Deflation: Beijing’s blind spot or its strategy?

China’s deflation is often framed as a policy failure — but that diagnosis may be only half right.

A growing consensus among Western institutions holds that China is sliding into a self-inflicted deflationary trap. Eurasia Group ranks it among the top global risks for 2026, while the IMF’s 2025 Article IV assessment has called for more forceful and urgent macroeconomic stimulus. The narrative is familiar: weak demand, policy paralysis, structural imbalance and an economy drifting toward Japan-style stagnation. 

With the 21st Party Congress approaching in 2027, expectations are high that Chinese President Xi Jinping will prioritise political control and technological supremacy over the consumption stimulus needed to break the cycle. This interpretation is not without basis. But it rests on the assumption that Beijing is optimising for the same macroeconomic objectives as Western policymakers. This article offers a different reading.

China’s deflation reflects two overlapping forces: genuine demand-side weakness and supply-side price compression driven by industrial expansion in sectors Beijing has deliberately prioritised. Distinguishing between the two is essential — both for understanding China’s economic trajectory and its spillovers across the region.

The evidence supporting the policy failure narrative is substantial. Rhodium Group estimates that actual 2025 gross domestic product (GDP) growth fell below 3%, and broader price indicators reinforce the concern. China’s GDP deflator — the most comprehensive measure of economy-wide prices — has remained negative for ten consecutive quarters. As Rhodium Group notes, history offers no precedent for a major economy sustaining near-5% real growth through years of persistent deflation of this duration.

In parallel, producer prices have declined for over three years, while corporate profitability has deteriorated sharply. Notably, a Bloomberg analysis of roughly 6,000 listed firms found widespread margin compression and rising losses, as firms cut prices in response to weak demand.

The structural drivers are clear. A prolonged property downturn has eroded household wealth and confidence, while local government debt constrains fiscal expansion. Manufacturing overcapacity has pushed producer prices lower, and consumption remains subdued. Deflation has become self-reinforcing: falling prices erode corporate returns, which discourages investment — and without investment, demand weakens further, driving prices lower still.

Beijing has acknowledged these concerns. The Outline for Expanding Domestic Demand Strategy (2022–2035) formalised consumption growth as a long-term priority. Following this, the 2025 Central Economic Work Conference acknowledged the contradiction between weak demand and strong supply. Furthermore, Qiushi — the Party’s leading theoretical journal — published a compilation of Xi Jinping’s statements on the topic titled “Expanding Domestic Demand is a Strategic Move” (扩大内需是战略之举), indicating that Beijing views the issue as manageable within its existing framework. 

Alongside demand weakness runs a distinct form of deflation — one rooted in industrial success rather than economic stagnation.

In sectors central to Beijing’s strategy, falling prices reflect scale and productivity gains rather than weakness in demand. Carbon Brief’s analysis of Centre for Research on Energy and Clean Air data — based on official figures from the country’s National Bureau of Statistics — found clean technology contributed over one-third of China’s GDP growth in 2025, some 15.4 trillion RMB or 11.4% of GDP, comparable to the entire economies of Brazil or Canada. Without these sectors, overall growth would have fallen to around 3.5%, missing the official target by a wide margin.

Within this expansion, EVs and batteries accounted for 44% of the clean energy economy’s contribution, and clean energy drove more than 90% of the net rise in investment. Overall producer prices still fell 2.6% across the economy. The result is a paradox: within aggregate deflation, these sectors expanded strongly in both volume and value.

Policy commitments help reinforce this dynamic. China’s “dual carbon” targets — peaking emissions before 2030 and reaching carbon neutrality by 2060 — require sustained clean energy expansion regardless of near-term price pressures. 

