China's inflation challenge

China's headline CPI returned to growth in February after four months of deflation raised concerns of sustained price falls. We forecast very slight inflation, of an average 0.5%, in 2024, due to higher food prices, stable core inflation and further stimulus, but domestic demand remains weak. Low inflation in China should contribute to the global disinflation process, primarily via lower export prices. This would support insurance markets but may be controversial among producers in importing countries. Global economic impacts would be more negative if China were to experience a Japan-like stagnation scenario, but we see the likelihood of this as low.

• Muted inflation in China since 2023 reflects weak domestic demand, which is set to continue weighing on the inflation outlook.
• We expect 2024 CPI to remain subdued at 0.5% given steady core inflation, a recovery in food prices, and further policy easing.
• Low inflation in China should contribute to the global disinflation process, which would support insurance markets.
• The key channel would be lower export prices, but this may be unpopular with producers in importing countries.
• We see the likelihood a stagnation ("Japanification") scenario as low given China's large fundamental demand and capacity for stimulus.

February 2024 brought some relief on China's inflation outlook. After four months of deflation, headline CPI rose by 0.7% y-o-y and by 1% m-o-m in February, the biggest jump for two years. Base effects contributed, as the Chinese New Year holiday fell in February this year, driving up food and services CPI, vs in January in 2023. Core CPI went up by 1.2% y-o-y. The period of deflation since October 2023 had raised concerns of the economy facing a Japan-style stagnation scenario of falling prices and low inflation expectations.

Headline CPI contracted by 0.8% year-on-year (y-o-y) in January 2024, though core CPI continued to hold up. In 2023, headline CPI rose by only 0.2% on average, down significantly from the average 2% growth in 2016-2019. A higher unemployment rate, slower income growth, and the real estate market downturn led to very weak domestic demand. We expect deflationary pressures to ease in 2024, with muted but positive inflation resulting from stable core CPI growth, higher food prices and greater policy leeway for the PBoC as the Fed ends its tightening cycle. Therefore, we forecast full-year CPI inflation at 0.5% this year, higher than 2023.

The real estate sector downturn is a key factor for weak consumer sentiment, and this will likely continue. In February, the PBoC announced the largest cut to the five-year loan prime rate (LPR) since 2019, to 3.95% from 4.2%. The move followed a series of policies announced in 2023¹ to shore up consumer confidence and avert a property market collapse. The latest monthly figures for real estate investment and property sales (see Figure 1) suggest early signs of stabilisation in the market, which is not yet solid in our view.

Figure 1. Property sales and real estate investment, y-o-y change

Other deflationary forces are expected to mitigate this year. Unemployment is falling, improving to 5.1% at the end of 2023 from a 5.6% peak post-COVID-19 reopening in February 2023. Cyclical factors that weighed on CPI in 2023 are reversing, for example food price deflation due to softer pork prices and a high base in 2022. Pork CPI rose by 0.2% y-o-y in February, although the destocking process will likely last until mid-2024. Energy prices are skewed to the upside due to supply concerns, geopolitical tensions and expected global monetary easing, despite anticipated lower global demand, supporting a moderate CPI rebound.

We expect the government to increase policy stimulus to boost consumption. Goldman Sachs estimates that the total fiscal deficit, including additional "special bonds", policy bank bonds and local government financing vehicles, could reach 12% of GDP in 2024, but more may still be needed.² A key concern is the rising real interest rate, pushed up by declining inflation (see Figure 2), which is dampening both consumer and corporate demand through higher debt costs.

Figure 2. Increase in real interest rate, y-o-y

We previously highlighted the risk of a liquidity trap,³ reflected in the money supply staying above credit growth (see Figure 2).⁴ This suggests the effectiveness of monetary support is reducing, given individuals' higher intent to replay outstanding loans, and explains the gap between M2 growth (9.7%) and nominal GDP growth (5.4%). Still, the PBoC has more leeway for easing now that the US tightening cycle is over.

Figure 3. Growth of M2 money supply vs growth in credit (total social financing), y-o-y

Soft inflation in China should support the global disinflation process through lower prices for exported manufactured goods, though this may add pressure to producers in other markets. We do not anticipate a shock to the insurance market since insurance prices are generally inelastic, and global disinflation would support insurance markets.

We view the risk of "Japanification" as low. China has the world's largest, and increasingly sophisticated, manufacturing sector, the world's largest middle-income group, and the second-largest consumer market, which should all support steady core inflation. China's relatively healthy sovereign balance sheet⁵ and cross-border capital controls also make it more able to prevent a price-deflation spiral, a key phenomenon in Japan's "lost decades".