The Mystery of China's 15 Years of Deflation

Why the Chinese economy continues to defy Milton Friedman's predictions.

The challenges and perils faced by China’s economy have changed tremendously in character over the past half-century period.

This is of course an inevitable byproduct of the vast transformation in China’s economic life, wrought by the dismantling of its Soviet-inspired command economy and the journey of reform and liberalisation launched by Deng Xiaoping in 1978.

A critical area of change has been on the monetary and inflationary front - the nature of the price movements that have such a profound impact upon consumption and investment decisions, as well as the stores of wealth amassed by households and businesses.

Throughout the formative years of the People’s Republic of China, a recurring adversary for its economic leadership would be torrid levels of inflation.

In the 1950s, the freshly victorious Communist Party first needed to grapple with the residual hyperinflation created by the Chinese Civil War, and the money printing used by the fleeing Nationalist government to fund its military expenditures.

Barry Naughton - one of redoubtable doyens of Chinese economic history, considers the quelling of this hyperinflation to be the key policy accomplishment of the first generation of Communist Party leaders.

This accomplishment was all the more impressive given that it coincided with huge fiscal outlays needed to support the war in the Korean Peninsula.

Inflation would once again emerge as the most vexing challenge for China’s economic decision-makers during the opening stages of the reform and opening era, throughout the 1980s and 90s.

While reform led to surging levels of economic growth, it also had the attendant effect of driving painful inflationary spikes, as China’s regional governments dialled up credit and monetary expansion to foster development.

China underwent three such bouts of inflation during the 1980s, the last of which culminated in the widespread public unrest and political turmoil that rocked the nation’s capital in 1989.

Each one of these inflationary episodes led to an abrupt, albeit temporary, retrenchment of China’s reform agenda.

They triggered a touchpaper reaction from China’s geriatric party conservatives - chief amongst them economics tsar Chen Yun, who harboured traumatic memories of the post-war hyperinflation of the 1950s.

Inflation remained an acute concern for China up until the eve of the Global Financial Crisis (GFC) in 2008. China’s consumer price index (CPI) posted a rise of 4.8% for 2007, prompting an initial tightening of macroeconomic policy by Beijing.

China’s leaders were of course forced by subsequent events to hastily backpedal, with Premier Wen Jiabao eventually launching a mammoth four trillion yuan stimulus package to deal with the economic fallout of the 2008 crisis.

China’s post-Covid PPI struggles

Matters have changed profoundly since the GFC. Beijing’s long-standing struggle with the malignant djinn of inflation now appears to be well and truly the painful recollection of a bygone era.

China stands alone amongst the world’s major economies in averting a torrid episode of inflation in the wake of the Covid pandemic.

It’s instead weathered protracted deflationary pressure over the past several years - a phenomenon which points to supply chain shocks as the culprit for rapid price gains in other countries, as opposed to the fiscal and monetary loosening used by their governments to shore up their economic health.

China’s Producer Price Index (PPI) first began to slide in 2021, entering negative growth territory in year-on-year (YoY) terms in October of the following year.

This decline coincided with the peak period of the pandemic, when municipal lock-downs and restrictions on cross-border travel would be expected to undermine the demand that fuels price growth.

Chinese PPI has continued to languish, however, even following the curtailment of Covid-related movement restrictions.

As of the end of 2025, China had posted 39 consecutive months of negative YoY PPI growth, with the print for December coming in at -1.9%.

The mystery of China’s 15 years of deflation

Li Xunlei (李迅雷), chief economist at Zhongtai International, argues that Chinese deflationary pressure is far from just a post-Covid phenomenon.

He points out that China’s current problems with deflation extend for at least the past fifteen years, to the very start of Xi Jinping’s time in office as paramount leader.

According to Li, 2012 is the watershed year in China’s economic history when it comes to inflation.

He sees it as marking the divide between the long-standing struggle with inflation since the founding of the People’s Republic, and a protracted period of deflationary pressure coinciding with China’s emergence as the world’s preeminent manufacturing power during Xi’s term as president.

“This is far from the first time that China has seen sustained episodes of negative growth in PPI,” Li writes in the opinion piece “The Mystery of PPI’s Lost 15 Years” (李迅雷：PPI“失去十五年”之谜) published by Yicai.

“From March 2012 to August 2016 - during Xi Jinping’s honeymoon period as China’s paramount leader, PPI posted 54 consecutive months of negative YoY growth.

“Even during the height of the pandemic, China saw its producer prices decline, with negative YoY PPI growth from July 2019 to January 2021.”

As a consequence of these repeated bouts of deflation, Li conclude that “from 2012 until the present, China’s long-term PPI growth has been negative.”

