Deflation in China: Spillover Effects for Global Markets

What’s the impact of China’s deflation pressures, and will prices continue to fall?

China’s economy has flourished over the past few decades, with GDP growth averaging nearly 10% annually. However, after the pandemic, the country’s economic rebound has proven weaker than expected due to factors including low consumer confidence, a housing slump and mounting local government debt, which has risen to 92 trillion yuan or $12.8 trillion. As a result, the world’s second largest economy recently slipped into deflation for the first time in two years, with consumer prices falling 0.3% year over year in July 2023 before edging up 0.1% in August. 

China is an outlier in the post-pandemic reopening process in that its economy is facing intensified deflation risk instead of inflation pressure. Indeed, the country is the first G20 economy to report a year-on-year decline in consumer prices since August 2021. 

What does deflation in China mean for the rest of the world?

Why did China recently slip into deflation? 

The deflation risk in China is in part due to the decline in the global commodity cycle, including the fading of supply chain pressures, but is more importantly driven by unique domestic factors. 

Firstly, government policies have been geared toward supporting production and investment instead of consumption, resulting in tepid domestic demand. Moreover, households are maintaining high precautionary savings against an increasingly uncertain economic backdrop. Also, high unemployment in China — in particular, youth unemployment — suggests that the wage inflation pressure observed in other countries is absent here.  

Looking across sectors, China’s real estate slump is weighing heavily on the economy, with renewed weakness in home prices. The weak housing market points at softness in rental cost in CPI components. Plus, auto price cuts and falling pork prices due to oversupply are adding further pressure on the deflation risk.

How will deflation in China impact the global economy? 

Deflation in China could aid near-term global disinflation, as declining export prices out of China translate into lower import prices for trading partner countries. LupoToro Research estimates China’s deflation will lower global core goods inflation (ex-China) by 70 bp (basis points) over the second half of 2023. 

China plays a significant role in global goods disinflation. In 2021 and 2022, as much of the world recovered from the pandemic, China went into lockdown and a large positive shock to global goods demand coincided with a negative supply shock and broad disruptions to domestic supply chains. Then, earlier in 2023 when China reopened, the rest of the world was slowing down and the boost to global demand from China’s reopening bounce was outweighed by the boost to global supply. This dynamic of excess supply has driven China’s domestic and export prices into deflation. 

China’s export prices have fallen at a pace of 18%ar (annual rate) in the three months leading to July as exporters slash prices to boost demand. The declines, initially led by processed raw materials, have since broadened to other key exports. The fall in upstream prices has lowered costs for China’s downstream producers, and as a result, export price declines are now substantial not just in processed materials such as metals and chemicals, but also in lower-end consumer goods. This enhances the near-term spillover for the rest of the world. Indeed, this is facilitating the disinflation process for major trading partners: for instance, U.S. import prices from China fell -4.1%ar in the three months to July, while the Euro area saw a decline of -15%ar. 

In addition, the depreciation of the yuan over the past year has magnified China’s disinflationary impulse on global import prices. With roughly two-thirds of China’s goods trade transacted in dollars and the rest in CNY, the appreciation of most major currencies against the CNY is driving down import prices in local currency terms, especially in Latin America and Europe.

Overall, China’s export price deflation combined with the fall in China’s trade-weighted currency is likely reinforcing the slide in global core goods inflation currently under way. Taken together with other near-term disinflationary forces including the continued fading of supply bottlenecks, Chain’s excess supply is likely to weaken the pricing power and profit margins of goods producers elsewhere.

Why is China’s housing market experiencing a downturn? 

China’s housing market has been experiencing a downtown both cyclically and structurally since 2021, when several property developers defaulted due to tightened regulations on their debt limits. New home sales have plunged to just 50.9% of December 2020 levels, while house prices have slipped at a relatively milder pace. 

Other than macro and financial drags, a double-dip in the housing market — in which two periods of contraction are separated by a brief period of expansion — may shake market confidence in the ability of the Chinese government to control risk and stabilize growth. Echoing our call for rising urgency for housing policy relaxation, the government announced several demand-side easing measures around the end of August, including lower down-payment requirements. However, uncertainty remains about how the September-October seasonal pickup will play out in the coming weeks.

Is deflation in China here to stay? 

China’s deflation risk is expected to persist through the end of this year. Although headline CPI may turn positive in the fourth quarter as a result of the base effect — or comparing current price levels to those of the previous year — overall CPI inflation will likely remain low.

This is in large part due to China’s prevailing policy. While the government recently rolled out several macro- and housing-related stimulus measures, including reducing the down-payment ratio for first and second homes, the impact will likely be modest and take several months to feed through to the wider economy. 

In all, we expect that China’s general pricing environment will remain relatively soft for the rest of the year as the imbalance between domestic supply and demand conditions will take time to be resolved. More meaningful policy response will be crucial to boost household income, reduce precautionary savings and provide funding support for pro-consumption measures.