By Zhang Junkuo, Liao Yingmin, Deng Yusong

China's price level has been declining since 1998. Despite a slight pick up in 2001, a negative growth reappeared in January-May 2002. In view of the factors causing the current price declines and the trend of their changes, the price level throughout 2002 will be lower than that of 2001. And a possible negative growth cannot be ruled out for the entire year. Price is a composite reflection of the performance of the national economy. Therefore, continuous price declines deserve careful study.

I. An Analysis of Price Decline in January-May and the Trend for the Whole Year

(1) The basic state of prices in January-May

During the January-May period, the general level of nationwide consumer prices continued the declining momentum of the final quarter of last year, and the range of decline was larger. The price level was 0.8 percent lower than that in the same period of last year. The range of decline was 0.7 percentage points larger than that in the final quarter of last year. From January to April, of the eight classified indexes, only three categories -- tobacco, liquor and related products; entertainment, stationery and services; and housing - saw their prices rising slightly, respectively by 0.2 percent, 0.6 percent and 0.2 percent. All the remaining categories saw price decline. In particular, household appliance and services saw their prices decline by 2.4 percent, clothing saw its prices fall by 2.1 percent, medical care and personal articles saw their prices drop by 1.0 percent, transportation and communications saw their prices dip by 1.5 percent, and food items saw the prices 1.0 percent lower. The ranges of these declines were all larger than those in the fourth quarter of last year. Also from January to April, the producer prices of industrial products were 3.8 percent lower than that of the corresponding period of last year. Although the ranges of monthly declines were smaller, the accumulated average decline range was still 0.2 percentage points higher than that in the fourth quarter of last year. Specifically, while the price decline range for capital goods shrank only slightly, the import prices for raw materials dropped by 4.8 percent, 4.6 percent, 4.7 percent and 3.8 percent in the four months. The ranges of these declines were larger than that in the fourth quarter of last year. In contrast with the above price trend, however, housing price rose by 5.7 percent in the first quarter over the same period of last year, and the range of price rise was 3.8 percentage points higher than that in the last fourth quarter.

Month	Jan	Feb	Mar	Apr	May
Consumer prices nationwide	Over a year earlier	-1.0	0.0	-0.8	-1.3-1.1
	Over preceding month	0.3	1.1	-1.3	-0.3
	Accumulated	-1.0	-0.5	-0.6	-0.7-0.8
Producer prices of industrial products	Over a year earlier	-4.2	-4.2	-4.0	-3.1
Prices of capital goods	Over a year earlier	-5.0	-4.7	-4.5	-3.4
Import prices of raw materials	Over a year earlier	-4.8	-4.6	-4.7	-3.8

(2) Direct causes of price declines

1. The price-pulling factors have weakened. In recent years, the government adjustment of the prices for some commodities and services has been the main force pulling up the prices. In 2001, for example, some regions raised the tuition fees, housing rent, the price of water for civilian use and other charges, thus forced the price indexes for the category of education, culture and entertainment and for the category of housing to rise by 6.6 percent and 1.2 percent respectively over the same period of the year before. In 2002, the central and local governments at various levels strengthened the regulation and control over the prices of the monopoly commodities and services, and improved the government pricing mechanism. As a result, policy-oriented price adjustments covered less items and the government ability to raise prices was weakened. At the same time, personal housing rents reduced after the housing reform, and the interest rate of housing loans was lower. From January to April, the prices of the above two items rose by 0.6 percent and 0.2 percent over the same period of last year, with their range of price rise being respectively 6.0 and 1.0 percentage points lower. Obviously, their ability to pull prices up has weakened.

2. The price-stabilizing factors have undergone changes. In 2001, grain prices began a recovery rise of 1.5 percent (national retail price index), thus bringing an end to the continuous decline of food prices in the preceding four years. Food prices in 2001 were at the same level of the previous year. That was the main factor for stabilizing the price level. In 2002, however, grain export in the first two months dropped by 10.7 percent while grain import increased by 79.1 percent due to the impact of China''s accession into the WTO. Because of the impact by imported low-priced grains and the improvement in grain production, grain prices began declining. The decline during the January-April period was 1.5 percent (consumer prices in 36 large cities). As a result , food prices dropped by 1.0 percent. This was due to the changes in the price-stabilizing factors.