Rather than aggressively reflating demand, Chinese policymakers have prioritised the development of “new quality productive forces” (新质生产力) under the 15th Five-Year Plan, focusing on advanced manufacturing, clean energy and emerging technologies. Meanwhile, “anti-involution” (反内卷) measures introduced in 2024–2025 through Ministry of Industry and Information Technology (MIIT)-led interventions in solar, batteries and EVs, aim to curb destructive price competition that could erode margins in strategic sectors. These signal a leadership willing to tolerate deflation where it reflects industrial upgrading, while intervening selectively to preserve long-term productive capacity. 

This approach has historical precedent. Japan, South Korea and Taiwan all suppressed consumption during their high-growth phases to fund industrial transformation. In this light, Beijing appears to make a similar calculation: that the window to secure dominance in key sectors like clean energy, artificial intelligence (AI) and advanced manufacturing is narrow enough to justify near-term costs.

Some Chinese economists support this. Peking University’s Justin Yifu Lin argues that China’s scale advantages in sectors like clean energy generate a “latecomer advantage” (后来者优势), where rapid scaling drives greater cost reductions than in advanced economies. This indicates that price compression is not a distortion but the means through which industrial consolidation and competitiveness are achieved.

Challenges loom large. Research indicates over one-quarter of listed Chinese companies are now unprofitable, the highest share in 25 years, reflecting persistent overcapacity and weak domestic demand. As competition intensifies, margins compress and losses widen. If this demand weakness persists, the industrial champions Beijing is nurturing may increasingly depend on external markets for revenues that the domestic economy cannot absorb.

This points to a structural imbalance in China’s consumption share. The National Development and Reform Commission reported in December 2025 that household consumption accounted for just 39.9% of GDP in 2024, well below developed-economy norms. Tolerating deflation as a transitional cost only works if consumption can eventually rise — and that rebalancing remains uncertain.

Chinese economists identify structural causes. For instance, Liu Shijin (刘世锦), former deputy director of the State Council’s Development Research Centre, argues China’s household consumption as a share of GDP sits approximately 20 percentage points below the global average — a gap rooted in urban-rural inequality and weak social protection that cannot be resolved through stimulus alone. 

The hukou system (户籍制度) exemplifies this constraint. By tying access to education, healthcare and social insurance to a person’s registered place of household origin rather than where they live and work, it creates powerful incentives to save rather than spend. With China having nearly 300 million migrant workers, of whom 132 million were living in cities away from their registered place of origin (and without full entitlement to urban public services), precautionary saving is a rational response to institutional exclusion.

The IMF estimates that hukou reform, combined with expanded rural social spending, could lift consumption by up to 3 percentage points of GDP — a structural dividend that demand-side stimulus alone cannot replicate. Without it, households facing institutional exclusion from urban services will continue to prioritise precautionary savings regardless of stimulus scale.

Beijing has acknowledged the need for reform too, including in the 15th Five-Year Plan. Research covering 332 cities also confirms that thresholds remain highest in the largest cities and have fallen most slowly there — precisely where the consumption gains would be greatest.

For Southeast Asia, the implications are immediate. China’s industrial expansion is reshaping regional economies through investment, supply chains and trade. Countries like Vietnam, Thailand and Malaysia have become major solar manufacturing hubs, while Chinese EV and battery firms have committed some US$80 billion to production across the region.

This brings both benefits and risks. Affordable Chinese technologies accelerate decarbonisation and help suppress inflation — with deflationary spillovers that have helped push regional inflation back toward pre-pandemic levels. But dependence on Chinese supply chains also creates vulnerability. As recent US tariffs on Southeast Asian solar exports show, external shocks can quickly disrupt industries tied to Chinese capital and production networks.

The challenge for regional policymakers is not whether to engage with China’s industrial system, but how. The gains from lower-cost technology are real — but so too are the risks of overdependence in an increasingly contested global economy.

China’s deflation reflects two major dynamics. Treating it solely as a policy failure risks missing how productivity gains and industrial policy are simultaneously reshaping price signals and output. For external actors, especially in Southeast Asia, the key task is not whether China’s deflation reflects failure or strategy, but how to respond to an economic model in which both operate simultaneously.

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