At the onset of the Iran crisis, the inflation trend in the Chinese bond market seemed to align with the global trend. Traders once considered China as an economic entity similar to other countries. However, data quickly showed a retreat to prove that the traders’ optimism was unfounded.
A recent analysis by the Financial Times pointed out that the yield of China’s ten-year government bonds rose slightly from 1.83% on February 27, the eve of the US-led coalition’s strike against Iran, to 1.90% on March 9. However, in the following weeks, the yield quickly fell back to 1.82% on April 3, even lower than before the Iran conflict.
This quiet retreat is more convincing than any official statements from the Chinese Communist Party, clearly indicating that deflationary forces still dominate in China, a phenomenon that cannot be ignored.
The reasons behind this mechanism are simple. Normal re-inflation of currency requires one or both of the following: either a substantial relaxation of monetary policy or a significant expansion of fiscal stimulus. Currently, China lacks both.
In terms of monetary policy, the People’s Bank of China (PBOC) has not eased its monetary policy at all. The benchmark lending rate remained unchanged in March, marking 11 consecutive months of stability. This means that the actual borrowing costs remain high, leading to weak credit demand from households and small businesses due to lack of confidence and high interest rates.
Fiscal policy is also constrained. Although the Chinese authorities have the means for massive stimulus, they are reluctant to target areas that benefit consumers. Traditional stimulus measures like infrastructure spending are ineffective due to economic overcapacity. Meanwhile, local governments are tightening their finances, struggling to manage accumulated debts. The stimulus measures launched by the CCP, such as consumer vouchers and family subsidies, are too small in scale and targeted to be effective in boosting overall demand.
The author of the article pointed out that the oil crisis triggered by the Iran war has made the Chinese economy even more complex. Traditionally, soaring commodity prices increase input costs under conditions of saturated capacity, leading to inflation. However, China’s production capacity is far from saturated in industries such as steel, chemicals, solar panels, electric vehicles, among others.
With weak domestic demand in China, the transmission mechanism of inflation is unable to function normally. The oil crisis will not trigger inflation; instead, it will suppress the only engine supporting the Chinese manufacturing sector from completely shrinking.
In the past, China relied on external demand to alleviate excess production capacity. However, rising energy prices are likely to harm global economic growth, weaken the purchasing power of many of China’s trading partners, slow export orders, and exacerbate China’s overcapacity issue.
Excess production capacity combined with decreasing demand inevitably leads to deflation. As a result, factory prices will be suppressed, profit margins squeezed, new investments hindered, exacerbating the long-standing issue of stagnant wages and income in China. Despite last year’s claim of 5% GDP growth in China, wages for private sector workers in urban areas only increased by 1%, resulting in continued weak consumption.
In other words, the oil shock not only fails to provide an avenue out of the current predicament but exacerbates China’s deflation trap. To change the current situation, the CCP must either genuinely reform fiscal policy by directly transferring significant payments to households, restructuring local government debts, or expanding a sustainable social security system to prevent panic savings among the populace. Alternatively, they could adopt a more aggressive monetary policy framework to trade a loose financial environment for nominal growth. However, in the short term, the Chinese authorities are unable to achieve either of these points.
The article concludes that while many countries around the world are concerned about inflation pushing up yields, China’s long-term yields remain low, even lower than before the severe impacts on oil prices. A reviving economy experiencing inflation should not exhibit such indicators. Even a major disruption in the global oil market is unlikely to change China’s deeply rooted economic problems.