3. The price-declining factors increased and all consumer prices declined. Technological advance has lowered the costs of cultural, educational and communication products and forced down their prices. Sustained market oversupply deepened the declining range of the prices of industrial and consumer products. After the WTO accession, the impact of imported products on the domestic market also restrained the prices.

4. The rapid growth of supply restrained a rebound in the prices of capital goods. Thanks to the rapid increase in fixed asset investment and industrial production, the rising demand for capital goods brought the prices of capital goods slightly up. As a result, the price declining range is small. Beginning from February, the monthly price comparison became positive. The rising market demand has not only led to a rapid growth of the supply of domestic capital goods but also the entry of the imported low-priced products into the domestic market.

(3) Prices for the whole year will remain at low levels.

The above analysis indicates that from January to May, the price-declining pressure surpassed the price-pulling force. The result was that the prices posted a negative growth. As to the price prospect for the whole year, the price-pulling factors include the central government policy to continue expanding government direct investment through the issuing of treasury bonds, the picking up of the world economy and the stabilization of the prices of the basic and raw materials on the international market. At present, the prices of copper, aluminum and steel are slightly higher, while the prices of petroleum and finished products are stable. The rebound of the prices of capital goods is stronger than the general price level and will play a positive role in pulling up the prices. The basic situation of structural overcapacity and the imbalance between domestic demand and supply will not change fundamentally. As there are lots of factors at both the demand and supply ends that are unfavorable for price stability, the pressure for price declines is still great. In addition, China has begun fulfilling its WTO commitments as from 2002. With lower import duties and increased tariff quotas, the prices of imported products on domestic market are bound to fall. This will intensify the competition between imported products and domestically produced products, and force down the prices of domestic products. We expect that throughout the first half of the year, the level of prices will continue the sliding trend at the end of last year. In the second half of the year, the level of prices is likely to pick up somewhat as a result of the gradual implementation of the macro regulatory policies and the gradual improvement of the world economic situation. For the whole year, the price trend of the first half will be declining while that of the second half will be rising. The general level of prices for the whole year will be lower than that of last year. Of course, a possible negative growth cannot be ruled out.

II. Root Causes of Continuous Price Decline

(1) Serious overcapacity is the basic cause of continuous price decline.

The general price level is a result of the interaction between the general supply and the general demand of the national economy. Therefore, the continuous declining of prices and even a negative growth undoubtedly are first and foremost a demonstration of the imbalance in the general supply-demand relationship, or more Accurately, a result of continuous general oversupply. But this is not the whole story. A more important question is what has caused the general supply-demand imbalance. Is it because the general demand has not increased fast enough, or is it because there has been a structural overcapacity at the supply end in relation to the structure and scale of the general social demand? Or if it is because of the existence of both factors, which factor is more important? Straightening this issue out is very important for understanding what is the essence of the continuous decline of China''s price level and what policy options should be adopted.

Through the analysis of the performance of the Chinese economy in recent years and at the present time, our basic view is that the continuous decline and even a negative growth of the general price level, which arose from a general supply-demand imbalance of the national economy, are related to both the demand end and the supply end. But the main cause or the main aspect of the contradiction is at the supply end. This is because judging from the growth changes of all categories in recent years and at the present time, we find it hard to come to a conclusion that the general demand has continued to be inadequate or that there exists a visible inadequacy of the general demand. As indicated in Table 2, the growth range of nationwide fixed asset investment has been at a basically normal level in recent years, except in 1999 when the growth range was markedly lower. In the January-May period of 2002, the investment growth rate (state-owned and other economies) was more than 25.9 percent. The growth of export demand was tangibly lower in 1998 and 1999 due to the impact of the Asian financial crisis. But it picked up later on. In the first five months of this year, export growth was 13.2 percent. In particular, export growth in May was 18 percent higher than that in the same period of last year. In the area of personal consumption, the general growth of retail commodities indicated that personal consumption has been basically normal. There has been no sign of visible declines.

