China's Deflation Mystery: 15 Years Unpacked

The economic landscape of China has undergone profound transformations over the past half-century. This evolution is a natural consequence of the nation's shift from a Soviet-inspired command economy to a market-oriented system, initiated by Deng Xiaoping in 1978. A pivotal area of change has been the dynamics of monetary policy and inflation, which significantly influence consumption, investment decisions, and the accumulation of wealth by households and businesses.

Historically, inflation was a recurring challenge for the People's Republic of China. In the 1950s, the nascent Communist Party successfully reined in the hyperinflation inherited from the Chinese Civil War, an achievement considered significant given the concurrent fiscal demands of the Korean War. Inflation resurfaced as a critical concern during the reform era of the 1980s and 90s, with periods of surging economic growth often accompanied by painful inflationary spikes fueled by regional governments' credit and monetary expansion efforts. These episodes, including three major bouts in the 1980s, frequently led to policy retrenchments.

The fight against inflation remained a primary focus until the eve of the 2008 Global Financial Crisis (GFC). China's consumer price index (CPI) rose by 4.8% in 2007, prompting initial tightening of macroeconomic policy. However, the global crisis necessitated a swift reversal, leading to a massive four trillion yuan stimulus package to mitigate the economic fallout.

China's Post-GFC Deflationary Shift

The economic narrative has dramatically shifted since the GFC. China now finds itself in a unique position among major global economies, having largely averted the post-Covid inflationary surge. Instead, the nation has grappled with protracted deflationary pressures for several years, a phenomenon that underscores supply chain shocks as the primary driver of rapid global price increases, rather than the fiscal and monetary easing adopted by other governments.

China's Producer Price Index (PPI) began its descent in 2021, entering negative year-on-year (YoY) growth territory in October of the following year. While initially coinciding with pandemic-induced lockdowns and restrictions that curbed demand, the PPI's decline has persisted even after the easing of Covid-related measures. As of late 2025, China recorded 39 consecutive months of negative YoY PPI growth, with December's figure at -1.9%.

The Enduring Mystery of China's 15 Years of Deflation

Li Xunlei, chief economist at Zhongtai International, posits that China's deflationary challenges are not merely a post-Covid anomaly but a sustained trend spanning at least 15 years, coinciding with Xi Jinping's tenure as paramount leader. According to Li, 2012 marks a critical turning point in China's economic history, shifting from a long-standing battle with inflation to a prolonged period of deflationary pressure. This era parallels China's emergence as the world's preeminent manufacturing powerhouse.

Li highlights multiple sustained episodes of negative PPI growth, including a remarkable 54 consecutive months from March 2012 to August 2016. Even during the peak of the pandemic, from July 2019 to January 2021, producer prices continued to decline. Consequently, Li concludes that China has experienced long-term negative PPI growth from 2012 to the present, labeling this "The Mystery of PPI's Lost 15 Years."

Defying Milton Friedman: Money Supply vs. Deflation

Milton Friedman famously asserted that "inflation is always and everywhere a monetary phenomenon," attributing it to an excess of money and credit chasing too few goods. This theory often explained China's past inflationary bouts, such as the hyperinflation of the 1950s and the credit-driven spikes of the 1980s. However, China's current deflationary spell appears to challenge Friedman's dictum.

Li Xunlei points out that China's money supply growth has been robust over the last decade and a half, with Beijing significantly expanding credit to fuel economic development. From 2010 to 2025, China's GDP more than tripled in nominal terms. Concurrently, broad M2 money supply surged by 368% from the end of 2010 to the end of 2025. Despite this substantial monetary expansion, the PPI has failed to register commensurate growth, or even consistent positive movement. This divergence leads Li to describe China's 15-year PPI deflation as a "mystery that warrants unravelling."

Supply-Demand Mismatch: The Core Culprit

The protracted deflation in China appears to stem from fundamental shifts in supply and demand dynamics. Over the past 15 years, these two forces have moved in opposing directions, exacerbating deflationary pressures. China has witnessed an extraordinary expansion in its manufacturing capacity, solidifying its position as the world's leading full-spectrum manufacturing power. Simultaneously, Chinese demand has faced considerable headwinds, with exports constrained by trade tensions and domestic consumption undermined by sub-par growth in household wealth.

