How China could use the War in Iran to crush deflationary inertia
ICBC economist Cheng Shi wants Chinese fiscal policy to prolong the economic impact of the oil price shock.
As the War in Iran drags on amidst abortive efforts to conclude a peace deal, speculation mounts over which global powers stand to gain or lose most from a conflict which will determine the future trajectory of energy prices.
From the perspective of policymakers in Beijing, China could be the one economy which has already derived major benefit from the conflict affecting the Strait of Hormuz - despite East Asia’s general reliance upon imported sources of energy.
The spike in global oil prices has helped China to deal with the long-standing problem of domestic deflationary pressure - an issue which has been an acute problem for Beijing since the Covid pandemic - and arguably Xi’s full term in office.
China’s producer price index (PPI) just broke a 41-month streak of declines, with data from the National Bureau of Statistics pointing to a 0.5% rise compared to the same period last year.
In a sign of the impact of the turmoil on global oil markets created by the War in Iran, the rise in producer prices was most apparent in energy-intensive industries such as the non-ferrous metal mining - which saw a 36.4% increase, and non-ferrous metal smelting and processing, which logged a 22.4% rise.
Using the oil shock to restore inflation
Leading pundits in China believe that a short, sharp oil price shock could have a positive long-term impact upon its economy, by providing a quick fix for the interminable deflation that’s been holding back credit-driven demand.
One such commentator is Cheng Shi (程实), chief economist at ICBC International. He argues that Beijing should take advantage of the leap in oil prices caused by the impasse surrounding the Strait of Hormuz to restore moderate levels of inflation.
“External energy shocks can catalyze a short-term rebound in PPI and improve price expectations…taking them from low-level inertia to a steady state of moderate recovery,” Cheng writes in the opinion piece entitled “Chinese prices are shifting from low price inertia to warming up and rebounding” “程实：中国物价正从低价惯性转向温和回升”) published by Yicai.
He advocates for Beijing stepping in with judicious fiscal and monetary policy to fully capitalise upon the impact of oil price spikes, helping to solve the dilemma of deflationary inertia in China once and for all.
Under the base assumption that the oil crisis will prove short-lived, Cheng highlights the need to “leverage external shocks to break expectations of low prices…thus consolidating the momentum of the shift in price movements.”
One way to achieve this will simply be for Beijing to use higher levels of fiscal spending to extend the inflationary impacts created by the initial shock in oil prices.
“Price improvements relying solely on cost-driven factors are often temporary - once external shocks weaken or prices fall, the momentum of price increases may slow,” Cheng writes.
“Consequently, transforming exogenous shocks into endogenous demand is the key to current policy efforts.”
Expansive fiscal spending will very likely be needed to step up aggregate demand in the Chinese economy, in order to compensate for the tepid condition of household consumption and private investment.
China is already well-positioned to cater to this task, given that it’s unleashed the mandate for greater fiscal spending ever since Donald Trump won the 2024 presidential election, in order to compensate for the economic headwinds emanating from his second term in office.
“Fiscal expansion will further strengthen in 2026, and be coupled with increased counter-cyclical and cross-cyclical adjustments to monetary policy,” Cheng writes.
“The deficit is set to reach a record high of 5.89 trillion yuan, while the combined impact of multiple [debt] instruments could bring total broad fiscal spending to over 11.5 trillion yuan, providing solid support for demand recovery and price improvements.
“This will create the critical policy conditions for promoting a trend of price increases and moving away from temporary improvements.”
On the monetary policy front, China’s official policy rate sits at just 1.4% , which domestic analysts have warned leaves the central bank with limited room to boost growth or inflation via further interest rate cuts.
The average required reserve ratio (the amount of base money that commercial banks are required to stow with the central bank, thus restricting their ability to lend) for Chinese financial institutions is considerably higher, however, at 6.2%.
This means the Chinese central bank still has ample room for cuts to the reserve ratio, which can help to fund fiscal spending by creating more room on the balance sheets of banks for purchases of Treasury bonds.
Cheng does note the risk of “excessive accumulation of imported price pressures” if Beijing seeks to capitalise upon the oil price shock to restore domestic inflation.
He contends, however, that Beijing is in a better position than other major economies to fine-tune the impact of rising oil prices in China via macroeconomic measures, thanks to precautionary policies that have amassed large-scale oil reserves and led to a more structurally diversified energy sector.
“Compared to some economies facing strong price pressures, China’s pricing mechanism for oil effectively buffers external shocks, and consumer prices can be controlled overall,” Cheng writes.
“According to the IEA’s (International Energy Agency) Total Energy Supply (TES) statistics, oil accounts for approximately 18% of China’s primary energy mix, far lower than the US (36%), Japan (37%), South Korea (37%), and Germany (34%).
“China’s energy consumption is primarily driven by coal and clean energy. There is ample domestic supply of the former and its price is dominated by the domestic market, while the latter is largely unaffected by international oil prices.
“This means that the transmission of international oil price fluctuations to China’s overall energy costs is naturally diluted…a difference [which] gives China a certain degree of flexibility and initiative in the global policy environment.”
China sees deflation as long-term dilemma
In stark contrast with the world’s other major economies that have struggled to contain price gains since Covid, deflation has recently emerged as one of the most besetting dilemmas faced by China’s economic stewards.
It has contributed to what policymakers and economists in China roundly refer to as “insufficient domestic demand” - an issue that consensus opinion deems to be the nation’s biggest macro-economic challenge.
In addition to crushing the profits of Chinese enterprises in the grip of cut-throat Schumpeterian competition, deflation is believed to be a key factor behind the general reluctance of both households and businesses to take out loans for spending or investment.
This is because it raises the real cost of borrowing ,just at a time when interest rates in China sit at very low levels, leaving the central bank with limited room for further cuts to reduce the price of credit.
The Chinese central banks’s seven day reverse repo rate - which is viewed as the most telling and important of its policy rates, currently sits at just 1.4%, following a 10 basis point reduction in May 2025.
For these reasons, China’s top economists and policymakers are heavily focused on the need to restore moderate levels of inflation, via large-scale initiatives such as Xi Jinping’s anti-involution campaign, which seeks to curb industrial overcapacity, rampant enterprise competition and breakneck price cuts.