Chinese economy falls into deflation

August 10, 2023
Posted by: OptimizeIAS Team
Category: DPN Topics

Chinese economy falls into deflation

Subject: Economy

Section: Inflation

Context: Chinese economy in deflation as consumer prices fell for the first time in more than two years in China, signalling further weakening demand.

Key Points:

China’s economy has been facing multiple headwinds such as sluggish consumer spending, the unravelling of the real estate crisis, and weakening exports, which have pushed its economy into deflation.
The consumer price index (CPI) fell by 0.3 per cent in July from a year ago. The cost of food, transportation, and household goods all declined.
Signs of deflation have become more prevalent in the world’s second-biggest economy in recent months, sparking concerns that China could enter a prolonged period of stagnation.
China did not undertake massive COVID-era support as seen in developed economies. While this helped it avoid the rampant inflation shock seen elsewhere, disposable household income fell as wages and property asset values simultaneously stalled.

What is deflation?

Deflation is a decrease in the general price of goods and services. As the purchasing power of currency rises over time, consumers can buy more with this money, but that won’t translate into profit for businesses, and they will have to sell their products or services for less.

Why consumer inflation is a better indicator of inflation/deflation

Consumer inflation is a better indicator of deflation than wholesale inflation because it directly reflects changes in the prices of goods and services consumed by households.
Unlike wholesale prices that focus on goods sold to businesses, consumer prices influence purchasing power, consumer behavior, aggregate demand, and monetary policy decisions.
Consumer inflation’s broader scope and direct impact on households make it a more accurate measure of the potential economic repercussions of deflation.

What are the causes of deflation?

The first cause is a decrease in aggregate demand, which is the total amount of goods and services that consumers and businesses are willing to buy. This can happen during a recession, when people are less confident about the economy and are less likely to spend money.
An increase in aggregate supply, which is the total amount of goods and services that businesses are willing to sell. This can happen when businesses become more efficient and are able to produce more goods and services at a lower cost.
A decrease in the money supply, which is the amount of money in circulation. This can happen when central banks raise interest rates or sell government bonds.

What are the impacts of deflation?

With the decrease in economic growth, businesses may also see their profits fall, which would hurt their investment and hiring plans. This could also lead to an increase in unemployment, as businesses may have to lay off workers in order to cut costs.
The lower demand also results in lower demand for capital goods with an overall fall in investments, this will result in lack of demand for bank credit.
A decrease in asset prices, such as stocks and real estate, as people becomes less willing to pay high prices for assets that are expected to lose value in the future. This may lead to a decrease in consumer spending, as people may delay purchases in the hopes of prices getting lower in the future.

How can China come out of deflation?

Beijing must roll out more forceful plans to restore confidence and stimulate consumer spending. This can be done through a combination of fiscal and monetary policy, along with structural reforms. (see box below)

Strategies to combat deflation:

Monetary Policy Adjustment: Central banks can implement expansionary monetary policies to combat deflation. This involves lowering interest rates and engaging in quantitative easing to increase the money supply, making borrowing cheaper and encouraging spending.
Fiscal Stimulus: Governments can increase public spending and cut taxes to boost demand in the economy. This injection of funds can encourage consumer spending, business investment, and job creation, thereby combating deflationary pressures.
Currency Depreciation: Allowing the national currency to depreciate can make exports more competitive on the global market. A weaker currency can boost export demand, increase revenue for domestic producers, and help counter deflation.
Structural Reforms: Implementing structural reforms to enhance productivity, increase competitiveness, and promote innovation can stimulate economic growth. Such reforms may involve changes to labor markets, regulations, trade policies, and investment in education and research.
Expectation Management: Boosting consumer and business confidence is crucial to encourage spending and investment. Clear communication from government and central banks about their commitment to combat deflation and maintain price stability can influence expectations and behavior. If consumers and businesses anticipate future price increases, they are more likely to spend and invest in the present.