Inflation in China: in which direction will the snake creep?
In this article we analyse what factors explain China’s recent cycle of low inflation and what risks could transform it into a deflationary crisis.
While most advanced and emerging economies have faced a period of high inflation in the past two years, in China it has remained close to zero. Core inflation, which excludes more volatile components such as food and energy, has stood at around 0.5%, not far from the average recorded since 2005 (around 1%), but showing a persistent downward trend since 2018. What is behind the recent cycle of low inflation and what risk factors could transform it into a deflationary crisis?
In the last two years, 50% of the components of the consumer basket have maintained negative average inflation (23% of them below –2%) and only 10% have recorded inflation above 2% (see first chart).1 Among the most visible symptoms of the recent moderation in inflation in the Asian giant are persistent declines in the prices of food, durable goods, cars and rents.2 In the case of food, despite falling prices observed in various products (such as meat, oil and eggs) and their high relative weight in the basket, these declines are likely to be reversed given the high volatility of these components. On the other hand, the falls in rental prices are another symptom of the crisis in the real estate sector which has plagued the country since 2021. Given that it will be difficult to absorb the excess capacity in this sector, it will continue to exert downward pressure on inflation in the coming years, whether directly (due to declines in rental and housing prices) or indirectly (due to lower demand for durable goods related to housing and confidence
or wealth effects).
- 1. In a previous deflationary episode, in 2009, core inflation stood at –1%. Over 30% of the consumer basket had inflation above 2% at the time (mainly essential goods and services, such as food and housing), while services inflation stood at –1% in the period (versus around 1% since 2023).
- 2. For example, there have also been significant price declines in telecommunications equipment, although they have been smaller than those recorded historically (–2% in the last two years compared to almost –10% since 2001).
It is also worth highlighting the automotive sector (see second chart), which has been recording deflation of around 5% for two years now (compared to a historical average of –2%), in a context marked by productivity improvements in the sector, fierce competition and in which the demand for cars has slowed, serving as an illustrative case of the structural factors behind the current cycle of low inflation.3 With all this, there are factors that suggest that the downward pressures on inflation of recent years are not so limited to specific sectors and that the Chinese economy is facing chronic oversupply (or lack of demand).
- 3. Specifically, sales of basic passenger vehicles have increased by around 2% in 2023 and 2024, compared to a historical average growth of around 4% per year, while sales of SUVs have increased by around 15%, compared to a historical average of over 30%. Together, these two categories account for more than 80% of total vehicle demand.
In order to analyse the phenomenon of overcapacity in China’s industry more systematically, we have compared the evolution of investment with that of production prices. Although there is a negative correlation between the two variables, that is, the greater the accumulated investment in recent years, the greater the falls in production price inflation, the situation varies by sector. On the one hand, sectors such as the automotive industry, machinery and textiles show moderate investment flows and moderate price falls, whereas the electrical and electronics equipment sectors have among the highest investment flows, but with moderate production price falls. This invites us to think that this is a multidimensional phenomenon. In more technologically advanced sectors, the rebound in investment can simply be explained by higher investment needs and more dynamic demand.4 On the other hand, in sectors such as metals and the chemicals industry, which combine high cumulative investments with significant price reductions, the case appears to be different.
In the case of some of these sectors, the combination of high investment and significant price declines is compounded by a steady decline in profitability (see third chart). This is the case in the cheminicals, paper, textile and automotive industries, while the most extreme cases are found in the minerals and ferrous metal processing sectors. In the former, there has been cumulative investment growth of 30%, while prices have fallen by 9% and profits by more than 50%. In the latter, investment has almost doubled, with prices falling in excess of 10% and profits by around 90%. On the other hand, sectors such as electrical products, electronics and machinery have registered increases in their profitability in the same period.
- 4. In addition, some of these sectors are included in the Made in China 2025 plan, which seeks to develop certain industries that are considered strategic. Also, in the case of sectors such as electronics or electrical equipment, this concerted investment effort has been accompanied by significant gains in global market shares in recent years (this is the case, for example, of components related to green energies).
The current deflationary cycle in China thus has some important nuances. Although the problems of overcapacity in industry appear to be concentrated in certain sectors of the economy, such as the chemicals and metals industries, they have major ramifications for other economic sectors. On the other hand, in sectors such as textiles or durable consumer goods (such as the automotive sector), the episode of falling prices could be explained rather by stagnating domestic demand.
Also, despite localised problems, chronic overcapacity problems in industries at the beginning of the value chain will continue to apply pressure on prices downstream, i.e. in sectors that use these products as production inputs. Similarly, the real estate crisis will continue to apply negative pressure on prices and on Chinese consumer demand.5 In this regard, inflation in China is likely to remain close to zero in the coming years.
But is this just another deflationary cycle or could the Chinese economy enter a phase of «Japanisation»? This process refers to a prolonged phase of low economic growth and low inflation, which in the case of Japan since the late 1980s originated in the bursting of a housing bubble and very low fertility rates – two factors which it has in common with the current situation of the Chinese economy. In this equation, the determining factor will be how domestic demand evolves. Since the opening up of the Asian giant’s economy in the 1990s, the imbalance between supply and demand in China has been absorbed by the rest of the world; indeed, this «offset» has even intensified in recent years, with China gaining global market share thanks to its consistently high price-competitiveness. Faced with a new escalation of trade tensions, this time the main task will lie on the other side of the wall. Will the Chinese economic model be able to adapt?
- 5. For further details, see the Focus «What is going on with Chinese consumers?» in the MR07/2024.
- 1. In a previous deflationary episode, in 2009, core inflation stood at –1%. Over 30% of the consumer basket had inflation above 2% at the time (mainly essential goods and services, such as food and housing), while services inflation stood at –1% in the period (versus around 1% since 2023).
- 2. For example, there have also been significant price declines in telecommunications equipment, although they have been smaller than those recorded historically (–2% in the last two years compared to almost –10% since 2001).
- 3. Specifically, sales of basic passenger vehicles have increased by around 2% in 2023 and 2024, compared to a historical average growth of around 4% per year, while sales of SUVs have increased by around 15%, compared to a historical average of over 30%. Together, these two categories account for more than 80% of total vehicle demand.
- 4. In addition, some of these sectors are included in the Made in China 2025 plan, which seeks to develop certain industries that are considered strategic. Also, in the case of sectors such as electronics or electrical equipment, this concerted investment effort has been accompanied by significant gains in global market shares in recent years (this is the case, for example, of components related to green energies).
- 5. For further details, see the Focus «What is going on with Chinese consumers?» in the MR07/2024.
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