October 2024

Since the beginning of 2024, the market has engaged in discussions about whether China's economy is facing greater deflationary pressures. Although deflation does not have an exact definition in academia, the basic consensus is a "prolonged period of widespread price declines," with the intuitive feeling being a continuous decline in the general price level. Why the deflationary pressures in our country continue to intensify is the main content that this article will discuss. Especially with a series of stimulus policies recently introduced, what else needs to be done to curb deflationary risks? This article intends to propose relevant suggestions on policy approaches.

I. The Current Domestic Deflationary Pressure Has Further Increased

The recent heated market discussions on deflation are related to the continuous sluggishness of the main macro indicators measuring inflation domestically. As of the end of September 2024, the nominal CPI year-on-year and the core CPI year-on-year, excluding food and energy, have been in a low inflation range of 0%-1% for over a year; the industrial producer price index (PPI) year-on-year has been in a negative range for nearly two years, with a wider decline in the third quarter. By the end of the second quarter of 2024, the GDP deflator index had a cumulative year-on-year decrease of -0.9%, and the continuous overall negative growth of the main domestic inflation indicators reflects that the general level of commodity prices is in a continuous decline.

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At present, the main central banks and statistical departments worldwide usually use the 12-month average to assess macro inflation indicators to judge the development of inflation trends. The following is a statistical analysis of three main domestic inflation indicators:

1. The overall CPI is at a low level. In September 2024, the CPI year-on-year was +0.4%, with the CPI year-on-year being positive for eight consecutive months, but the highest monthly increase did not exceed 1%, and the average CPI year-on-year over the past 12 months was 0.1%. Such a low level of CPI average is rare in the economic development of China over the past few decades, occurring once during the 2008 international financial crisis and another during the 1997-2003 Asian financial crisis and its initial recovery phase.

2. The PPI is generally in a negative growth range. As of the end of September 2024, the PPI year-on-year over the past 12 months was -2.2%, and the PPI year-on-year average has been in a negative range for 17 consecutive months, with the duration likely to further increase. Since 1997, there have been two instances where the PPI year-on-year average has been in a negative range for more than two years, once from 1997 to 2000 (30 months), and another from 2012 to 2017 (53 months).

3. The GDP deflator contraction has exceeded one year. By the end of the second quarter of 2024, the GDP deflator index had been in a negative range for five consecutive quarters. Since 1997, there have only been two instances where the GDP deflator index has been in a continuous negative range for more than two quarters, once from the second quarter of 1998 to the fourth quarter of 1999 (7 quarters), and another from the second quarter to the fourth quarter of 2009 (3 quarters), both during periods of economic crisis contraction.

From the above, it can be seen that, in terms of the duration and magnitude of price declines, this round of deflationary pressures is not small. Currently, China's GDP deflator has been in negative growth for five consecutive quarters, the PPI has been in negative growth for more than five quarters, and some durable consumer goods in the CPI have experienced significant negative growth. For example, CPI sub-items such as household appliances, transportation tools, and communication tools have been falling year-on-year for more than a year. In the process of the continuous decline of the PPI year-on-year, although the domestic price transmission effect is not as significant as overseas, the prices of some terminal consumer goods are still very likely to be dragged down by the PPI in the future. Some important means of production have been continuously declining over the past two to three years, such as rebar, coke, cement, and float glass, with cumulative declines ranging from 40% to 60%, and the industry's loss area continues to expand. Overall, the current industrial sector fits the basic characteristics of "deflation and falling prices," while the terminal consumer market is not in a completely deflationary environment, but there is a potential possibility for "low inflation" to develop into "deflation."

II. Five Factors Constitute Deflationary PressureSince the reform and opening up, the domestic economy has maintained a relatively high growth rate for a long period. Except for a few periods with severe external shocks, the experience of deflation has been rare. In contrast, overseas developed economies have had more mature research on deflation over the past century, which can be referred to. Economics and the history of the world economy tell people that once the economy falls into deflation, it will have a great destructiveness. To effectively deal with deflationary pressure, it is necessary to first identify the main causes of deflation. We believe that the following five points may be the direct causes of deflation in large economies like China.