Chinese deflation defies Milton Friedman

The economist Milton Friedman is renowned for having opined that “inflation is always and everywhere a monetary phenomenon” - that it’s the inevitable product of too much money and credit chasing too few goods and services.

This is generally considered to be the culprit for Chinese inflation in the 1950s - with the outgoing Nationalist government having printed an excess money to fund the war, as well as in the 1980s - when China’s local governments extended a surfeit of credit via control of the state-owned banks.

China’s ongoing bout of deflation, however, would appear to defy Friedman’s signature dictum.

Li points out that China’s money supply growth has boomed over the past decade and a half, as Beijing has turned up the spigots of credit to oil the nation’s economic development.

In 2010, China’s GDP was less than 40 trillion yuan. By 2025, Chinese GDP had more than tripled in nominal terms to 140 trillion yuan.

From the end of 2010 to the end of 2015, China’s broad M2 money supply posted an even greater increase of 368%, expanding from 72.6 trillion yuan to 340 trillion yuan.

In spite of all this, China’s PPI index has failed to budge upwards over the same time period, let alone post a commensurate surge in growth.

Li consequently refers to the fifteen year period of PPI deflation in China as a “mystery that warrants unravelling.”

Supply-demand mismatches the real culprit

The cause of China’s protracted deflation would appear to lie in fateful changes to supply and demand relations. Over the past 15 years, the two have moved in contrary directions that would both serve to exacerbate deflationary pressures.

China has seen a dramatic expansion in supply during Xi’s time in office - as a result of its emergence as the world’s preeminent full-spectrum manufacturing power.

During this same period Chinese demand has confronted considerable headwinds, with exports hampered by trade tensions, and domestic consumption undermined by sub-par growth in household wealth levels.

“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,” Li writes.

Chinese economists identify a range of factors that have held back domestic demand and contributed to ongoing deflationary pressure.

These include a decline in government investment spending after Wen Jiabao’s GFC rescue package; easing growth in household incomes which have fallen beneath long-term rates of increase, as well as the high level of real interest rates - a factor which is both caused by and contributes to deflation.

Chief amongst the factors contributing to China’s weak demand would appear to be the property slump that kicked off towards the end of 2021, and its subsequent impact upon levels of household wealth.

The baleful impact of China’s housing slump

Lian Ping (连平), director of the China Chief Economist Forum, has highlighted the role of the property market slump in undermining the wealth of Chinese households.

He points to these negative wealth effects as the key factor behind the weakness of domestic demand and the ensuing rise in deflationary pressure.

“A contraction in the prices of major assets means that the asset-based incomes of workers has been reduced,” Lian writes in the opinion piece “What we still need to do to suppress deflationary risk” (连平：抑制通缩风险还需要做些什么) published by the Chief Economist Forum.

“The decline in asset-based incomes of the private economy increases their aversion to various types of financial risk assets, as well as reduces large-scale expenditures on things such as luxury items, big-ticket commercial goods and housing.”

“For the household sector, real estate is the main area for their asset allocations,” Li Xunlei observes.

“During cycles of home price increases, their asset-based income rises, but during declines, their asset-based income is reduced.

“This is of no benefit to growth in household consumption.”

Li further points out that the property slump has had adverse impacts on demand in other spheres of the economy - chief amongst them fiscal expenditures.

The pivotal role of the property market in China’s economy means that a slump hits local government revenues and fiscal spending, in addition to having negative wealth effects on households.

This is because China’s local governments have long depended on land transfer revenues to fund their spending.

The Chinese fiscal system as a whole is characterised by an imbalance which sees the central government take a disproportionate share of tax revenue, while local governments bear a greater burden of expenditures.

“Real estate is closely related to local government fiscal revenues,” Li writes.

“From 2021 until the present, local government land transfer revenues have fallen by nearly 60%.

“The fall in local government land fiscal revenues will inevitably impact its spending capability, and thus have a negative impact upon the expansion of demand.”

Boosting domestic demand viewed as the solution

Despite recent reports that Xi Jinping was oblivious to the negative impacts of deflation, China’s economic policymakers and experts are keenly aware of the need to stymie further downward pressure on prices.

“Historical experience has clearly proven that relative to gentle inflation, deflation brings with it even more dangerous potential risks for the economy,” Lian Ping writes.

“These include liquidity traps, severe contraction of enterprise balance sheets and systemic financial risk.

“The threat is extremely great, and warrants a high level of attention, as well as medium and long-term systemic and targeted counter strategies.”

If a supply-demand mismatch - as opposed to parsimonious money creation by the banking system - is the cause of China’s deflationary dilemma, then the solution would naturally lie in counter adjustments to supply-demand relations.

