Soon, China will launch a price war... as it will have no other choice.

As European households still grapple with the severe social consequences of inflation, on the other side of the world, another threat is already looming: deflation. In China, the major concern is no longer rising prices, but rather their decline. In January, year-on-year consumer prices fell by 0.8%. This marks the fourth consecutive month of decline and the steepest drop since 2009.

Even more worrisome, Chinese industrial production prices have been declining for eleven straight months. In January, they recorded a 3.4% decrease. This situation is a logical consequence of the deteriorating economic conditions in the country, particularly the real estate crisis that began in late 2021 with the troubles of Evergrande, which was liquidated on January 28 by a Hong Kong court.

The crisis has spread across the country, affecting most major developers and depriving them of the ability to complete their projects. Concurrently, confidence in the real estate market has collapsed, and the overcapacity stemming from the bubble years between 2015 and 2021 has led to a drop in selling prices, deterring many buyers from entering the market, thus further depressing prices.

By late November 2023, new construction prices experienced an unprecedented decline since 2014. In Beijing, prices of existing homes also fell by 1.4% year-on-year. At its peak, the real estate bubble may have accounted for nearly 30% of the Chinese GDP. Consequently, the crisis has had a negative impact on activity, depriving many companies of markets, reducing income for local governments, and adversely affecting household incomes, as many used real estate as a form of retirement savings.

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Industrial overproduction, a true Chinese strategy

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The Chinese government hesitated to openly support the real estate sector, whose adjustment was inevitable. The strategy pursued then relied on an idea advocated by Xi Jinping since the late 2010s. The Chinese president is obsessed with the "middle-income trap", meaning China's inability to join the ranks of high-income countries. To overcome this, he advocates for upgrading the economy through the development of advanced technological sectors.

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With the onset of the real estate crisis, Beijing intensified its efforts in this direction, directing credits and subsidies towards three major sectors already in development: electric vehicles, renewable energies, particularly solar, and lithium batteries. In the last quarter of 2023, production in these three sectors increased by 28.5%, 54%, and 30.3% respectively compared to the previous year, according to the National Bureau of Statistics. In 2023, China became the world's largest automobile producer.

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Simultaneously, investments in technological sectors increased by 10.3%, offsetting the 9.6% decline in the real estate sector. This strategy temporarily maintained the appearance of growth, as reflected in official figures. However, it opened a new front reminiscent of the situation following the 2008-2009 crisis: what to do with all these produced goods?

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In Xi Jinping's development model, overproduction is not accidental; it is structural. The Chinese market cannot absorb this production for several reasons. Firstly, the real estate crisis negatively impacted confidence and, consequently, the consumption of durable goods. The rise in youth unemployment exacerbated concerns. In June 2023, this rate reached a peak of 21.3% of the active population aged 16-24, before the government stopped publishing the figure and, through a change in statistical methodology, reduced it to 14.3% by December.

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Secondly, China's development model, centered on supply, still relies, despite rising Chinese wages, on a wage cost advantage. Seeking to gain market share in the technology sector, China has no choice, given its relatively low labor productivity, but to suppress wages. It's worth noting that in 2022, household consumption's share of China's GDP was 37%, nearly 16 points below the global average and 7 points lower than the average for high-income countries.

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All this leads the Chinese market to be unable to absorb all the technological products designed domestically. This is at the heart of Xi Jinping's strategy of "developing new productive forces", as advocated during the Politburo meeting on January 31st.

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As in the 1990s, the shift in China's economic model will have to rely on exports and the establishment of dominance in international markets. It is this leadership that will, in turn, elevate living standards in China. Xi Jinping has always been critical of any demand-side policies or welfare state. His central idea is that the development of productive forces leads to consumption, not the other way around.

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Thus, in Xi Jinping's development model, overproduction is not accidental; it is structural. It ensures dominance in sectors that will promote the upgrading of the Chinese economy. Chinese products are then immediately available for the global market and at competitive prices.