First, the real interest rate is relatively high. An increase in the real interest rate will suppress consumption and investment, and have a negative impact on economic growth and price levels. The difference between the 10-year Treasury bond yield and the nominal CPI on a year-on-year basis is used to measure the level of the real interest rate. As of the end of September 2024, China's real interest rate was 2.27%, at a relatively high level over the past decade. Although in the past few years, the competent departments have announced the adoption of an active fiscal policy and a prudent and flexible monetary policy, guiding domestic interest rates to decline, including Treasury bond yields, bank loan interest rates, corporate bond issuance interest rates, etc. However, the overall decline in policy interest rates is relatively limited. In the past 12 months, the 10-year Treasury bond yield has declined by 38 basis points, and the 1-year LPR has declined by 10 basis points, while the 5-year LPR has declined by 35 basis points.

Looking back at the period of the Asian financial crisis from 1997 to 2000, in order to deal with deflation, the central bank implemented a loose monetary policy. During this period, the deposit benchmark interest rate was cumulatively reduced by 522 basis points, and the bank reserve requirement ratio was cumulatively reduced by 700 basis points. Affected by this, the domestic real interest rate quickly dropped from the 8%-10% range in 1998 to less than 3% at the end of 2000. After the significant reduction in real interest rates, a relatively loose and low-cost capital environment was created, which helped the domestic economy out of the deflationary environment at that time.

Due to the impact of the international financial crisis, the central bank adopted a loose monetary policy in 2008, cumulatively reducing the deposit interest rate by 189 basis points, and cumulatively reducing the bank reserve requirement ratio by 200 basis points in the second half of 2008. The real interest rate quickly declined and remained in a negative range. However, in 2009, the central bank did not further reduce the deposit interest rate and reserve requirement ratio. The real interest rate quickly rose from around -1.5% at the beginning of 2009 to a positive level and exceeded 4% by the end of 2009. The rapid rise in real interest rates led to a phased decline in domestic price levels, and the GDP deflator continued to be negative from the second quarter to the fourth quarter of 2009, promoting a phased deflationary situation.

At the beginning of the 2020 epidemic outbreak, in order to deal with the sharp contraction of both supply and demand, the central bank successively reduced the loan market报价 interest rate (LPR) (a total reduction of 30 basis points for the 1-year term and 15 basis points for the 5-year term) in the first half of 2020, and once reduced the reserve requirement ratio by 50 basis points. The Ministry of Finance announced for the first time the issuance of 1 trillion yuan of special government bonds for epidemic prevention and control. Driven by an active fiscal policy and a loose monetary policy, the domestic real interest rate quickly dropped from around 0.25% at the end of 2019 to -0.75% in the middle of the third quarter of 2020, helping CPI and PPI to reach the bottom and rebound in a short period of time. The GDP deflator increased by 0.53% year-on-year for the whole year, avoiding a continuous deflationary situation.

At present, the domestic real interest rate is at a relatively high level over the past decade, and it has experienced a rise of about one year since the first quarter of 2023. The increase in real interest rates has increased the cost of residents' consumption expenditure and corporate investment expansion, and the credit growth of residents and enterprises has obviously slowed down, suppressing the release of domestic demand.

Second, the reduction of government investment expenditure. When the economy faces an increasing risk of deflation or is in a state of deflation, the government will often increase fiscal expenditure to support the expansion of total demand and promote price increases.

In response to the "once-in-a-century" international financial crisis in 2008, the Chinese government implemented a very active fiscal policy. From 2007 to 2010, China's fiscal expenditure maintained an average annual growth rate of more than 20%, and the ratio of China's annual fiscal budget expenditure to GDP increased from 18.3% at the beginning of 2007 to 22.3% at the end of 2010. Among them, investment fiscal expenditure increased significantly, with the average annual growth rate of transportation, agriculture, forestry, water affairs, and resource exploration expenditures ranging from 40% to 78%. The continuous fiscal effort timely made up for the shortage of total social demand and played a strong positive role in stimulating demand and boosting price levels.

At present, the continuous weakening of domestic fiscal expenditure capacity. As of the end of the second quarter of 2024, the ratio of China's annual fiscal budget expenditure to GDP was 21.6%, which is a low level over the past 14 years. Although the active fiscal policy has been implemented for many years, the focus of fiscal policy mainly focuses on "people's livelihood expenditure, social security, and scientific research investment", while traditional investment expenditure has obviously slowed down. In the past two and a half years, the average annual fiscal expenditure for transportation and agriculture, forestry, and water affairs was 3.5% and 4.4%, respectively, both at historically low levels. At the same time, due to the continuous decline in land transfer income, the growth rate of local government fund income has slowed down, leading to a continuous decline in the growth rate of local government fund expenditure. As of the end of August 2024, the total national government fund expenditure decreased by 21.1% year-on-year; among them, the total national land transfer income decreased by 25.4% year-on-year, both of which have declined significantly for three and a half years. At present, some local governments are still in the difficult stage of debt resolution, and the financial resources for expanding new investment are limited. The decline in local fiscal support has had varying degrees of drag on prices in various regions.

