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Since September 2022, China’s producer price index has remained below 100, signaling a worrying trajectory of deflation in the country’s industrial sector. Although its consumer price index has shown some improvement this year, the fluctuations in monthly growth suggest the recovery is fragile. At the Shanghai Bund Summit this month, China’s former central bank governor Yi Gang said the country should focus on combating deflationary pressures.
Deflation in China is more than just falling prices; it is a symptom of deeper structural issues in the economy. The core problem is a mismatch between the money supply and the demand for money from households and businesses. When the government does not provide sufficient money to meet the demand, consumers and companies find their actual money holdings fall short of their needs, prompting them to hoard cash. The persistent negative growth rate of M1 (money in circulation and demand deposits) relative to M2 (which includes M1 as well as savings and other deposits) since February 2021 and a sharp decline in M1 growth rate since January 2024 indicate monetary disequilibrium and reduced aggregate demand.
Weaker consumption, in turn, forces businesses, especially in key industrial sectors, to cut production and reduce employment. According to a recent survey by Mysteel of 247 Chinese steel mills, the operating rate of blast furnaces declined by 6.44 percent year over year to 77.63 percent. Given that blast furnaces are central to industries such as construction, automotive manufacturing, and heavy machinery, this decline reflects a non-trivial slowdown in industrial activity and the deflationary pressure facing the Chinese economy. Additionally, urban unemployment rates have remained above 5 percent over the past year. In August 2024, China’s youth unemployment rate for ages sixteen to twenty-four (excluding students at school) increased to 18.8 percent—the highest in the last eight months since the National Bureau of Statistics updated its method of calculation.
China risks falling into a self-reinforcing cycle. As consumers and businesses continue to hold off on spending and investment, deflationary pressures deepen, further depressing prices and economic activity. The longer this cycle persists, the more challenging it becomes to reverse.
Deflation also exacerbates debt burdens. It increases the real value of debt, making it harder for borrowers to service loans, even if the nominal value remains unchanged. (Note that China’s outstanding debt in the past three quarters has continued to grow.) This issue is particularly severe in China, where local governments, property developers, and households with mortgages are already burdened by significant debt. In a deflationary environment, debt repayment becomes even more difficult, increasing the odds of financial instability.
The implications of China’s deflation also extend beyond its borders. As domestic demand shrinks, China’s imports decline. At the same time, deflation lowers the prices of Chinese exports, worsening the already existing trade imbalances with key partners like the United States.
To address deflationary pressures, Chinese policymakers have two potential paths.
The first option is to decrease the demand for money by lowering essential living costs such as education, healthcare, and housing, particularly for middle- and low-income workers. Reducing these costs would ease the financial burden on households, allowing them to meet their basic needs without hoarding cash. However, this approach is challenging to implement in the short term due to its potential disruption of entrenched economic interests. Specifically, education providers, healthcare institutions, property developers, and affluent homeowners may oppose such reforms, given the adverse impact on their financial positions.
The second option, which is more immediate and feasible, is for the central government to step in and increase the money supply. While expansionary monetary and fiscal policies are useful, traditional supply-side measures—like lowering the reserve requirement ratio or issuing large-scale government bonds for infrastructure investment—are insufficient to resolve deflation because the fundamental monetary disequilibrium would persist.
The actual key to tackling deflation is to increase household disposable income and boost consumption through several targeted measures. One potential policy is to offer tax breaks to companies that raise wages, especially for middle- and low-income workers. This will directly stimulate consumption without placing a significant cost burden on businesses. Additionally, lowering personal income taxes for middle- and low-income households will have an immediate impact on consumption, as these groups are more likely to spend rather than save additional income. This could quickly revive demand and alleviate deflationary pressures more effectively than supply-side interventions.
Expanding tax credits and deductions is another way to increase disposable income and stimulate demand. For example, offering targeted credits for families with children—or deductions for essential expenses like healthcare, education, and housing—can relieve financial burdens on households. This flexibility allows for increased spending on other goods and services, further bolstering demand.
China now stands at a critical juncture. While increasing the money supply may initially reduce fiscal revenues and increase central government deficits, the broader economic benefits can offset the immediate fiscal impact. The cost of inaction is far higher. A deeper and more prolonged deflationary spiral would lead to further declines in production, employment, and consumption, creating a more significant risk of financial instability. By adopting timely and well-calibrated policies now, China can break the deflation cycle, stabilize its economy, and ensure long-term sustainable growth.
