While U.S. investors struggle with the harmful impacts of inflation at home, the second-largest economy in the world is waging the complete opposite war in 2023. For much of this year, China has reported worse-than-expected gains or flat readings in its consumer price index, or CPI, a measure of inflation. The country saw a 0.3% year-over-year decline in consumer prices for July, but modest growth returned in August at 0.1%. Economists were optimistic that China’s September CPI report would show modest but positive pricing growth, but data released Oct. 12 showed a flat reading, leading many to worry that prices could tip back to deflation.
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China has the world’s second-largest economy, generating $17.9 trillion in gross domestic product in 2022. China has also been a major source of global economic growth for decades, averaging more than 9% GDP growth per year since 1978. However, that impressive economic growth slowed to just 3% in 2022 thanks to aggressive COVID-19 lockdowns and restrictions in China. Economists were calling for a sharp rebound in China’s economy in 2023 once the lockdowns were lifted, but that rebound has fallen well short of expectations so far. In July, China reported 6.3% year-over-year GDP growth in the second quarter, a number that benefited by being compared to severely depressed 2022 levels. That growth represented just a 0.8% increase on a quarterly basis, significantly below the 2.2% quarterly growth in the first quarter.
Weak domestic demand and a slumping housing market in China have weighed on the Chinese economy, and U.S. investors are monitoring economic data closely to stay ahead of a potentially volatile situation.
Understanding Economic Deflation in China
What Is Deflation?
A deflationary period is characterized by falling asset prices, which may seem like a good thing at first glance because deflation increases the purchasing power of consumers. However, deflation is typically a sign of a weak economy. While prices and wages decline, the value of debt does not, increasing financial pressure on people and companies that hold debt.
While it may seem strange for prices to be falling in such a high-growth economy as China’s, there are unique dynamics at play in China that help explain the recent phenomenon. This is certainly not the first time China has experienced deflation in recent decades, and the Chinese government appears to be taking steps to remedy the situation.
Historical Examples of Deflation in China
A real estate investment boom in the early 1990s led to a clamp-down on lending by state-controlled banks in China in the latter part of the decade. Corporate finances deteriorated, investment and consumption weakened and pricing growth dipped into negative territory in China from 1998 through 2002.
China also experienced relatively brief periods of deflation during the extreme economic disruptions of the Global Financial Crisis in 2009 and the COVID-19 pandemic in 2021.
The potentially troubling thing about current deflation in China is that the economic weakness is happening during a period in which many other developed economies around the world are overheating rather than underperforming.
Key Causes of China’s Recent Economic Deflation
There are several key factors contributing to the current deflationary environment in China. The Chinese government has aggressively invested in supporting economic growth in recent decades, but it has primarily focused its efforts on supporting production and investment rather than consumption.
At the same time, the draconian “zero-COVID” lockdown policies in China in recent years spooked many Chinese citizens, leading them to maintain high precautionary savings levels in the uncertain economic climate. Consumer spending supports the economy, while consumer savings serve as a vacuum for demand.
It’s common for Chinese homebuyers to put down large deposits on properties before construction is completed. However, the Chinese government has taken steps in recent years to crack down on speculation in the real estate market by targeting the debt levels of mainland property developers.
Bradley Thompson, director of portfolio strategy at New Canaan Group, says these crackdowns are causing highly indebted developers to fail.
“If the developers fail, people who put deposits down may never see their homes built and possibly will lose their deposits. Fears over this prospect have caused people to stop buying new homes, which has hurt developers’ cash flows and (is) becoming a self-fulfilling prophecy,” Thompson says.
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3 Reasons Chinese Inflation Matters to Investors
U.S. investors may be tempted to simply ignore China’s economic struggles, as U.S. GDP was up 2.1% in the second quarter and the stock market has performed well so far this year. But China’s deflation problems have broader implications for many investors.
The Impact on the Global Economy
Fifty years ago, Americans could make the argument that deflation in China’s economy was China’s problem. In 2023, it’s an entirely different story.
Inbok Song, portfolio manager at Matthews Asia, says U.S. investors should pay attention to China because of how much the U.S. and Chinese economies are intertwined.
“For the U.S. investors, the status of the Chinese economy is important as China continues to be a major trading partner for the U.S. in terms of goods and services, both imports and exports,” Song says.
As of August 2023, China was the third-largest U.S. trading partner behind only Mexico and Canada, representing about 10.9% of total U.S. trade, according to the U.S. Census Bureau.
Jeff Rose, founder and CEO of GoodFinancialCents.com, says the modern global economy is so interconnected that stability in all the largest economies are important to financial markets.
“China is a significant player in the world market, and its economic health can influence global trade, investment flows and commodity prices,” Rose says.
For example, China imports about 70% of the global share of traded iron ore, 72% of aluminum, and 60% of copper and soybeans. It also imports more than 25% of the global share of traded crude oil and consumes more than 50% of the global production of coal, according to a report from J.P. Morgan.
Potential Risks and Opportunities for U.S. Investors
Deflation and economic weakness in China create obvious risks for U.S. investors exposed to Chinese stocks or emerging market exchange-traded funds, such as the iShares China Large-Cap ETF (ticker: FXI).
Rose says there are several types of U.S. asset classes that could be at risk if China’s economy stalls.
“For U.S. investors, especially those with international portfolios, China’s deflation could impact the performance of various investments, including international stocks, mutual funds and certain sectors that are closely tied to China’s economy, like manufacturing and technology,” Rose says.
Song says economic instability in China could have a severe effect on U.S. Treasury bonds if China ramps up its selling of U.S. bonds.
“Although China has been reducing its U.S. Treasury holdings since 2012 to diversify their foreign reserves, China is still the second-largest foreign holder of U.S. Treasurys after Japan,” Song says.
There are also ways for investors to potentially profit from a Chinese economic downturn, including inverse ETFs, such as the ProShares Short FTSE China 50 (YXI).
Potential Conflict Between China and Taiwan
Finally, governments throughout history have used military conflicts as a means of economic stimulus and as a political distraction during difficult times. Tensions between China and Taiwan have been rising, and if China chooses to launch a military conflict with Taiwan, it could have major implications for the U.S. economy.
Taiwan currently produces about 70% of the world’s semiconductors and about 90% of the most advanced chips used for applications such as cloud computing and artificial intelligence. A disruption of chip production in Taiwan could have a disastrous impact on the technology sector and the U.S. economy as a whole.
Conclusion: Why Investors Should Monitor China’s Economic Deflation
American investors are dealing with their own struggles with inflation, making it easy to ignore China’s deflationary battle across the Pacific. However, the U.S. and global economy rely heavily on China, so Chinese deflation could have a negative effect on global commodity demand, the U.S. Treasury market and even the high-end semiconductor industry.
With that in mind, investors will be hoping to see a return to positive growth when the National Bureau of Statistics of China reports its CPI reading for October. Further flat or near-flat CPI numbers could augur very real risks of deflation, which can be a self-perpetuating loop as consumers delay spending and wait for lower prices in the future.
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3 Reasons Why China’s Economic Deflation Matters to Investors originally appeared on usnews.com