	1998	1999	2000	2001	Jan-May, 2002(state-owned & others)
Fixed asset investment	13.9	5.1	10.3	12.1	25.9
Of which: Renovation & transformation investment	15.2	-0.7	13.9	15.3	17.6
Real estate investment	13.7	13.5	21.5	25.3	36.7
Total export value	0.5	6.1	27.8	6.8	13.2
Total commodity retail	6.8	6.8	9.7	10.1	9.3

Note: The figures of fixed asset investment from 1998 to 2001 were the growth of the whole society, while those of January-May of 2002 were the growth of the state-owned and other economies.

Why have the prices posted continuous decline and even negative growth when the growth of the general demand was not low? The reason can only be that while the demand growth was normal, the overcapacity at the supply end was more serious. In particular, with the development of the Chinese economy, the increase in personal income and the changes in consumption structure, there have been serious oversupply and overcapacity in relation to the social demand for ordinary agricultural products and processed products.

1. In agriculture, the reduction of grain output for three consecutive years and the structural adjustment of grain production have somewhat eased grain oversupply. As a result, grain prices stopped declining and began picking up in 2001. But in early 2002, grain stock reached a record high instead of declining. Added with the impact of the imported low-priced grain, grain price began sliding down. In the short term, grain oversupply is hard to change, which will restrain the level of food prices.

2. In industry, the gross overcapacity arising from years of overlapped construction projects is hard to shrink within a short period of time. The processing and manufacturing industries are in a transitional period of industrial upgrading and consumption structural changes. The overcapacity, coupled with product structure similarity, has aggravated market oversupply. The Market Bureau of the State Economic and Trade Commission and the China National Commercial Information Center conducted an investigation and analyzed the supply and demand situation of the main commodities on the commodity market across the country in the first half of 2002. The results of the investigation indicated that of the 600 varieties of main commodities investigated, 82 varieties reported a basic supply-demand balance, accounting for 13.7 percent of all the commodities investigated. This proportion was 3.4 percentage points lower than that in the second half of 2001. Another 518 varieties reported oversupply, accounting for 86.7 percent of all the commodities investigated. This rate was 3.4 percentage points higher than that in the second half of 2001. No commodity reported over-demand. In a buyer''s market, the price decline arising from oversupply and market competition is an inevitable result of the “survival of the fittest” and economic restructuring.

Therefore, the main or basic cause of the ongoing decline of the general price level is that there has been a serious overcapacity at the supply end. It is not because of a slow growth of the general demand or a serious inadequacy of the general demand. This understanding is very important for correctly controlling the basic orientation of China''s macroeconomic policy at the present stage.

First, removing all system and policy obstacles unfavorable for structural adjustment and accelerating the upgrading and transformation of the economic structure are fundamental policy for overcoming the prolonged decline of prices and ensuring a sustainable and healthy economic development. Of course, the decline of the price level arising from lower cost and fierce competition is something inevitable. Enhanced productivity and survival through competition can promote the upgrading of products and the rationalization of production structure. When market efficiency is high, the price rise arising from the introduction of new products will offset the price decline of old products and stabilize the general price level. But in China, the market lacks an environment for fair competition due to institutional factors and therefore lacks efficiency. One factor is that the state-owned enterprises noted for outdated products are ignoring their efficiency and trying hard to acquire a certain market share through price cuts so as to justify their existence. This has made it impossible for the outdated production capacities to quit in a timely manner and for the competition to ensure the survival of the fittest. The other factor is that some small and medium-sized enterprises reduced their production inputs in violation of laws and regulations, such as lower product quality, inadequate inputs in production safety (especially in the coal mining sector) and failure to offer medical, retirement and unemployment insurances for their employees, so as to reduce production cost and seize the market with relatively low prices. The result is that structural adjustment and continuous price decline are prolonged.