Third, the balance sheet recession of important industries. According to Irving Fisher's "debt-deflation" theory, during the industry recession process, debt and deflation are the two most important variables. After a long period of development, some important pillar industries in China are in a state of "over-indebtedness", and then enter the debt repayment stage under the dual influence of external (regulatory requirements) and internal (decline in investment returns or losses), and enterprises often adopt the method of "selling assets at a low price" to seek survival during the debt repayment period.Currently, some traditional pillar industries in China are undergoing a deep adjustment phase, which has a negative impact on commodity inflation. Among them, the real estate, traditional infrastructure, and traditional automotive industries face the greatest adjustment pressures. Commodities involved in traditional industry chains have issues such as high inventory levels, slow asset turnover, and long accounts receivable collection periods, putting pressure on industrial product prices. By the end of the second quarter of 2024, the macro leverage ratio of the real estate industry had dropped to 20.2%, a cumulative decrease of 2.7 percentage points over two years, and a decline of 12.4 percentage points from its historical peak at the end of the third quarter of 2018. The macro leverage ratio of the real estate industry is not only at its lowest historical level but also has the potential to further reduce leverage in the foreseeable future.

At the micro level, in order to quickly recover sales receipts and improve corporate cash flow, companies often have to adopt more aggressive "price reduction promotions" to promote the liquidation of traditional industrial product inventory. Recently, the continuous "price war" in the domestic automotive industry has led to widespread financial strain and even increased risk of closure for car dealers. In recent times, various regions in China have introduced a variety of "trade-in" discount policies to stimulate consumption and revitalize the economy, which have also had a certain suppressive effect on prices.

Fourth, the growth rate of residents' income has slowed down. According to traditional economic theory, a slowdown in wage income generally leads to income earners welcoming a decrease in the general price level. Experience has shown that once the slowdown in workers' income growth becomes a trend, it will have a negative impact on the revenue of sales companies and gradually lead to companies developing an aversion to raising employees' wages. Employees' weakened expectations or pessimism about wage growth will delay purchasing behavior, waiting for lower commodity prices in the future. Over time, this repeated behavior will drive prices to cycle downwards. By the end of the second quarter of 2024, the growth rate of per capita disposable income (annualized) of urban residents in China was 4.7%, and for more than two years, this indicator has been below 5% for most of the time, at a low level over the past two decades. The slowdown in domestic residents' income growth continues to exert downward pressure on prices.

Fifth, the value of important asset prices has shrunk. The shrinkage of large asset prices means a reduction in workers' property income. Unlike the impact of wage income on daily consumption expenditure, the decline in property income will lead to the private sector developing an "aversion" to various financial risk assets and reducing large expenditures, including luxury goods, high-priced goods, and housing purchases. Looking back over the past two years, the prices of domestic stocks, real estate, financial products, and other asset prices have generally continued to fall. The second-hand housing price index of the 70 major cities nationwide has fallen by 10% in total, and the value of existing housing in some areas has shrunk by more than 30%-50%; the Shanghai Composite Index fell from 3,200 points to below 2,700 points; the RMB exchange rate fluctuated weakly, with the US dollar to RMB mostly operating in the weak range of 7-7.35; the return on bank and financial institution financial products generally fell to a low return range of 2%-3%, and the overall wealth effect of the residential sector has significantly weakened. In view of the weakened expectations for investment returns on major assets, the behavior of the residential sector to repay loans in advance has significantly increased, the overall growth rate of residents' consumption expenditure has slowed down, the demand for traditional high-priced goods such as cars and white liquor has significantly weakened, and it has dragged down the consumer price level.

In summary, from the perspectives of government departments, corporate departments, financial departments, and residential departments, it can be seen that the current deflationary pressure is relatively large and is still increasing, with systematic and deep-seated reasons. These factors did not form overnight but have accumulated over a long period. Identifying the problems makes it easier to prescribe the right treatment and dosage, effectively regulate and reduce deflationary pressure.

