Deflation in China – why is it bad?

China has been in a deflation environment for a third consecutive month since December – see graph from FT – China’s consumer prices fall for third month as economic recovery lags. The CPI fell 0.3% on year in December with producer prices falling by 2.7%. The main reasons behind these figures are less consumer demand both domestically and in overseas markets – exports fell by 4.6% – and a slowdown in the property sector. To counter act this the Chinese government has relaxed lending rates in the latter which accounts for over 25% of economic activity in the economy. Even so it will take time for these policies to be transmitted through the economy and whether they will provide enough stimulus to see prices go north.

What is deflation and why is it bad? Deflation is a continuous fall in the level of prices usually measured by the consumer price index. Japan has been an example of deflation in 2010 even with expansionary fiscal and monetary policy. Deflation is usually caused by a fall in AD leading to a negative output gap where GDP is less than its potential. However excess AS can also cause a drop in prices but this is not as common. Although falling prices is good for consumers there are negatives for the economy:

• Deflationary expectations – consumers hold back on spending as they expect prices to drop further.

• Value of debt – this rises when prices fall and can impact consumer confidence and spending

• Cost of borrowing – increases as real interest rates will rise if nominal rates of interest do not fall in line with prices

• Profits for business – lower prices hit the revenue streams of business which can lead to higher unemployment as firms look to reduce costs.

• Confidence in the economy – falling asset prices including a drop in property values hits wealth and confidence — leading to a decline in AD. 

How do you get out of a deflationary spiral?

This is easier said than done. Japan tried the policies below with limited success and it ultimately comes down to consumers willingness to borrow and spend money. Expansionary monetary policy – cutting interest rates to stimulate demand and quantitative easing by printing money and injecting it into the economy in the hope that consumption increases and therefore AD. Expansionary fiscal policy – dropping taxes and increasing government spending. Again this relies on consumers buying more and more stuff to maintain growth and AD. In China they have relied on building more ghost cities and blowing up and rebuilding bridges with the intention of generating GDP and higher prices.

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