Second, in a situation where the structural contradictions are unlikely to be fundamentally solved within a short time, a policy to expand demand is necessary for maintaining economic and social stability. But the policy should not jeopardize the environment for structural adjustment and should be consistent with the tasks and requirements of structural adjustment. In other words, the policy must help promote structural adjustment, instead of forming new structural contradictions. For instance, the continuous decline of prices is both an objective reflection of the supply-demand relationship arising from the structural contradiction of supply and a market condition for a smooth adjustment of the economic structure and a healthy development of the economy. If demand expansion is overemphasized just to alleviate the difficulties of the enterprises and ensure a market demand for the products that ought to be eliminated, it will ease the pressure for the enterprises to carry out structural adjustment and prolong the process of structural adjustment. Again, the fiscal policies adopted to spur domestic demand should be implemented in a way that helps the enterprises to carry out technical innovation of their equipment, develop new products and enter into new areas of business, and not the opposite.

(2) The structural contradiction at the demand end also restrained the expansion of general demand and the picking up of prices.

While we know that the structural contradiction at the supply end is the main factor restraining the pick up of prices, we should also realize that the relatively fast growth of the general demand, especially the domestic investment demand and consumption demand, is to a very large extent a result of the regulation by the state''s macro policies. A further analysis reveals that at the demand end, there are also some structural constraints that impede both the further expansion of demand, especially the final consumption demand, and the structural adjustment of the enterprises.

1. The widening personal income gap, the slow growth of peasant incomes and the shrinkage of personal financial assets all have an unfavorable impact on the expansion of personal consumption demand.

First, although the disposable personal income in the urban areas rose by 16.2 percent in the first quarter of this year, the increase of laid-off personnel and the growing pressure on urban employment have further widened the income gap. As a result, the marginal consumption effect arising from income increase is weakening. The statistics about the personal income in the urban areas in the first quarter indicate that the income of the 20 percent high-income people accounted for 46.2 percent of the total income while that of the 20 percent low-income people accounted for only 6 percent of the total income. The disparity was 7.66 fold. For the high-income people, if society cannot provide new consumer products after their general consumption demand is met, their incomes can only be turned into savings. For the low-income earners, their consumption ability is also low. This explains why personal savings still grew drastically when the interest rate was cut repeatedly. Investigation indicates that in the first quarter of the year, the personal consumption tendency index was 67 percent, which was 5.7 percentage points lower than the 72.7 percent in the same period of last year.

Second, the consumption growth of the peasants who account for more than 60 percent of the total population has been slow. During the January-April period, the retail volume of consumer goods at or below the county level rose by only 6.2 percent, which was 3.2 percentage points lower than the 9.4 percent growth in the urban areas. Lower prices of farm products, slow growth of peasant incomes and heavy economic burden were the main factors that slowed down the consumption growth of the peasants. In the first quarter of the year, the net per capita income of peasant was 7.2 percent higher than that of the same period of last year. This growth rate is slightly higher than that of the past, but is still 9 percentage points lower than the income growth rate of the urban residents.

Third, since the beginning of this year, the performance of the stock market has been sluggish, with the stock price index continuously falling and the stock value drastically shrinking. In addition, the interest rate of bank deposits continued to decline. This has caused a serious shrinkage of personal financial assets and affected their consumption sentiments.

2. The development of private enterprises still confronted many restrictions and social investment potentials were yet to be fully tapped.

Private investment, which accounted for 30 percent of the total fixed asset investment, was not active. In the first quarter of this year, collective and individual investments respectively grew by 12.6 percent and 9.1 percent, far below the 25.1 percent growth rate of the fixed asset investment made during the same period by the state-owned and other economies. At present, there are three factors affecting private investment. One is the industrial access barrier. The system of examination and approval still plays an important part, and administrative monopoly still exist in many industries. Only a few limited industries are open to private investment. The second is the financing difficulty. Financing channels are not smooth and the credit guarantee system is incomplete. The third is the excessive taxation. As a result, investment returns are too low. As the relevant legal system is incomplete, the protection of the investors'' rights and interests is weak.