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For advanced countries, the choice is seemingly the most logical: rather than investing resources in building an expensive and time-consuming industrial tool, it is better to use Chinese products to advance towards "climate goals". Beijing's strategy is to build dominance in the market, rendering any competition unnecessary.

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The Chinese Offensive Through Prices

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Here arises the question of deflation. If the Chinese strategy succeeds, imports will exert negative pressure on prices. This pressure will be even stronger as it forces wages across the entire economy to align downwards. This is what had already happened when, between 2009 and 2014, China went through its first overproduction crisis. The United States and then Europe had to face a deflationary risk, which was not unrelated to the eurozone debt crisis. When prices weaken, the burden of debts becomes heavier for debtors.

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However, this time, the stakes are even higher because Chinese production of electric vehicles is endangering a significant portion of European and American industrial activity: the automotive industry. This is happening even as Western groups have lagged behind in this area.

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During the period 1990-2015, Western countries had ceded less profitable industries to China to focus on high-end production. Chinese overproduction did not then threaten the European industry. On the contrary, it could favor German machine tools, for example, as well as high-end car exports to China. But the situation has completely changed: now, Beijing is seeking confrontation in what remains of Western industry.

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This is why Western countries are attempting to react. The United States, which has entered into an almost direct confrontation with Beijing, is the most advanced in this regard. With Donald Trump's protectionist measures and then Joe Biden's Inflation Reduction Act, they have diversified their supplies. In 2023, for the first time in twenty years, China was surpassed by Mexico as the top supplier to the United States, and US imports from the People's Republic declined by 10%.

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But these figures are misleading because China bypasses obstacles by exporting to Mexico, which then re-exports to the United States. Supply chains have therefore not been fundamentally altered.

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On February 18, Deputy Secretary of State for International Affairs Jay Shambaugh, returning from a trip to China, expressed concern about China's industrial support and supply-side policies. And he warned that "the rest of the world would respond" to this policy of exporting Chinese overproduction.

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Last year, the European Union also launched an investigation into Chinese subsidies for electric vehicles. An investigation that could lead to increased customs duties in this area, but probably not until quite late. Meanwhile, the market is flooded with cheap Chinese products.

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Moreover, Western authorities remain highly ambiguous about the policy to adopt towards China. Indeed, the export of Chinese deflation is also a short-term means of reducing inflation and allowing a decrease in interest rates. Several observers, such as Bloomberg columnist Daniel Moss, already believe that "the decline in Chinese prices will quietly but powerfully aid many central banks."

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But there are also more concrete reasons. First, because Western delays in green technologies mean that China has the advantage of availability. The ecological perspective of Western governments is largely accountable; it is limited to achieving quantified carbon emission reduction targets. Chinese products enable rapid progress towards these objectives, and for this reason, there is little likelihood of obstacles to their development in Western markets.

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Finally, the overall situation is complex. Chinese advancement is such that European manufacturers have already made significant agreements with Chinese actors to progress in the electric field, sometimes even with their own competitors. In 2023, Volkswagen reached an agreement with Xpeng, and Stellantis with Leapmotors.

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Similarly, the issue concerns not only the assembly of electric vehicles but also equipment and embedded electronics. BMW, for example, announced that it will be using products from the Shenzhen Appotronics group to equip its electric vehicles. In mid-February, the automotive equipment group Forvia (formerly Faurecia) announced significant investments in its Chinese production, forming partnerships with local companies. In reality, China is already the indispensable hub for electric vehicle production. Even Tesla is increasingly relying on its Shanghai plant.

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And regarding the other two sectors, the situation is hardly different. China accounts for 80% of the solar cell market and 50% of lithium batteries. However, the price war risks further strengthening this position. Faced with such power, the moderate protectionism of the United States and the European Union appears ineffective and contrary to their own objectives.

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The Potential Effects of Deflation

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Consequently, one should indeed expect to see Chinese overproduction weigh on the prices of advanced countries. Especially since this overproduction is not limited to just these three sectors. January's production price figures show a general price decline, affecting not only automobiles (-1%) but also textiles (-1.3%), metal products (-1.8%), computer products, and the paper industry.

