China’s deflation problem

China’s deflation problem

While western policymakers grapple with high inflation in the wake of pandemic China faces a growing threat from falling prices.

• The ending of China’s lockdown late last year was widely expected to ignite a surge in demand which would fuel inflation much as had happened in the West since 2021. Instead, demand has faltered and inflation has fallen with Chinese consumer prices unchanged in the last year. At a similar stage in their post-lockdown recoveries, the US and the EU were posting accelerating inflation of over 5.0%. Chinese producer price inflation, a measure of materials and utility prices, has fallen by 5.4% in the last year, the most rapid decline in seven years.

• Increasingly the concern is that China could succumb to a period of excessively low inflation or falling prices. This has been Japan’s experience since the early 1990s, a period that has become synonymous with sluggish growth and stagnating or falling asset prices. Chinese policymakers recognise the threat. Earlier this month Yin Jianfeng, deputy director-general of the National Institution for Finance and Development, a state-affiliated think tank, said that China is showing evidence of the “Japan disease”.

• When China lifted its zero-COVID restrictions at the end of last year, few would have anticipated this outcome. Many observers expected a sharp rebound in activity, with demand so strong that it would drive global commodity prices higher. Instead, China's recovery has been plagued by weak domestic demand, evidenced by slowing consumer spending and a slump in private investment, a very different experience from that seen in the West.

• A major difference between China’s response to the pandemic and the West’s lies in China’s zero-COVID policy. It placed China’s population under draconian restrictions but without the substantial financial transfers to affected households made in the US and Europe. Rather than supporting incomes and jobs, Beijing's fiscal stimulus was channelled towards infrastructure spending and businesses. As a result, Chinese households that had experienced the fruits of decades of growth were exposed to job insecurity and a loss of income, many for the first time.

• This has reverberated through the real estate market that was already facing problems in the form of excess capacity and over-leveraged developers. In the absence of Western-style support for households, consumers have battened down the hatches and are avoiding major new commitments. The Chinese housing market has weakened, with new home sales and new development plummeting in the last year. Sharply higher youth unemployment, now at over 21%, has added to the difficulties facing the household sector. (The official job rate for cities is just 5.0%. The Chinese government blames high rates of youth unemployment on the unwillingness of young graduates to take less skilled jobs. Certainly there appears to be a mismatch between the rising supply of graduates and the number of higher-paid jobs on offer from larger companies.) 

• Unsurprisingly, consumers have become more cautious and are prioritising saving and paying off debts over spending.

• Caution is also the watchword in the corporate sector. Chinese factories that expanded to meet surging western demand in 2021 and 2022 are facing flagging export demand. Domestic consumers have not filled the gap, leaving some businesses with excess inventories which they have tried to shift by cutting prices (China’s electric vehicle makers have marked down prices for this reason and also in response to Tesla’s price cuts).

• Private businesses are also concerned about regulation and weak demand, in the domestic and international markets. The sprawling technology sector is still smarting from a domestic regulatory crackdown aimed at promoting “common prosperity”. Many firms face greater trade frictions and scrutiny in western markets and US export restrictions. The business counterpart to the defensive positioning of consumers is the way in which Chinese corporates are cutting investment spending to build cash balances.

• The fact that lower interest rates have failed to stimulate spending and borrowing is a particular cause for concern. The worry is that the China could slip into a 'liquidity trap', similar to Japan's experience in the 90s and noughties, where interest rates cuts fail to spur borrowing and spending. China's property sector seems closest to exhibiting these symptoms. Despite significant monetary easing the market remains in the doldrums. 

• Chinese policymakers will work hard to prevent a sharp adjustment in the housing market. Property accounts for a significant share of household wealth and a crash could threaten social stability. This was evident in the mass protests against developers of unfinished homes last year. The government has the capacity for, and past experience of, aggressive market interventions. During the Asian financial crisis in 1998, Shanghai made home purchases income tax deductible, providing targeted fiscal support to the property market.

• China’s Academy of Social Sciences, a state-sponsored think tank, wants to go further, and has called for the introduction of a comprehensive fiscal stimulus package, including direct transfers to low-income households to boost consumption. As one of the least indebted governments in the world, China has headroom to borrow to fund a stimulus programme in the same way western governments did during the pandemic.     

