The reading comes a day after news that the country suffered its biggest fall in exports since the early days of the pandemic, while imports tanked again as domestic and global demand fall away.
The Consumer Price Index, the main gauge of inflation, fell 0.3 in July, the National Bureau of Statistics said, having flatlined in June.
While it was marginally better than the 0.4 percent decline forecast in a survey by Bloomberg, it marked the first drop since the beginning of 2021 and will add to pressure on authorities to provide much-needed support to the economy.
Deflation refers to falling prices of goods and services and is caused by a number of factors, including waning consumption.
And while cheaper goods may appear beneficial for purchasing power, falling prices pose a threat to the broader economy as consumers tend to postpone purchases in the hopes of further reductions.
A lack of demand then forces companies to reduce production, freeze hiring or lay off workers, and agree to new discounts to sell off their stocks -- dampening profitability even as costs remain the same.
China experienced a short period of deflation at the end of 2020 and early 2021, due largely to a collapse in the price of pork, the most widely consumed meat in the country.
Prior to that, the last deflationary period was in 2009.
Many analysts fear a longer stretch of deflation this time around, as China's main growth engines stall and youth unemployment is at a record high of more than 20 percent.
Ongoing turmoil in real estate, a sector that has long accounted for a quarter of China's economy, is the "main source" for this "deflationary shock", said economist Andrew Batson of Gavekal Dragonomics.
Deflation is also being driven by flagging exports -- historically a key source of growth for China, he added.
- 'Cause for concern' -
Tuesday's worst-than-expected drop in exports had a direct impact on tens of thousands of export-oriented companies in China, which are now operating at a much slower pace.
"The latest Chinese inflationary data did little to inspire confidence that an economic turnaround is forthcoming," Tim Waterer, chief market analyst at KCM Trade, said in a note.
"The inflation data... was further evidence that China remains a cause for concern from a global growth perspective," he added.
Meanwhile, the producer price index fell 4.4 percent in July -- slightly better than June's 5.4 percent fall but marking the 10th consecutive month of contraction.
The index measures the cost of goods leaving factories and gives an overview of the health of the economy.
Declining producer prices mean reduced margins for companies.
The grim data suggests that China may struggle to achieve a five percent growth target set for the year.
The world's second largest economy only grew 0.8 percent between the first and second quarters of 2023, according to official figures.
And many economists are now calling for a vast recovery plan to boost activity.
But for the time being, the authorities are sticking to targeted measures and declarations of support for the private sector -- with little in the way of tangible steps.
Still, Wednesday's poor numbers may "put pressure" on the government to reconsider, economist Zhiwei Zhang of Pinpoint Asset Management suggests.
How China is responding to economic challenges
Beijing (AFP) Aug 9, 2023 -
China on Wednesday reported it had entered deflation for the first time since 2021 -- the latest indicator pointing to a slowdown in the world's second-largest economy.
Here's how Beijing is attempting to reverse the downturn:
- Targeted stimulus -
During the global financial crisis of the late 2000s, China unveiled a massive four trillion yuan ($556 billion at current exchange rates) stimulus plan.
The plan sparked an infrastructure boom of roads, airports and high-speed train lines -- but also brought the risk of unnecessary projects and growing debt.
These days, keen to clean up its finances, Beijing now prefers targeted measures to a massive, costly stimulus plan, according to Larry Hu, economist at Macquarie.
In July, the government unveiled measures to encourage the purchase of electric vehicles and household appliances.
- Sluggish consumption -
China has in recent weeks announced a series of measures to boost consumption, including large-scale festivals and sporting events, as well as an increase in spending on services involving catering and healthcare.
But this doesn't tackle the root of the problem, according to analysts at Trivium, a China-focused research firm.
"Consumers aren't spending because income growth has slowed and the economic outlook remains uncertain," Trivium analysts wrote in a note.
The country's post-Covid recovery is running out of steam, with one in five young people unemployed and households tightening their belts.
"Until these two issues are addressed, consumption will not pick up in a meaningful way," the analysts wrote.
- Deflationary spiral -
While on paper falling prices may seem like a good thing for purchasing power, a drop into deflation poses a long-term threat.
Instead of spending, consumers postpone purchases in the hope of lower prices.
And in the absence of demand, companies cut back on production, freeze hiring or lay off staff and agree to further price cuts to clear their inventories, which weighs on profitability as their costs remain the same.
In the current economic climate, households will remain "cautious about making purchases of big-ticket items given the potential risks of job losses and salary cut", according to Ken Cheung, analyst at Mizuho Bank.
- Property crisis -
Bricks and mortar are a pillar of the economy in a country where property has long been seen as a safe bet for middle class Chinese seeking to grow their wealth.
Yet financial woes at a large number of developers, many of whom are now struggling to stay afloat, are fuelling a crisis of confidence among potential buyers and depressing prices.
The central bank has extended its support for developers until the end of 2024 and extended loan repayments to enable developers to complete existing projects.
Several cities, including Zhengzhou in central China, have also relaxed purchasing rules to stimulate demand.
But the results may fall short of expectations, warns Nomura bank analyst Ting Lu, who pointed to a "weak confidence about the future" and "falling population" as drivers of a decline in housing demand.
- Trade under threat -
China, long described as "the workshop of the world", remains highly dependent on exports.
The threat of recession in the United States and Europe, combined with galloping inflation, has weakened international demand for Chinese products.
In July, exports fell 14.5 percent year-on-year -- the biggest drop in more than three years.
To support the export sector, Beijing could allow the yuan to depreciate against the dollar, according to Mizuho's Cheung.
This strategy, which China has used in the past, would technically make the cost of its goods more competitive abroad.
- Geopolitical tensions -
Some Western leaders are advocating "decoupling" from China's economy amid tensions with Beijing.
The Chinese government's "increasingly authoritarian efforts to control Chinese society and draconian legislation like the updated anti-espionage law have also greatly eroded domestic and foreign confidence in doing business in China," according to US-based consultancy SinoInsider.
A revised law dramatically expanding China's definition of espionage came into force in July, prompting experts to warn that even companies with tenuous links to organisations accused of spying could get swept up in crackdowns.
Foreign direct investment in China fell to its lowest level since 1998 in the second quarter, according to Goldman Sachs.
"Beijing has few good options for rescuing the economy," SinoInsider analysts wrote in a note.
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