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In 2022, China accounted for 20.8% of the EU's goods imports and 14% of those of the United States. These are positions capable of influencing prices in most of the markets concerned. Especially as the first countries to be affected by this exportation of Chinese deflation will be emerging countries, which are close partners of the People's Republic.

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Deflation increases the real level of private and public debts, leading to spending restrictions that further worsen the situation. For businesses in these countries, this means having to align with Chinese prices to maintain positions in their own markets as well as internationally. The effect of the decline in prices of Chinese industrial products is thus broader than what the Chinese trade share in imports would suggest.

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The phenomenon has undoubtedly already begun. Import prices for manufactured goods in the eurozone have already fallen by 3.05% in a year. In France, this decline was 1.7% in December 2023. While still significantly higher in level than pre-pandemic prices, this drop foreshadows strong pressure on industrial prices. In France, production prices fell by 1.2% in December compared to a year earlier. And eurozone wages began to decline in nominal terms in the last quarter of 2023.

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As we have seen, some may rejoice in this: the decline in import prices will accelerate disinflation and make it possible to lower central bank rates. But this would largely be wishful thinking in view of the real situation of Western economies, and particularly European economies. Contrary to what is often thought, deflation is scarcely more desirable than inflation. The most violent and lasting crises of capitalism, those of 1873, 1929, and 2008, are inherently deflationary.

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Since the pandemic, these economies have largely experienced a slowdown in their growth rates. Everywhere, real living standards have been weakened by inflation. Industries have all suffered, at best, a further weakening of their productivity gains and a stagnation of their production. Finally, 2024 heralds the return of austerity and budgetary restrictions in the eurozone.

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Strong downward pressure on prices in this context would have dire consequences. As living standards have been significantly affected by inflation, it will likely be impossible to resist price-based competition. Faced with this situation, Western industries would have no choice but to pass on this downward price pressure to employees and suppliers in an attempt to safeguard their margins, weakening household demand and the overall productive fabric.

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Some industries will undoubtedly struggle to survive, and "green" reindustrialization projects would become fantasies. In these conditions, workers would have to accept wage moderation and job cuts. In a context where living standards have not yet recovered from the effects of inflation, the impact on demand would be formidable.

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Moreover, what remains of the European industry would be targeted. Employment compensation could then only be made in low-productivity and low-paying service sectors.

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It should also be noted that deflation increases the real level of private and public debts, leading to spending restrictions that further worsen the situation. Perhaps central banks would return to more accommodating policies, but the experience of 2009-2019 proves that their effectiveness in this area is limited.

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General Instability

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Obviously, the situation isn't there yet. Inflation remains high, but a shift towards a deflationary crisis cannot be ruled out as production prices have fallen into the red in many Western countries. And the Chinese strategy is far from a winning one. By playing with fire, Beijing risks being the primary victim of deflation and entering a delicate stagnation phase akin to Japan's. Above all, the American example shows that the development of a high-end industrial sector is not a guarantee of income growth for the majority.

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On Tuesday, February 20, a significant five-year mortgage rate for the Chinese market was lowered by 0.25 points, its largest drop since 2019. And more aggressive measures may be taken in early March when new economic policy objectives are defined. However, as seen, overproduction is a structural aspect of the Chinese strategy, and the idea is likely more about preventing a downward spiral than ending deflation. Therefore, no inflection point is to be expected.

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On the other hand, Western economies seem quite defenseless. They don't truly have the means for a return to hard-line protectionism, due to a lack of suitable productive tools and a complexity of value chains. The United States is certainly determined to maintain its technological edge, especially through mastering the production of next-generation semiconductors. But it's a defensive position that masks a weakness in advanced markets, where China is already building its hegemony.

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The fact that the global capitalism is being tossed between deflationary and inflationary crises primarily reveals its internal inconsistencies and contradictions. Any attempt to resolve a crisis in one part of the world leads to a new phase of a more global crisis, which already seems embedded in the ecological crisis. Economic stabilization thus does not seem to be on the horizon.