III. Suggestions for Systemic Response to Deflationary Pressure

Historical experience has shown that compared with moderate inflation, deflation poses more dangerous potential risks to the economy, such as liquidity traps, severe decline in corporate balance sheets, systemic financial risks, etc., which are extremely harmful and must be given high importance. It is necessary to implement medium and long-term, systematic, and targeted response strategies based on China's actual situation. Although a package of economic stimulus measures has been introduced since late September, it is still necessary to continue to promote expansionary policy measures for a period in the future. The main goal and task are to expand total demand, reduce financing costs, resolve debt risks, increase property income, and improve economic expectations.

First, increase government investment expenditure and continue to expand total demand. The primary proactive policy to combat deflation is to increase fiscal expenditure and expand government effective investment. Currently, the proportion of local government bond repayments to issuance has been rising year by year, from 20% in 2018 to 46% at the end of August 2024. The scale of funds for local governments to expand investment expenditure is relatively limited. It is recommended that the central finance implement a more proactive policy, continue to appropriately increase leverage, and the deficit ratio can reach about 4%, maintaining the continuity of fiscal investment expenditure, increasing the construction of public infrastructure and affordable housing in large cities. Expand the issuance scale of ultra-long-term special national debt, issuing more than 2 trillion yuan per year for five years; achieve a net financing amount of local debt to GDP ratio of more than 5% per year. By injecting a larger incremental fiscal fund, directly increase the income of the corporate and residential sectors, guide state-owned and private enterprises to increase investment, and enhance personal consumption capacity. It is difficult for unilaterally increasing fiscal consumption expenditure and transfer payments to form effective tax revenue sustainably, so it is recommended to increase the expenditure of fiscal investment projects.

Second, continue to implement a moderately loose monetary policy, maintain reasonable and sufficient liquidity, and effectively reduce the actual interest rate level. Although the central bank has introduced loose monetary policy measures such as reducing reserves and interest rates since late September, from the perspective of the need to cope with deflationary pressure, it is still necessary to further reduce the reserve requirement ratio through a strong loose monetary policy in the future, release a large amount of liquidity, and continue to lower the interest rate level. The Federal Reserve's interest rate reduction process has provided a good external environment for China to implement a moderately loose monetary policy. Although the domestic deposit benchmark interest rate has been at a low level of 1.5% for a long time, and the seven-day reverse repurchase interest rate is 1.5%, the long-term (five-year LPR) loan interest rate is still at a relatively high level of 3.85%. It is necessary to significantly reduce the actual interest rate level and reduce corporate financing costs through a certain degree of interest rate reduction in the future. It is recommended to adjust the monetary policy tone to moderately loose to better guide market positive expectations and boost confidence.

Third, promote urbanization development and expand their consumption demand by providing fiscal subsidies for farmers to settle down. It is recommended to increase the transfer payment strength of the central finance to local finance. Enhance the transfer payment ability of the central finance in the field of people's livelihood to local areas, and establish a more solid social security system for the population to become urban residents after the transformation of agricultural population, including increasing the subsidy strength in the fields of medical insurance, pension, employment, housing, children's education, etc. At present, China still has 477 million rural population and more than 380 million floating population. The transformation of rural residents into urban citizens will greatly improve their consumption level and drive the growth of investment demand for urban infrastructure construction and affordable housing construction. After the population of farmers turning into citizens settles down and lives a happy life, the increase in wage levels and income will inevitably be conducive to the continuous growth of consumption demand. Referring to the International Monetary Fund (IMF)'s calculation of China's GDP in 2030 based on purchasing power parity, it is expected that the average annual transformation of farmers into citizens will drive the GDP growth rate by about 1 percentage point. Since the overall consumer price level of urban areas is higher than that of rural areas, the process of farmers becoming citizens will help to suppress the continuous decline of the overall price level.Fourthly, allocate fiscal and financial resources to support the proactive deleveraging of sectors experiencing balance sheet recessions. For the current and foreseeable future, a crucial task is to mitigate the deflationary impact caused by localized balance sheet contractions triggered by the decline of traditional sectors. Failure to promptly implement effective measures to manage debt could lead to businesses in these industries resorting to more aggressive price reductions and substantial discounts on the sale of existing assets. It is recommended to provide more financial support to enterprises with clear main business lines and stable operations, expand operational re-lending programs, maintain smooth liquidity for businesses, and reduce the likelihood of further significant price reductions by such enterprises, which could be detrimental to price stability.

