Concerns of Over Deflation in China

• 14 Aug 2023

For Prelims: Concerns of Over Deflation in China, Consumer Price Index, Deflation, Inflation, Gross Domestic Product, Debts, Wholesale Price Index.

For Mains: Concerns of Over Deflation in China, Implications of Deflation in China on India.

Source: TH

Why in News?

Recently, China’s National Bureau of Statistics reported that the Consumer Price Index (CPI) had declined in July 2023 by 0.3% compared to a year earlier, causing Deflation in the Country.

What is Deflation?

• About:
  • Deflation is the opposite of Inflation. It refers to a sustained and general decrease in the overall price levels of goods and services in the economy.
  • In a deflationary environment, consumers can buy more goods and services for the same amount of money over time.
  • However, deflation can occur for various reasons, such as reduced consumer demand, oversupply of goods, technological advancements that lower production costs, or tight monetary policies by central banks.
    • In China’s case, reduced consumer demand and economic slowdown are the reasons.
• Impact:
  • Positive:
    • Lower Interest Rates: In a deflationary environment, central banks may lower interest rates to encourage borrowing and spending. Lower interest rates can lead to reduced borrowing costs for businesses and consumers, potentially stimulating investment, consumption, and economic activity.
    • Improved Savings Incentives: Deflation can encourage saving because the value of money increases over time. Savers are more likely to see the value of their money grow, which can incentivize them to save more for the future, contributing to long-term financial stability.
    • Economic Efficiency: Deflation can prompt businesses to become more efficient and streamline their operations. Falling prices can encourage companies to reduce costs, innovate, and become more competitive in order to maintain profitability. This focus on efficiency can lead to productivity gains and long-term economic growth.
    • Favorable for Fixed-Income Beneficiaries: People who rely on fixed-income investments, such as retirees with pension plans or fixed annuities, may benefit from deflation. Since the value of money increases, their fixed income becomes relatively more valuable, providing them with a stable and reliable source of income.
  • Negative:
    • Downward Spiral of Economic Contraction: When consumers expect prices to fall further, they delay purchases, leading to decreased demand for goods and services. This reduction in demand can lead to lower production, reduced business revenues, and even layoffs, which in turn further reduce consumer spending.
      • This cycle can create a downward spiral of economic contraction, job losses, and financial instability.
    • Drive Down Business Revenue: Lower prices drive down business revenues, leading to lower profits, less investment, and potentially higher unemployment as companies pare back on production in the face of decreased demand.
    • Expensive Service Debt: Deflation can increase the real burden of debt. As prices fall, the value of debt remains constant or even increases in real terms. This can make it more difficult for individuals, businesses, and governments to manage their debt obligations.
      • In times of deflation, the relative purchasing power of every dollar spent on debt repayment is higher than it was before prices began falling.
  • However, economic situations can be complex, and the actual effects of deflation can vary depending on the specific circumstances of an economy.

What Caused Deflation in China?

• Zero-Covid Policy:
  • The Chinese economy has been struggling for more than a year. The most prominent was a heavy-handed Zero-Covid policy that saw entire cities shut down, sometimes for weeks at a time, in an effort to prevent the spread of the coronavirus.
• Slowdown in Property and Banking Sector:
  • The property sector, which in recent years accounted for between 20% and 30% of GDP (Gross Domestic Product), has suffered a severe slowdown, with a number of major developers unable to service their Debts, and many projects left incomplete.
  • The banking sector is also burdened by bad loans, many of which were made to local government agencies that have experienced sharp declines in revenue.
• Unemployment:
  • Increasing unemployment among younger workers is also a problem, with the official jobless rate for people ages 16 to 24 at 21%, and some experts expressing concern that the real number is significantly higher.

How can China’s Deflation Impact India and the World?

• India:
  • Positive Effect: If investment in the Chinese economy is lowered owing to the increasing slowing rate of their economy, and now deflation, India could potentially emerge and take over as the manufacturing hub for the developed economies.
    • For India, if economic reforms are accelerated, India can become the next manufacturing hub.
  • Negative Effect: China remains one of the biggest importers of iron ore from India. The east Asian country imports almost 70% of Iron-ore from India.
    • Therefore, a slower economy for China would mean the amount of import into China could fall, spelling somewhat doom from India's economy.
• World:
  • Global Supply Chains:
    • Many global supply chains are intricately linked with China. If China's export engine is sputtering due to deflation and weak demand, disruptions in supply chains could affect industries worldwide, including those in India that rely on intermediate goods from China.
  • Global Growth:
    • China is the world's second-largest economy, and its economic health has a significant impact on global growth.
    • A sharp decline in China's economic activity due to deflation could lead to reduced demand for goods and services worldwide, contributing to a slowdown in global economic growth.
  • Central Banks and Monetary Policy:
    • Central banks in various countries might face challenges in managing monetary policy in response to deflation in China.
    • Lower global demand could lead to reduced inflationary pressures and impact the effectiveness of interest rate policies.

Way Forward

• Policymakers around the world, including in India, would need to closely monitor these developments and formulate strategies to mitigate potential negative impacts.
• The implications of deflation can include increased debt burdens, altered consumer behavior, reduced business investment, and challenges for monetary policy.
• Addressing deflation will require a combination of fiscal stimulus and monetary policy measures to boost demand and reignite economic growth.

Q. Which one of the following statements is an appropriate description of deflation? (2010)

(a) It is a sudden fall in the value of a currency against other currencies

(b) It is persistent recession in both the financial and real sectors of economy

(c) It is persistent fall in the general price level of goods and services

(d) It is a fall in the rate of inflation over a period of time

Ans: (c)