As people forget the Great Depression of the 1930s and economists study ways to combat inflation, deflation has become the new thorn in the global economy. Japan has been feeling the effects of deflation since the early 1990s. Over the last decade, it has tried in vain the classic monetary and fiscal means to break out of the deflationary cycle and stimulate the economy. In recent years, Hong Kong has been experiencing deflation and various sectors have been working hard to revive the economy through enhancing economic integration with the Mainland.

Despite China's strong economic growth, consumer prices in the Mainland have been under deflationary pressure for some time. According to the China Statistical Journal, the consumer price index in China last year fell consecutively between the months of January and November. Typically, economic growth and inflation go hand in hand. Yet China's GDP registered 8 per cent growth in 2002. So this begs the question, why is China experiencing persistent deflation? When will inflation return? And what impact is deflation having on the Mainland and Hong Kong economies?

Deflation in China is mainly being driven by oversupply, sluggish domestic demand, improvements in productivity and poor management of funds by the banking sector. Quarterly economic growth rates for the Mainland in 2002 show a significant downturn at 8.1 per cent, 7.8 per cent, 7 per cent and 6.6 per cent respectively, the effects of which began to show up in the Chinese consumer price index in April-May figures.

With GDP growing faster than residents' incomes, especially among farmers, combined with high unemployment, and healthcare, pension and education reforms, uncertainties about future income began to arise and consumers tightened their purse strings. Moreover, the poor performance of China's securities markets is weakening and waning consumer spending power of the middle-class added to deflationary pressure. In contrast, strong external demand spurred enormous export growth, which helped slow the falling price trend in the latter half of 2002.

But with China's domestic market now facing an oversupply of goods, deflation could worsen. One of the main reasons for this is due to more foreign products entering the market as custom duties are reduced in line with China's WTO commitments. On average, tariffs on foreign products were reduced from 15.3 per cent to 12 per cent last year. This led to a remarkable 20 per cent rise in imports over 2001's figures. As a result, prices on international markets now have a greater impact on prices in China. For example, foodstuff, cotton and oil imports costing less than domestic commodities squeeze domestic market prices.

Greater global competition is also forcing companies to look at automating their operations to boost productivity and sharpen their competitiveness, which also means cheaper prices. To enhance integration with the world market, China introduced a couple of anti-trust, free market-oriented policies last year. This slowed down -- and in some cases reversed -- the trend of rising public services prices, including electricity, transportation, medicine and communication.

Deflation can give some indication of the status of money supply. According to statistics compiled by the People's Bank of China, money supply has been growing at around 14 per cent annually over the past few years, much higher than the country's nominal GDP growth rate. This means the circulation of currency contributed to deflationary pressure. Due to China's economic transition and the slow pace of reform among state-owned banks, adopting monetary policies as macro-economic control measures have proven to be futile. Along with the continuous rise in banks' loan-to-deposit ratio, the amount of currency in circulation has fallen. Supply of currency has been increasing faster than investments, further fanning the deflationary trend.

No country can afford to neglect the effects of deflation, to which Hong Kong can attest. Since China is among the primary importing countries of Hong Kong, falling prices there could add to deflation in the territory. Although deflation can give consumers greater spending power, it ultimately gives way to weaker demand as consumer confidence begins to erode. In short, economies suffering from deflation can get into a vicious deflationary cycle.

On the flip side, deflation can help increase consumers' spending power, raise the standard of living of China's poorer residents, and weed out weaker companies.

Mild deflation in China has so far kept the economy from going into recession, and the economy has enjoyed steady growth for the whole of 2002. Subsidy measures for the agricultural industry announced in January 2003 are aimed at boosting farmers' spending power. Reform of the banking system will also help improve the circulation of money, but China's current unemployment problem and banks' non-performing assets mean that defeating deflation won't be easy. These are major challenges facing the new Chinese leadership, and will have a great impact on the Mainland economy.