AsianFin -- China's central bank has issued a rare and urgent warning: despite a surge in overall liquidity, prices are not rising in tandem — in fact, deflationary pressure is mounting.
The People's Bank of China (PBOC) signaled a dramatic policy pivot from curbing price gouging to guarding against "low-price dumping," raising concerns that a deeper financial distortion may be taking hold: financial "air loops," where money circulates within the financial system without effectively reaching the real economy.
At the heart of the issue is a troubling paradox. While monetary supply and credit growth are expanding, consumer prices remain stubbornly weak. In 2024, China's broad money supply (M2) grew by 7–8%, and total social financing also saw solid growth. Yet, the Consumer Price Index (CPI) rose only 0.5%. It's a disconnect that analysts liken to filling a pond with water and seeing no rise in the water level.
Money Supply Up, Prices Flat: What's Going Wrong?
This anomaly reveals a critical problem: liquidity is failing to reach consumers and productive private enterprises. Instead, much of the capital is flowing into infrastructure and state-owned entities, while small and medium-sized enterprises (SMEs) and individual borrowers struggle to access credit.
The consequences are severe. With capacity utilization in some sectors as low as 74.3%, Chinese firms are being forced into a cutthroat price war — slashing prices just to survive. Industries like solar energy and EVs, once high-flying darlings of China's industrial policy, are now mired in intense competition that is eroding margins and dragging down the overall price level.
The situation contrasts sharply with the U.S. response to economic slowdowns. In 2020, Washington pumped direct stimulus into households, fueling demand and triggering inflation. China, by contrast, has focused on boosting supply while demand remains lackluster — resulting in what economists call a "low-inflation trap."
As companies slash prices to chase limited demand, profits deteriorate. To stay afloat, many are resorting to layoffs and wage cuts, feeding a vicious cycle: lower incomes lead to weaker consumption, which in turn depresses demand even further.
The property and manufacturing sectors are under particular pressure. Inventory liquidation has become prolonged and painful, with companies forced into fire sales. Consumers, anticipating further price drops, delay purchases — especially big-ticket items like smartphones. Precautionary savings are rising sharply, and in early 2025, deposit growth continues to outpace loan growth.
This deflationary mindset is deeply entrenched. "Unless necessary, don't buy a new phone" has become a common refrain — reflecting collapsing consumer confidence.
Adding to the complexity is the inefficiency of China's project-based investment model. Government-led initiatives, while boosting short-term GDP, have resulted in massive overcapacity. Some new energy industrial parks have vacancy rates exceeding 40%. Worse, funds earmarked for these projects are often diluted by inefficiencies in the distribution chain — with only 40% of intended investment reaching actual deployment in some cases.
This mirrors Japan's experience in the 1990s, where debt-driven investment failed to lift inflation or growth, culminating in a prolonged deflationary spiral.
What's Next: From "Protecting Projects" to "Protecting Incomes"
To escape this loop, economists say China must urgently shift its policy focus. In the short term, stimulating demand directly through broader consumer subsidies, expanded childcare support, or even a 10 trillion yuan stimulus package could help boost confidence and spending.
In the medium term, rebalancing credit allocation toward SMEs and away from inefficient state-led investments is crucial. And in the long run, China needs structural reform: upgrading industries, fostering innovation, and nurturing "hidden champions" — mid-sized global leaders in niche markets, much like Germany's manufacturing model.
Additionally, China could learn from the U.S. Inflation Reduction Act, which combines industrial policy with demand-side support to avoid price wars and encourage value-added manufacturing.
At its core, China's economic malaise stems from a breakdown in monetary transmission. Loose monetary policy has failed to ignite demand or generate inflation. Instead, capital is circulating in financial silos while overcapacity weighs down prices. Without targeted reforms to restore the connection between finance and the real economy, the risk of a deflationary spiral will only grow.
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