trade environment, and the policy responses of the government. China’s economy is expected to grow by 8.5% in 2021, according to the IMF, but the growth rate is likely to moderate to 5.6% in 2022, as the base effects fade and the structural challenges persist.
