Deflationary Pressure builds in China

US tariffs are a deflationary shock for China and this is starting to show

There’s a widespread view that China has the upper hand in the tariff stand-off with the US. That’s wrong, as I laid out recently. US tariffs are a negative shock to China’s exporters who have to scramble to sell their goods elsewhere or transship them to the US via third countries. In either case, this is a deflationary shock for China, given how important exports are for the overall growth model.

There’s of course a third option, which is for China’s exporters to sell more of their goods domestically. It certainly looks like that’s what they’re trying to do. Producer price inflation for durable consumer goods - precisely the kind of goods that would have been going to the US - fell to -3.9 percent year-over-year in Sep. ‘25, the most severe pace of deflation in this category since Sep. ‘04.

The chart above shows year-over-year producer price inflation for consumer goods (black line) and for durable consumer goods (blue line), which are most likely to have been impacted by US tariffs. The imposition of substantial US tariffs in 2025 overlaps with a sharp drop in producer price inflation for the latter category, consistent with the idea that exporters are marking down prices in an attempt to sell goods at home.

The bottom line is that China’s exporters are hurting. Just-in-time manufacturing means warehouse capacity is limited, so it’s important to keep goods moving. The only way to do that in the face of the tariff shock, which makes it much harder to sell in the US, is to discount and thereby generate new demand abroad and domestically. That’s a negative shock to the profitability of China’s exporters. The recent decision to escalate the tariff stand-off using rare earths may very well be a reflection of the pain China’s exporters are feeling.