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Is China the next deflation threat?

Customers look at items at a shop in Beijing, Sept. 19, 2014.
ChinaFotoPress | Getty Images
Customers look at items at a shop in Beijing, Sept. 19, 2014.

Add China to the list of countries grappling with the threat of deflation.

Fresh data on Friday from the Chinese National Bureau of Statistics showed that consumer prices rose just 2 percent last year, well below the government's target of 3.5 percent.

Prices of commodities and raw materials at the producer level, meanwhile, were 3.3 percent lower than a year earlier, the 34th consecutive monthly decline and the biggest drop since September 2012.

Oil-consuming countries around the world are seeing inflation fall as the price of crude oil has crashed since last July. By itself, that lowers energy bills and should help boost spending and economic growth.

But the global price drop is hitting a wide range of commodities and raw materials, from plywood to sugar. In Europe's slow-moving economy, prices overall shifted into reverse last month—down two-tenths of a percent in December—touching off worries that a prolonged period of falling prices could take hold, dragging economic growth along with it.

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So far, that doesn't appear to be happening—in Europe or China. Despite the plunge in oil prices, the costs of other consumer goods are rising, though slower than government officials would like.

While China's economy is still growing at a rate that would represent a boom in the developed world, the pace has slowed since it undertook a massive stimulus of borrowing and building after the global financial crisis of 2008.


China's growth pace likely slowed to 7.2 percent in the fourth quarter, according to a Reuters poll of economists. That would be the most sluggish rate since 2008 and the weakest pace in 24 years.

Low oil prices should help spur growth by boosting spending on other goods and services. China's bill for imported oil came to about 2.5 percent of gross domestic product in 2013, according to economists at Capital Economics. If prices stay below $60 per barrel, they figure that will add more than more than a full percentage point to China's falling GDP.

"Many are concerned about deflation, but most firms and households should find themselves better off," they wrote in a recent note to clients.

One antidote for slowing prices is to pump more money into the economy, a move the U.S. Federal Reserve undertook with a multitrillion-dollar bond buying program starting in 2008. After years of inaction, European central bankers are set to consider such a move at their next policy meeting Jan. 22.

China's central bankers are also expected to loosen the purse strings to spur growthwith interest rate cuts and lower reserve requirements for Chinese banks.

But while easing credit through the official banking system, Chinese leaders are grappling with a massive debt hangover from so-called shadow bankersprivate investors and money pools holding trillions of dollars in bad debts. Much of that money backed an epic building spree of new businesses, infrastructure and housing that has left behind a glut of unused capacity and empty apartments.

Deflation could make it much harder for China's leaders to navigate through that debt hangover, according to a report by analysts at Bank of America.

"A credit crunch is highly probable," said analysts David Cui and Tracy Tian.

A credit squeeze on top of China's ongoing slowdown could be painful. But the country holds nearly $4 trillion in reserves to shore up its financial system. And because the state controls its banking system, there is less risk of a Lehman-style financial crisis.

Chinese leaders can also exert some control of the pace of debt restructuring, extending credit to failing enterprises and gradually working through its bad debts.

Still, with the total debt pile estimated at rough 2.5 times China's GDP, any credit crunch would weigh heavily on an already slowing economy. As one of the world's largest consumers of commodities and raw materials, that ongoing slowdown will likely continue to put downward pressure on prices.