For a long time, the pillar industries of China's economic development have included real estate, construction, and traditional automotive manufacturing, among others. Prices for commodities directly related to these industries, such as primary resources, construction materials, and chemicals, may face long-term pressure, inducing the market to form long-term expectations of price reductions for these goods. In this economic cycle adjustment, the real estate industry has been severely affected. It is suggested to establish a national real estate stability fund to improve market expectations and alleviate risks in the real estate market. The initial fund size could reach trillions, with a special debt processing plan for the headquarters of major national and local key real estate companies to enhance market confidence. Part of the central fiscal funds could be used as the initial capital of the fund, with the remainder invested by policy banks, large commercial banks, joint-stock commercial banks, insurance companies, asset management companies, and private capital.

Fifthly, actively promote land system reform to unleash the potential for wealth appreciation from the trading of homestead land. Taking land system reform as a breakthrough, accelerate the pace of market-oriented circulation of homestead land, transforming it from having only use value to having both use value and asset appreciation potential, thus becoming an asset for the holder. It is estimated that the annual population scale of farmers becoming citizens is about 12 to 18 million, with an average increase in property income per household of 100,000 to 150,000 yuan. This move will sharply increase the property income of farmers with homestead land through transactions, narrow the income gap between urban and rural residents, enhance the consumption capacity and willingness of a significant portion of farmers, and stimulate consumer demand.

Sixthly, implement long-term preferential policies to reduce the tax burden on the private sector. It is recommended to focus on tax cuts and fee reductions by lowering basic tax rates and reducing arbitrary fines. For individual consumption incentive policies, it is appropriate to reduce short-term coupon activities and increase long-term preferential policies, such as lowering personal income tax rates. For private enterprises, in addition to continuing inclusive tax cuts and fee reductions, it is appropriate to reduce unnecessary regulatory pressures in various places to "lighten the burden" for market entities. Currently, some local governments, due to insufficient fiscal funds, resort to improper means of raising funds, infringing on the independent operation rights of some enterprises and undermining the enthusiasm of entrepreneurs for production and investment. The correct approach remains to help enterprises overcome difficulties, repay various debts owed to enterprises as soon as possible, reduce the tax burden on enterprises as much as possible, and extend the tax preferential policies that have been implemented.

Seventhly, strongly support the development of the capital market to increase residents' property income. Improve the construction of the capital market system, increase the proportion of core asset holdings by national sovereign investment funds, and it is recommended to increase the holding of core securities such as stocks and bonds by 1-1.5 trillion yuan annually, promote the prosperity and development of the securities market, and boost the confidence of various social entities. In view of the overall weak confidence and low valuation of the domestic capital market, it is imperative to increase policy support for the stable and healthy development of the capital market in both the short and long term. A series of recent policy measures to support the capital market have been introduced in a targeted manner, significantly changing the trajectory of the stock market. It is recommended to promote reform and innovation based on reality, strengthen the improvement of the capital market investor structure, vigorously cultivate bank-based securities institutions, and promote the further flow of various banking resources into the securities industry and the stock market; support the long-term development and growth of the capital market from the supply side, continuously increase investors' property income, and boost consumption capacity and willingness.

Eighthly, establish an economic expectation management mechanism to actively improve market expectations. It is recommended to enhance the consistency of macro policy orientation, so that various positive macro policies and non-economic policies work in the same direction and form a joint force; and after the policy is introduced, accurately publicize and interpret, and scientifically and reasonably guide public opinion to create a stable, transparent, and predictable policy environment to help economic entities form positive expectations. It is recommended to improve and perfect the survey, statistics, and monitoring system for micro-entity expectations, provide a scientific basis for policy formulation, and provide an objective basis for market expectations. Establish a coordination mechanism for the release of major policy information to improve policy transparency. Establish a normalized information communication coordination mechanism, build a communication platform between the government and market entities, establish an information feedback mechanism for market entities, encourage market entities to timely feedback their own demands, and form a virtuous cycle of two-way communication. Establish a policy system and mechanism for economic expectation management, taking into account short-term and medium-to-long-term goals, internal and external goals, introduce policy tools that directly affect micro-entity expectations, optimize the expectation transmission mechanism of macro policies, smooth the policy transmission channels, and improve the effectiveness of expectation management. Through systematic and targeted measures, break the negative cycle of economic downturn and price decline (deflationary expectations), and resolve irrational expectations of total demand and prices.