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How China can overcome its deflationary trap and revive its economy

China, the world’s second-largest economy, has been struggling with a slowdown in growth and rising debt levels for years. Recently, it faced another challenge: deflation.

Deflation is a situation where the prices of goods and services fall over time, reducing the purchasing power of money. It can have negative effects on the economy, such as lower profits, reduced investment, higher unemployment, and increased debt burdens.

According to the latest data from China’s National Bureau of Statistics, the consumer price index (CPI), a measure of inflation, fell by 0.3% year-on-year in August 2023, marking the first negative reading since October 2009. The producer price index (PPI), a measure of factory gate prices, dropped by 9.6% year-on-year in August 2023, the steepest decline since February 2016.

What are the causes of deflation in China?

There are several factors that have contributed to the deflationary pressure in China, such as:

  • The COVID-19 pandemic: The outbreak of the coronavirus in late 2019 and early 2020 disrupted the supply chains and demand for many goods and services in China and abroad. The lockdown measures imposed by the government to contain the virus also reduced consumer spending and business activity. Although China has largely recovered from the pandemic, some sectors such as tourism, hospitality, and entertainment are still facing weak demand.
  • The trade war with the US: The ongoing trade dispute between China and the US has also weighed on China’s economic performance and confidence. The two countries have imposed tariffs on billions of dollars worth of each other’s goods, affecting trade flows and prices. The trade war has also increased the uncertainty and risk aversion among investors and consumers.
  • The structural reforms: The Chinese government has been pursuing a series of structural reforms to shift its economy from a reliance on exports and investment to a more balanced and sustainable model driven by consumption and innovation. These reforms include deleveraging the financial system, reducing overcapacity in industries such as steel and coal, cracking down on environmental pollution, and opening up the market to more competition. While these reforms are necessary for China’s long-term growth, they also entail short-term costs and challenges, such as lower output, higher unemployment, and lower profitability.

How could deflation hurt Beijing?

Deflation could pose serious threats to China’s economic stability and social stability, such as:

  • Lower growth: Deflation could dampen China’s economic growth by reducing consumer spending, business investment, and government revenue. Consumers may postpone their purchases in anticipation of lower prices in the future, while businesses may cut back on their production and expansion plans due to lower profits and demand. The government may also face lower tax income and higher fiscal deficits as a result of deflation.
  • Higher debt: Deflation could also worsen China’s debt problem by increasing the real value of debt relative to income. China has accumulated a high level of debt over the years, reaching about 280% of GDP by the end of 2020. A large portion of this debt is owed by state-owned enterprises (SOEs), local governments, and households. Deflation could make it harder for these borrowers to service their debt obligations and increase the risk of defaults and financial instability.
  • Social unrest: Deflation could also undermine China’s social stability by eroding the living standards and welfare of its people. Deflation could lead to lower wages, higher unemployment, and reduced social spending. This could increase the income inequality and poverty in China, as well as trigger social discontent and unrest among the masses. Deflation could also challenge the legitimacy and authority of the ruling Communist Party of China (CPC), which has based its governance on delivering economic growth and prosperity to its people.

What is the way out of deflation for China?

To escape from deflation, China needs to adopt a combination of monetary policy, fiscal policy, and structural reforms.

  • Monetary policy: The People’s Bank of China (PBOC), China’s central bank, needs to ease its monetary policy to stimulate demand and inflation. This could include lowering interest rates, reducing reserve requirements for banks, injecting liquidity into the financial system, expanding credit supply to small businesses and households, and depreciating the yuan to boost exports.
  • Fiscal policy: The Chinese government needs to increase its fiscal spending to support economic activity and employment. This could include increasing public investment in infrastructure, health care, education, innovation, and green development; providing tax cuts and subsidies to consumers and businesses; expanding social welfare programs such as unemployment benefits, health insurance, and pensions; and issuing special bonds to finance local government projects.
  • Structural reforms: The Chinese government also needs to accelerate its structural reforms to enhance its economic efficiency and competitiveness. This could include reducing the role of SOEs and increasing the role of private and foreign enterprises in the economy; improving the allocation and regulation of financial resources; promoting innovation and technological upgrading; strengthening the protection of intellectual property rights and the rule of law; and deepening its integration with the global market through trade and investment agreements.


China is facing a deflationary challenge that could threaten its economic and social stability. To overcome this challenge, China needs to adopt a mix of monetary, fiscal, and structural policies to boost demand, inflation, and growth. However, these policies also entail risks and trade-offs, such as increasing debt, inflation, and external imbalances. Therefore, China needs to balance its short-term stimulus with its long-term sustainability.

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