As Li Xunlei succinctly puts it, "In analysing the fundamental reason that for the past 15 years PPI has been unable to rise, a single line summary would be that supply has been greater than demand." Chinese economists identify several factors contributing to weak domestic demand, including a decline in government investment post-GFC stimulus, slower household income growth, and high real interest rates. The most significant factor, however, appears to be the property market slump that commenced in late 2021 and its adverse impact on household wealth.

The Baleful Impact of China's Housing Slump

Lian Ping, director of the China Chief Economist Forum, underscores the critical role of the property market slump in eroding household wealth, identifying these negative wealth effects as the primary driver behind weak domestic demand and subsequent deflationary pressure. He explains that "A contraction in the prices of major assets means that the asset-based incomes of workers has been reduced." This reduction fosters aversion to financial risk assets and curtails large-scale expenditures on luxury items, commercial goods, and housing.

For Chinese households, real estate represents the main area of asset allocation. While rising home prices historically boosted asset-based incomes, declines now diminish them, hindering household consumption growth. Furthermore, the property slump has negatively impacted fiscal expenditures. Local governments, heavily reliant on land transfer revenues, have seen these revenues fall by nearly 60% since 2021. This decline inevitably curtails government spending capacity, further dampening aggregate demand.

Boosting Domestic Demand: The Strategic Solution

Despite some reports suggesting a lack of awareness, China's economic policymakers and experts are keenly aware of the imperative to counter deflationary pressures. Lian Ping warns that "Historical experience has clearly proven that relative to gentle inflation, deflation brings with it even more dangerous potential risks for the economy," including liquidity traps, severe contraction of enterprise balance sheets, and systemic financial risk.

If the root cause of deflation is a supply-demand mismatch, the solution lies in recalibrating these relations. Given Beijing's unwavering focus on expanding its real economy, particularly high-end manufacturing, a significant reduction in supply growth is unlikely. Therefore, the strategic emphasis shifts to expanding aggregate demand, especially domestic consumption, which aligns with China's broader economic policy ambitions, including the 15th Five Year Plan (2026-2030).

This focus on internal consumption is also driven by geopolitical considerations, aiming to reduce economic dependence on export markets amid heightened global uncertainties. Economists advocate for policies that boost household wealth, whether through transfer payments, wage increases, or stabilizing asset markets. Li Xunlei suggests focusing on "increases to the incomes of low-income households and expediting consumption," arguing that stabilizing the manufacturing sector will naturally follow from increased profits.

Recognizing the property slump's role in restraining consumption, Beijing views support for both the housing market and other asset markets as crucial for driving consumer demand via wealth effects. Lian Ping calls for "vigorous support for capital market development," while Li Xunlei emphasizes that "stabilising the housing market is also an effective means for spurring consumption."

Macroeconomic Policy Implications

Lian Ping advocates for a continued expansionary macroeconomic policy to combat deflation by bolstering demand. He recommends significantly increasing central government debt-driven fiscal spending, proposing that the deficit ratio be maintained around 4% (above the traditional 3% threshold). He also suggests expanding the issuance of ultra-long-term treasury bonds and increasing net local government debt financing to at least 5% of national GDP.

Complementing increased fiscal spending are tax cuts and reductions in government fees to stimulate household and business expenditure. Lian recommends "increases in long-term discount policies, such as reductions to personal income tax rates" and easing regulatory pressure on private businesses. Furthermore, he proposes using state-owned financial institutions to support enterprises in struggling industries, aiming to prevent spiraling price cuts by providing financial backing to stable businesses.

Finally, a "moderately loose monetary policy" is deemed essential. This involves maintaining "rationally ample" liquidity to support fiscal expansion and, critically, achieving reductions in real interest rates. Lian highlights that high real interest rates suppress consumption and investment, exacerbating deflationary pressures by increasing borrowing costs and slowing credit growth. Lowering these rates is crucial to stimulate domestic demand and foster economic growth.