Article - China risks deflation

Feb 24, 2009 (ST)

China's producer price index (PPI), a measure of inflation at the factory level, decelerated sharply to an annual rise of 2 percent in November. It was the slowest pace for the PPI since May 2006

SHANGHAI - CHINA is facing deflationary risks due to overcapacity in many industries amid a sharp downturn in demand, the central bank said in a report issued late Monday.

'Against the backdrop of shrinking general demand, the power to push up prices is weak and that for driving down prices is strong,' the People's Bank of China said in its report on fourth quarter 2008 monetary policy.

'There exists a big risk of deflation,' said the report posted on the central bank's Web site.

While falling prices might seem a welcome trend, a long spell of deflation can lead to destructive declines in wages, stocks and property prices, sapping corporate profits and prompting businesses to cut jobs and investment.

China's consumer price index, which had spiked last year to 12-year high of 8.7 per cent, has eased to 1 per cent in January.

Meanwhile, wholesale prices fell 3.3 per cent, the second straight month of decline, as costs for oil and other raw materials eased.

Such a fall in wholesale prices, which measures the cost of goods as they leave the factory, can indicate an impending decline in consumer prices.

The central bank's comments underscore China's challenge in balancing policy to suit fast-changing global and domestic pressures.

Until July, it noted, the prevailing concern was with surging inflation. But a sharp decline in demand for many products that began in the autumn has left many industries with excess inventory and too much production capacity - a chronic problem even before the downturn.

China's torrid economic growth slowed to a seven-year low of 9 per cent in 2008.

But the central bank also warned of potential longer-term risks from inflation due to the worldwide effort to expand credit and increase liquidity in the global financial system. -- AP

Questions

1. From the article, what are the causes of deflation in China?
2. Why would the Central Bank be concerned about deflation?
3. Explain why credit expansion and increased liquidity globally may lead to inflation in the future