All eyes should be on China. Deflation is getting worse

Investors are currently enjoying positive surprises regarding inflation mainly in the US, where it fell more than expected this week. Both the consumer CPI and the producers' PPI surprised in June in annual terms with a larger fall to 3 and 4,8%, respectively. The market bulls welcomed this, as it may mean that after the hike in July, the Fed will stop the cycle of hikes and, what's more, it will start rate cuts at the beginning of next year.

However, China should show us how to deal with disinflation and then deflation. It's right there deflation is knocking at the door and threatens to lead to a deflationary spiral with a slowing economy. Deflation, by its very nature, causes the economy not only to cool down, but also to collapse. What is the inflation situation in China?

The probability of deflation in China

In January 2023 CPI price index was at the level of 104 points, and in June it was already at the level of 102,7 points. This means that prices in China have already fallen by 1,24% since the beginning of the year, which is the biggest drop since February 2020. Moreover, in recent months, on a month-on-month basis, prices in China fall at a rate of 0,3 to 0,1 percent. This means that the probability of deflation in China on an annual basis for July or October is growing.

Recently, there has been a lot of talk in the media that China is on the brink of deflation. However, if nothing changes, China will fall into deflation in July or October on an annual basis thanks to the base and trends prevailing since the beginning of the year. On the one hand, it is a huge threat to the deflationary spiraland, on the other hand, raises hopes for a powerful stimulus to the Chinese economy to avoid deflation.

Moreover, the situation in China may be a good indicator of what the central bank, government and market might do if deflation knocked on the door of Europe or the United States. The key markets to look at seem to be emerging market ETFs with a large share of China, i.e. EEM, as well as copper and Hang Seng index.

The coming months may be very interesting in terms of how, on the one hand, the market will price in a deflation-recession spiral with the possibility of economic recovery and to raise prices at all costs by the PBOC or Chinese authorities.

About deflation in general

Here are some of the main reasons why deflation can be a threat and how you can overcome it:

Declining consumer spending: in deflation, the prices of goods and services fall, which may lead consumers to expect further price reductions. As a result, consumers are delaying purchases in the hope of even better deals in the future. This leads to a fall in demand and reduces consumer spending, which can hamper economic growth.

In this case, fiscal and monetary policy can be directed to spur consumer spending. For example, the government can increase infrastructure spending or introduce tax breaksto encourage consumers to spend more. The central bank can lower interest rates to reduce borrowing costs and stimulate investment and consumption.

Decrease in investments: Deflation can lead to a decline in investment as companies become cautious and avoid taking risks in an uncertain environment. If prices fall, future investment returns may be lower, reducing the incentives for firms to invest.

In this case, the government can take action to improve the investment climate, for example by reduction of corporate taxes, creating investment incentives or introducing structural reforms aimed at improving the business environment. In addition, the central bank can introduce monetary policy that favors investment, such as lowering interest rates or providing cheap credit to businesses.

Increase in debt: in a situation of deflation, the value of money increases, which leads to an increase in the real value of debt. This can be problematic for individuals and companies that have high debt. A decrease in income as a result of deflation can make it harder to pay your debts, which in turn can lead to financial trouble and bankruptcy.

In this case, the government can introduce debt restructuring or payment deferral programs to help individuals and businesses in financial difficulties. In addition, the central bank can apply a monetary policy that reduces the cost of borrowing through lowering interest rates or providing cheap credit.

A deflationary spiral: Deflation can lead to a deflationary spiral where price falls lead to further price falls. When consumers expect further price reductions, they delay purchases, which leads to a drop in demand. In turn, companies lower prices to attract customers, which exacerbates deflation. This downward spiral can lead to a hard-to-break cycle of price declines and reduce overall economic activity.

In this case, the government can use expansionary monetary policy to break the deflationary spiral, increasing the money supply in the economy. This may include lowering interest rates, asset purchases, or introducing a quantitative easing program to increase credit availability and stimulate demand.

Recovery from deflation usually requires coordinated action by the government and the central bank. Fiscal and monetary policies can be used to boost consumer spending, investment and reduce real debt. It is also important to break the deflationary spiral by increasing the money supply and stimulating demand.