• Even without such measures to boost demand, inflation is expected to edge higher in coming months due to the low base set by last year's prices. And despite weak demand, China is on track to meet the government's 5% growth target this year.

• This exposes the limitations of comparisons with Japan. Even if Chinese growth slowed to 3% in the medium term, it would be a multiple of the 1% average growth that Japan mustered in its decades-long liquidity trap. China has absorbed the lessons of Japan’s deflation and has the tools to avoid a similar outcome.

• With a rapidly ageing population and a shrinking workforce, China's growth rate has slowed from the dizzying double-digit rates seen in the ‘90s and noughties. Navigating the path from the investment-driven, rapid growth phase to a slower, consumption-dependent model was always going to be tricky. Further debt-financed stimulus could help China negotiate the latest turn. So far, policymakers seem unwilling to steer in that direction.

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OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index closed the week down 1.7% at 7,564. UK equities fell last week after the Bank of England raised interest rates for the 14th consecutive time and signalled that rates would need to be “sufficiently restrictive for sufficiently long” to return inflation to its 2% target.

Economics

• The Bank of England increased interest rates by 25 basis points to 5.25% solidifying expectations that the Bank rate will peak at 5.75% early next year
• UK prime minister Rishi Sunak said that inflation is not falling as fast as he would like, and the government must make “difficult” decisions to combat it
• The UK government announced plans for hundreds of new North Sea oil and gas licenses amid criticisms that the policy will hamper efforts to reach its net zero targets by 2050
• Fitch Ratings unexpectedly downgraded the US’s debt to AA from AAA due to concerns about the path of fiscal policy and the erosion of governance
• US equities fell and US Treasuries yields reached nine-month highs following the debt downgrade by Fitch Ratings
• According to Nationwide, UK house prices fell by 3.8% in the year to June, the biggest annual drop since 2009
• The UK’s biggest teachers union called off strikes in England as members accepted the government’s increased pay offer of 6.5% 
• US job growth was weaker than expected in July and job vacancies dropped to a two-year low
• US manufacturing activity contracted for a ninth consecutive month as industrial companies cut jobs due to falling demand 
• US oil inventories fell by a record amount of 17m barrels last week, suggesting that Saudi Arabia-led efforts to cut output are beginning to tighten supply
• GDP flash estimates indicated that the euro area returned to growth in Q2 2023 with a 0.3% expansion 
• The Italian economy unexpectedly contracted by 0.3% in Q2 2023 as a buoyant tourism sector failed to offset falling industrial output
• Unemployment in the euro area fell to 6.4% in June, a historical low, driven by lower unemployment in Germany
• Euro area inflation fell to 5.3% in July in line with expectations, but core inflation remained at 5.5%  
• The Brazilian central bank was the first to start monetary easing in Latin America by cutting the interest rate by 50 basis points to 13.25% 
• Turkish inflation increased sharply to almost 50% in July after falling for eight straight months as recent tax hikes temporarily increased prices

Business

• Ferrari upgraded its profit outlook for the year as buyers personalising their cars boosted revenues, in the latest sign that the luxury market continues to outperform
• BAE Systems increased its earning guidance for the year as the Ukraine war increased defence sales by 11% 
• Nomura Holdings reported earnings below expectations as revenues fell due to a slowdown in trading and dealmaking businesses
• Pharmaceutical company Pfizer’s revenues halved in Q2 2023 and demand for its COVID-19 productsa fell sharply
• Uber reported its first operating profits in Q2 2023 thanks to cost-cutting measures after years of heavy spending and aggressive growth
• The UK’s financial regulator vowed to “take action” if banks failed to pass on higher interest rates to savers

Global and political developments

• Former US president Donald Trump was indicted in connection with attempts to overturn the results of the 2020 election
• Russian local authorities handed out weapons to civilians in the Belgorod region that borders Ukraine, following the Ukrainian counteroffensive
• Russian attacks on Ukrainian grain silos added to worries of global food shortages as wheat prices rose by 4% early last week
• The European Commission clarified that weapons supplied to Ukraine can only be used for self-defence purposes after drones hit Moscow on Tuesday for the second time in three days

And finally… enthusiastic Taylor Swift fans have set a new record. In her latest show in Seattle, eager Swifties enjoyed the concert so much that they caused a 2.3 magnitude earthquake, according to seismologists – Shake it off!