While most major economies are grappling with inflation rates exceeding central bank targets, China faces a different challenge: low inflation and the persistent risk of deflation. This blog post delves into the factors contributing to China’s weak domestic demand and strong export performance, highlighting the economic intricacies at play.

China’s Inflation Conundrum

In June, China’s consumer prices rose by a mere 0.2% year-on-year, down from 0.3% in April and May. Notably, prices decreased by 0.2% from May to June, marking the third monthly decline in the last four months, underscoring deflation concerns. When excluding volatile food and energy prices, core inflation was slightly higher at 0.6%.

Drivers of Low Inflation

Several factors contribute to China’s very low inflation:

• Food Prices: In June, food prices dropped 2% year-on-year, with fresh vegetables and fresh fruit prices falling by 7.3% and 8.7%, respectively.
• Other Sectors: Conversely, prices for clothing and health care rose by 1.5%.
• Producer Prices: Factory gate prices fell by 0.8% year-on-year, continuing a trend of declines since September 2022, driven by excess capacity and declining commodity prices.

Weak Domestic Demand

China’s low inflation partly reflects weak domestic demand, influenced by:

• Residential Property Market Crisis: The decline in property prices has reduced perceived wealth, dampening consumer spending.
• Weak Job Market and Stagnant Private Investment: Economic uncertainty has led to high household savings and reduced consumer spending.
• Export Reliance: With domestic demand faltering, the government has turned to exports, particularly in information technology and clean energy sectors, to drive growth.

Challenges in Export Markets

Despite robust exports, China faces challenges:

• Trade Backlash: Accusations of unfair subsidies have led to restrictions on Chinese exports, particularly electric vehicles (EVs).
• Declining Exports: Chinese EV exports fell by 13.2% from May to June, impacted by trade actions from the EU and the US. Lithium battery producers are also facing financial losses.

Stimulating Domestic Demand

To address deflation risks and stimulate economic growth, China has taken modest steps such as:

• Subsidies: Targeted subsidies for completing unfinished home construction.
• Interest Rate Cuts: Modest reductions in some interest rates.

However, more significant measures may be needed, including:

• Strengthening the Social Safety Net: Encouraging lower savings and higher consumer spending.
• Fiscal Stimulus: Government spending to boost aggregate demand, potentially through borrowing and increased public investment.
• Market Deregulation: Removing economic bottlenecks to facilitate growth.

Monetary Policy and Bank Lending

The central bank has gradually eased monetary policy to stimulate credit activity, but growth in bank lending remains sluggish:

• Bank Lending: In June, bank lending grew by only 8.1% year-on-year, the slowest rate on record.
• Liquidity Trap: Despite lower borrowing costs, potential borrowers are not taking up loans, indicating weak domestic demand and poor economic sentiment.

Export Performance

Despite internal challenges, China’s export sector shows resilience:

• Export Growth: In June, exports grew by 8.6% year-on-year, the fastest rate in nearly two years.
• Import Decline: Imports fell by 2.3%, indicating weak domestic demand and potential future export challenges.

Shifting Trade Landscape

China’s trade dynamics are shifting in response to global trade restrictions and supply chain realignments:

• Export Destinations: In the first half of 2024, exports increased to Southeast Asia and Latin America, while declining to the US, EU, and Japan.
• Import Sources: Imports from the US, EU, and Japan decreased, while imports from India, Russia, and Southeast Asia increased.

China’s economic strategy hinges on balancing weak domestic demand with strong export performance. While the government has made strides in promoting key technologies and clean energy exports, ongoing trade restrictions and a sluggish domestic economy present significant challenges. Addressing these issues may require a combination of fiscal stimulus, social safety net enhancements, and strategic deregulation to ensure sustainable growth and mitigate deflation risks.