Why China is struggling with falling prices – and how it compares to Japan business and economy

While the rest of the world is grappling with rising living costs, China is facing the opposite problem: falling prices.

In July, the world’s second-largest economy officially slipped into deflation for the first time in two years as consumer prices fell 0.3 percent. Prices were already mostly flat in 2023, bucking the global trend of rising prices for everything from energy to food.

While lower prices may sound tempting to the average consumer, economists see deflation as a bad sign for the economy.

When prices fall for an extended period, consumers cut back on spending and companies cut back on production – which in turn leads to layoffs and lower wages.

The Chinese economy’s slide into deflation is the latest in a series of warning signs casting doubt on the strength of the post-pandemic recovery.

Why are analysts worried about falling prices in China?

China has slipped into deflation before, but this time economists are more worried about falling prices. When prices last fell in early 2021, millions of people were in lockdown and factories closed due to COVID restrictions.

After China lifted its strict “zero-COVID” restrictions late last year, China should now be on the road to recovery.

So far, China’s recovery has been sluggish.

While economic growth has recovered from its low levels during the pandemic, several investment banks have downgraded China’s 2023 outlook, as they believe Beijing’s target of around 5 percent cannot be met without major stimulus measures.

At home, Chinese consumers are still reluctant to spend after the grueling lockdowns, depriving the economy of a crucial boost in spending.

Overseas countries are buying less from China’s factories due to the uncertain global economic outlook and geopolitical tensions.

The bleak outlook comes as China’s economy may struggle to absorb a setback amid mounting challenges, including a record low birth rate, high local government debt, a sluggish real estate market and high youth unemployment.

Why are analysts comparing China and Japan?

China’s economic woes have prompted some observers to recall the struggles Japan faced in the early 1990s, when the collapse of a huge asset bubble led to a decade-long cycle of deflation and stagnant growth.

There are some striking similarities between China’s current situation and Japan’s situation just before the bubble burst.

At the height of its economic boom in the late 1980s, Japan was the world’s second largest economy and an export powerhouse known for its consumer electronics and automobiles – not unlike China today.

After a huge wealth bubble burst in the early 1990s, Japan suffered from decades of economic stagnation [Kirby Lee/USA Today via Reuters]However, alongside Japan’s booming economy grew a massive real estate and stock market bubble that burst in 1991 when the Bank of Japan hiked interest rates to cool rising asset prices.

Japan slipped into what it called a “balance sheet recession” as companies paid off the debt of their now-flooded investments rather than spend money on expansion.

More than 30 years of weak or negative growth followed, the so-called “lost decades”, during which companies and households held back on spending.

Japan’s efforts to halt its economic decline – including quantitative easing, ultra-low interest rates and tax cuts – have been a partial success at best.

Today, the country’s $4.9 trillion economy, the third largest in the world, is smaller than it was in the early 1990s.

What are the prospects for China’s economy?

China’s economic prospects are clouded by a growing list of challenges. The most pressing of these is the real estate sector, which accounts for almost a third of the economy.

Local governments across China have historically relied on the sale of land to generate revenue. This created an incentive to support the construction of real estate even when supply exceeds demand.

The result has been a proliferation of empty housing estates, so-called “ghost towns,” and redundant infrastructure, such as so-called “bridges to nowhere.”

It is estimated that vacant apartments accounted for up to a fifth of the housing stock in 2019.

The market’s shaky fundamentals came to light in 2021, when Beijing’s efforts to curb excessive borrowing caused major developer Evergrande to default on more than $300 billion.

Since then, the crisis has hit a number of other big developers, including Country Garden, China’s top-grossing developer last year, which is currently on the brink of a $200 billion default.

Country Garden is the latest real estate developer in China to have faced severe financial difficulties in recent years [File: Tingshu Wang/Reuters]”Like that [Japan and China] “Similarly, the open question is whether they’ve invested too much and accumulated a lot of debt,” Christopher Beddor, deputy China research director at Gavekal Dragonomics, told Al Jazeera.

