It’s remarkable how the media has turned China’s deflation dilemma into an enigmatic riddle. The truth is, most modern instances of deflation can be traced back to a singular culprit: relatively tight monetary policy. Yes, deflation could theoretically arise from a positive supply shock, but that’s about as common as a unicorn in today’s fiat money landscape.
Central banks face the perennial challenge of targeting only one economic goal at a time. In most developed nations, the inflation target hovers around 2%, a strategy that necessitates allowing for volatile exchange rates. Conversely, countries that choose to stabilize their exchange rates find themselves unable to effectively target inflation. When their currencies become overvalued, they are compelled to undertake “internal devaluation”—essentially a process of deflating domestic wages and prices.
In the past few decades, China has maintained a currency that is either rigidly pegged to the US dollar (from 1995 to 2005 and again from 2008 to 2010) or kept within a narrow band around it. Unlike the yen, euro, pound, or Swiss franc, the Chinese government has never allowed the yuan to experience dramatic fluctuations. This exchange rate policy means that Chinese monetary policy is, in effect, dictated by the USA. A robust dollar on the foreign exchange markets translates into deflationary pressures in China. Simple as that. Yet, the press often overlooks this critical aspect. Here’s Bloomberg:
Why is China experiencing deflation?
While the US and other major economies saw prices soar upon reopening from the Covid-19 pandemic, propelled by pent-up demand and supply shortages, the same didn’t hold true for China. Weak consumer spending power, coupled with a real estate downturn, has shaken consumer confidence, leading to hesitance in purchasing big-ticket items.
Tighter regulations in high-paying industries such as technology and finance have resulted in layoffs and salary cuts, further suppressing spending appetite. Although there’s a push for enhancing manufacturing and high-tech goods, demand remains tepid, forcing businesses to lower their prices.
And there you have it—an all-encompassing explanation. Much of the surrounding discussion veers into potential solutions, conveniently sidestepping the crucial issues of exchange rate adjustment or internal devaluation.
The article even features a graph that hints at the underlying factors driving these recurrent episodes of deflation in China:
The grey bands illustrate periods of deflation based on the GDP deflator. Note the extended stretch in the late 1990s, a brief episode around 2009, another short spell in 2015, and an ongoing period since 2023.
Next, let’s take a closer look at the real exchange rate of the US dollar against a selection of other currencies:
Observe the significant appreciation of the dollar during the late 1990s, a brief uptick in 2009, another surge in 2015, and a remarkably strong dollar in recent years.
While it’s not a flawless correlation, as the yuan has not always been rigidly pegged to the dollar—having depreciated somewhat in the late 2010s, which helped to keep the 2015 deflationary period brief—it’s generally true that a strong US dollar imposes tight monetary conditions on any country whose currency is pegged or closely aligned with it.
So, why didn’t most other nations experience deflation during the late 1990s? The answer lies in their willingness to allow their currencies to depreciate against the dollar. Those that resisted this adjustment (notably China, Argentina, and Hong Kong) faced deflation. Countries like Japan, which maintained a relatively stable yen/US dollar exchange rate between 1997 and 2002 amidst a global currency depreciation, also fell prey to deflation.
It’s not rocket science. In the 21st century, deflation is often the result of an exchange rate stabilization policy coupled with a robust US dollar.
