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Can China beat deflation?

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In Brief

At a time of slowing economic growth and massive corporate debts, a deflationary spiral would be China’s worst nightmare. And the risk is mounting. The producer price index (PPI) has been in negative territory for 39 consecutive months, since February 2012.


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The growth of China’s consumer price index (CPI), though still positive, has also been falling steadily, from 6.5 per cent in July 2011 to 1.2 per cent in May 2015. If past experience is any indication, China’s CPI will turn negative very soon.

In China’s last protracted bout of deflation, from 1998 to 2002, persistent declines in prices were the result of monetary and fiscal tightening that began in 1993, compounded by the lack of exit mechanisms for failed enterprises. After peaking at 24 per cent in 1994, inflation began to decline in 1995. But GDP growth soon began deteriorating rapidly. In an effort to revive growth in a difficult global environment and buffer exports against the impact of the Asian financial crisis, the Chinese government loosened monetary and fiscal policy beginning in November 1997.

But it was too little, too late. By 1998, when CPI inflation began to fall, producer prices had already been declining for eight months, and remained negative for a total of 51 months, with CPI growth beginning to recover after 39 months.

An obvious lesson is that the government should have switched to loosening earlier, and more forcefully. But this experience also underscores the impotence of monetary policy in a deflationary environment, owing to the unwillingness of banks to lend and of enterprises to borrow. The fact that loss-making enterprises were allowed to churn out cheap products, eroding the profitability of high-quality enterprises (and thus their incentive to invest), prolonged the deflation.

Nonetheless, China eventually managed to rid itself of deflation and return to rapid economic growth. For starters, a decline in investment during the deflationary period — together with firm closures, mergers, and acquisitions — reduced overcapacity, clearing the way for investment to rebound strongly in 2002. At the same time, expansionary fiscal policy increased effective demand, while the government, backed by its strong public-finance position, was able to tackle nonperforming loans effectively, thereby increasing commercial banks’ willingness to lend and firms’ ability to borrow.

Moreover, housing market reforms and the development of a mortgage-loan market in the late 1990s fuelled rapid growth in real estate investment, which reached an annual rate of over 20 per cent in 2000. As a result, real estate development became the most important contributor to economic growth, even as exports boomed following China’s accession to the WTO.

The problem with the emergence of these new growth engines is that it enabled China’s leaders to delay important structural reforms. As a result, China now faces many of the same challenges it faced in the late 1990s — beginning with overcapacity.

After 15 years of rapid growth in real estate development, this is not surprising. But that does not make it any less risky. In fact, if overcapacity is allowed to continue putting downward pressure on prices, China’s economic growth will not stabilise at a rate consistent with its potential. Instead, the economy will be pushed into a vicious spiral of debt deflation.

At this point, the authorities could eliminate overcapacity through firm closures, mergers and acquisitions, and other structural measures. They could also seek to eliminate excess capacity by using expansionary monetary and fiscal policies to stimulate effective demand. In theory, the long-term solution would be to pursue structural adjustments that would improve the allocation of resources. But that would be painful and slow. Striking a balance between the short- and long-term approaches will prove to be a major challenge for China’s leadership.

Complicating this effort is the fact that, unlike in 1997–2002, China cannot absorb overcapacity by stimulating real estate investment and exports. And no one knows whether the much-discussed ‘innovative industries’ can have the impact that real estate investment and exports did — not least because there is so much excess capacity in the traditional industries.

China must do whatever it takes to avoid falling into the debt-deflation trap. Fortunately, China still has room to invest in growth-enhancing infrastructure and innovative industries. Policies to expand social security and improve the provision of public goods could support these efforts, boosting domestic consumption by allowing households to reduce their precautionary savings.

But, at the same time China’s leadership must continue to pursue its agenda of structural reform and adjustment, even if it may have an adverse impact on growth in the short run. China simply cannot afford to continue to kick the reform can down the road.

Mark Twain once purportedly said: ‘History doesn’t repeat itself, but it does rhyme’. China should brace itself for a period of deflation, which may be even more protracted than the last one. But, with the right approach — and a bit of good luck — China can make sure that, this time, it recovers more sustainably than in the past.

Yu Yongding served on the Monetary Policy Committee of the People’s Bank of China from 2004 to 2006. He has also served as a member of the Advisory Committee of National Planning of the Commission of National Development and Reform of the PRC.

This article was originally published here by Project Syndicate.

One response to “Can China beat deflation?”

  1. As this post suggested China may face an extended period of deflation with a negative impact on economic growth, amid its structural reforms.
    It seems sensible to have expansion of both monetary and fiscal policies to head off potentially very serious deflation and excessively slowing in the economic growth, as the author has called for, that “China must do whatever it takes to avoid falling into the debt-deflation trap”.
    Structural reforms should, in the short term, be done in the context of stimulating economic growth and combating deflation. There should be enough room in China for it to invest, given that China’s capital stocks are still low in not only infrastructure in many locations with the need of continued urbanisation, but also in the short components of its structural imbalance. Understandably, China is still far from a high income country and it will take many years and decades to catch up with the levels of high income industrialised countries. Capital labour ratio in China is arguably still equally low as its per capita income. That indicates the needs for increasing its capital stocks not only in aggregate sense, nut particularly in the under balanced areas of its economy.
    It is, however, important to channel the monetary and fiscal expansions into the right areas of the real economy and prevent any excessive flow to its stock market for speculative activities.
    Although the housing market in China has seen very high property prices and the authorities have tried to dampen its further growth, the housing construction sector still have room to expand.
    Furthermore, its services sector has plenty of room to expand and its growth can be combined with the Chinese leadership’s push for innovation and promoting enterprenourship.
    In summary, China needs expansionary fiscal and monetary policies to stimulate the growth of the economy and address deflationary pressures. Structural reforms and adjustments, in the short to medium terms, need to be done in that overarching context. In both the short and long terms, China should not loose sight that its income is low, so is its capital labour ratio. The main focus of structural adjustments, particularly in the short term, should be on expanding infrastructure (including housing in cities and towns where further urbanisation will see a rapid increase in resident population and the capacities of the services sector.

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