“That means they will eventually have to pay off their debt, and that will mean lower growth.”

According to a study by Gavekal Dragonomics, 86 non-state developers had a combined debt of 725 billion yuan ($99 billion) last year, with 53 state-owned developers paying 174 billion yuan ($22.8 billion).

While Beijing is unlikely to fail to step in to prevent a full-scale housing market meltdown, some analysts believe policymakers may view the current moment as a painful but necessary corrective to China’s reliance on construction-led growth.

“It’s a risky strategy and it can spiral sideways very, very quickly in this market,” Bedor said.

“And that’s why all these real estate developers keep popping up in the news because there’s a constant argument about whether or not they’re going to bail out this company?”

How can China get out of this mess?

Economists largely agree that China needs to shift to an economic model more based on consumer spending than government-led investment.

But like the Japanese economy in the late 1980s, the Chinese economy faces structural problems that analysts say will be difficult to solve overnight.

Japan’s boom years were characterized by close ties between the Japanese state, banks and corporations, and a trade policy that supported industry towards individual consumers.

According to George Magnus, a research fellow at Oxford University’s China Center, the current situation in China is not dissimilar. Self-interest within the ruling Communist Party and state-owned companies make major reforms difficult.

“What China should do is abandon its obsession with state and party-led industrial policies, redistribute income and wealth to households and the private sector, implement tax and social security reforms, and allow capital, land and labor to be priced in the market” , Magnus told Al Jazeera.

“But I’m not holding my breath.”

The problem is also psychological: unless consumers are better off, they are likely to postpone purchases and investments and hold on to their savings.

While China’s gross domestic product (GDP) growth has recovered from the pandemic lull, it’s nowhere near the double-digit growth of the early 2000s.

Beijing has also unsettled the private sector with repeated crackdowns on sectors from technology to private education, making it difficult for foreign companies to do business.

Earlier this month, Beijing announced it would stop releasing youth unemployment data after the unemployment rate for 16-24 year olds surpassed 20 percent.

“Something new is needed that increases household incomes and consumption and shifts resources away from the government sector and investment to the consumer sector,” Magnus said.

“Given their Leninist credibility and fixation on supply and production, not many people are optimistic that the government is willing or able to do that.”

What is different about the situation in China than in Japan?

China has some advantages compared to Japan in the 1990s.

Despite being the second largest economy in the world, China is nowhere near as prosperous as Japan was at the time of its economic crisis and as a middle-income country has plenty of room for growth.

The situation is “quite similar, but I think the difference between the two is that China is still growing,” Alicia Garcia-Herrero, chief economist for Asia-Pacific at investment bank Natixis, told Al Jazeera.

“We’ll hardly make it to 5 percent, but it’s not negative growth like Japan was at the time of the collapse.”

Interest rates in China are also much higher than they were at the time of the Japan crisis, Garcia-Herrero said, meaning the Bank of China still has room to adjust monetary policy.

China’s central bank has cut interest rates to stimulate the economy [Jason Lee/Reuters]On Monday, the Bank of China cut the interest rate on one-year prime loans, a key benchmark for corporate loans, to 3.45 percent from 3.55 percent.

Gavekal Dragonomics’ Beddor said Beijing may still provide more support to the economy but a major stimulus package like the US is unlikely as it prefers to target support at producers rather than consumers.

“They can absolutely force money into the system if they want to, regardless of whether households are ‘confident’ or not,” Beddor said. “The problem is that they don’t want to do that today, they’re notoriously reluctant to use stimulus, and most importantly they don’t want to use stimulus to directly boost consumption.”

Beddor said China’s consumer prices could recover by the end of the year if consumer confidence improves.

“Basically, the reason for weak consumer prices is that demand in the economy is weak, so when demand increases, it will pick up,” he said.