3. In fixed asset investment, the growth of the investment used for upgrading and transformation is lower than that of the investment for real estate development. Since the beginning of this year, the growth rate of investment for upgrading and transformation is even lower than the average level of the fixed asset investment. This is an indication that the ability of the enterprises in technical innovation and product upgrading is weak and product upgrading is lagging behind. With the improvement in the living standard of both urban and rural residents, their consumption structure is undergoing changes. They are pursuing comfort, safety, fashion and personalization and demanding for corresponding new products and related services. But in a market environment noted for low-price competition, the efficiency of most enterprises is low and as such they lack the ability for technical innovation and product upgrading. In addition, China is exercising a system of production-type value added tax. As a result, the enterprises'' inputs in fixed assets and equipment cannot be offset before tax payment. This obviously increases the burden of the enterprises and dampens their enthusiasm to carry out upgrading and transformation. The result is that product upgrading is lagging behind and supply is seriously separated from demand. As the supply level and the production capacity are seriously redundant and market competition is extremely fierce, the price level continues to fall. Although the pace of China''s economic restructuring has somewhat quickened in recent years under the pressure of fierce market competition and falling prices and, ill particular, the information and communication industries scored rapid development, the overall tasks of structural adjustment have not been completed and the structural contradictions are still very acute. Therefore, the continuous decline of price is an objective reflection of the contradiction of the supply and demand structure and the serious redundancy of the production capacities.

III. Short-term Policy Suggestions

The oversupply arising from overcapacity is the fundamental cause of the price decline. The structural adjustment featuring ""survival of the fittest"" must be able to sustain the price decline effect arising from competition for a certain period of time. Therefore, a fundamental solution to the problem of continuous price decline requires efforts to accelerate the reform of the economic system and the adjustment of the economic structure. It cannot succeed overnight. However, on the basis of the macro regulatory policies designed to expand domestic demand, some short-term measures can be adopted to mainly solve the problems at the supply end, promote the adjustment of the economic structure, control the low-level production capacities and strengthen the ability to adapt supply to demand. At the same time, efforts should be made to further tap the potential of personal consumption demand and private investment demand, improve the supply and demand relations, contain the price decline and prevent major price fluctuation,

(1) Reform the value added tax system and increase the enterprises'' investment ability and enthusiasm

China''s existing value added tax system belongs to the production type of value added tax system. Under this system, the investment of the enterprises in equipment cannot be deducted in full from the base of the value added tax or be deducted gradually as depreciation on an annual basis. Such an investment was included in full into the base of the value added tax, on which value added tax is paid. This tax system is typical investment restraining. For this reason, many countries in the world, including the developed countries, have abandoned this kind of value added tax system. China''s continual enforcement of this tax system has not only restrained the investment ability and investment enthusiasm of the Chinese enterprises but also placed them in a disadvantageous position in competition with foreign enterprises in the areas of equipment investment and technical upgrading. Therefore, the existing value added tax system should be changed as soon as possible so as to increase the investment ability and enthusiasm of the enterprises. In the meantime, we suggest that while the treasury bond discount policy should continue to be enforced for the loans designed for technical transformation, discount fund inputs should be increased and discount scope be expanded so that more treasury bonds can be used to expedite structural adjustment and improve the supply-demand relationship. Policy support should be targeted toward all enterprises in society, while priority should be given to those projects noted for high technical contents, good product market prospects and fast formation of production capacities.

(2) Support private and small and medium-sized enterprises and mobilize the investment enthusiasm of the private sector

The development of the private enterprises and the small and medium-sized enterprises plays an important part in maintaining the vitality of sustainable economic growth, increasing employment, expanding investment demand and easing social contradictions. In view of the prominent problems confronting the private economy and the small and medium-sized enterprises, measures should be adopted in two aspects to promote their development. One is to ease the restrictions on the industrial access to the private economy. Reforming the government examination and approval system should be the starting point. Unnecessary administrative examination and approval should be gradually abolished and replaced with a registration and filing system. The other is to fundamentally solve the financing problems of the private enterprises and the small and medium-sized enterprises. Small and medium-sized private regional banks should be developed and a financial organization system serving private investment should be established and improved to facilitate the indirect financing of the private enterprises and the small and medium-sized enterprises. A multi-level capital market should be established to create conditions for the private enterprises and the small and medium-sized enterprises to directly raise funds. Efforts should be made in all aspects to create an equal investment and development environment for private investment, which will serve as a foundation for a rapid growth of private investment.

(3) Measures should be taken to alleviate the short-term impact of WTO accession on the peasants, increase their consumption ability and tap the potential of rural consumption.