Beijing is very unlikely to significantly dial back on supply growth. In large part due to renewed Cold War tensions, Xi is relentlessly focused on the growth of China’s real economy - in particular high-end manufacturing - and expanding China’s ability to supply goods and services coveted by the poor and affluent alike.

As a consequence, Chinese economists view the fix for deflation as lying in measures to expand aggregate demand - in particular domestic demand, with an especial focus on household consumption.

This is one of the reasons that China’s top economic pundits have repeatedly avered that the greatest problem for the national economy is insufficient demand.

“In future, we still need to continue to launch expansionary policy measures, whose chief mission and goal will be the expansion of aggregate demand,” Lian writes.

Fortunately for Beijing, boosting domestic demand and consumption already lies at the centre of its economic policy ambitions - including the 15th Five Year Plan which is scheduled to run from 2026 to 2030.

This focus is in line with China’s strategic exigencies ever since the worsening of Sino-US relations during the inaugural terms of US presidents Trump and Biden.

Increasing China’s domestic demand will make its economy far less dependent upon export markets, which are subject to heightened uncertainty amidst worsening geopolitical tensions. A similar line of reasoning lies behind Beijing’s quest for “sovereign scientific and technological independence.”

The standard line amongst both China’s policymakers and economists is that growth in domestic demand requires a rise in household wealth - whether this be achieved by means of transfer payments, wage increases, or the wealth effects of buoyed asset markets.

“The key to expediting a gentle rise in price levels lies in adjustments to supply-demand relations - in particular the expansion of effective demand,” Li Xunlei writes.

“It’s recommended that the focus for the expansion of domestic demand (investment and consumption) be placed on increases to the incomes of low-income households and expediting consumption.

“It isn’t necessary to fixate on stabilisation of the manufacturing sector, because if manufacturing enterprises can achieve profits, then they will naturally expand investment.”

Given the central role that China’s multi-year property slump has had in restraining consumption, Beijing views support for both the housing market and other asset markets as a key means of driving consumer demand via wealth effects.

Lian Ping calls for “vigorous support for capital market development, to increase asset-based household incomes,” while Li Xunlei points out that “stabilising the housing market is also an effective means for spurring consumption.”

Macroeconomic policy implications

Lian Ping wants macroeconomic policy to remain in expansionary territory for the foreseeable future, as part of China’s campaign to combat deflation by boosting demand.

As a consequence, he’s in favour of significantly stepping up debt-driven fiscal spending by the Chinese central government.

“In terms of active policy, the first recommendation for dealing with deflation is to increase fiscal expenditures and expand effective investment by the government,” he writes.

“Given that the funds of local governments for expanding investment expenditures are limited, I propose that the central government implement even more active [fiscal] policy, and continue to appropriately increase leverage.”

Lian has called for China’s deficit ratio to be held at around 4% - well above the long-standing threshold of 3%, as well as for an expansion in Beijing’s issuance of ultra-long-term treasury bonds to an average of at least two trillion yuan per year across a five year time period.

He also wants net local government debt financing to rise to at least 5% of national GDP.

The counterpart to increases in debt-driven fiscal spending will be cuts to taxes and government fees, in order to whet spending by households and businesses.

Lian recommends “increases in long-term discount policies, such as reductions to personal income tax rates.”

“For private businesses, in addition to general reductions to taxes and administrative fees, there should also be a reduction in needless regulatory pressure, in order to lighten the burden for market actors,” he writes.

Lian also wants the Chinese government to use its control of the state-owned financial sector to provide support to enterprises in struggling industries, in order to stymie spiralling price cuts.

“The main goal will be to reduce the deflationary impacts brought about by a contraction in the balance sheets of traditional sectors that are in decline,” he writes.

“[We should] provide greater financial support to those enterprises whose main operations are clear and whose business is stable…to reduce the likelihood of such enterprise further engaging in large-scale price cuts.”

Finally, “moderately loose monetary policy” will serve as the necessary complement to increases in fiscal expenditures and state-driven financial support for designated sectors.

In addition to maintaining “rationally ample” levels of liquidity to support expansionary fiscal spending, the goal will be to achieve reductions in real interest rate levels.

Lian views this as an especially critical task, given that deflation naturally raises borrowing costs by reducing the amount of money that businesses earn from their sales of goods and services.

“High real interest rates suppress consumption and investment, and have a negative impact upon economic growth and price levels,” Lian writes.

“[This] increases the cost of consumer spending by households and the expansion of investment by enterprises.

“Households and enterprises are then subject to marked slowdowns in credit growth, which suppresses the release of domestic demand.”