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The writer is chief economist for Asia Pacific at Natixis and senior research fellow at Bruegel
For a brief moment in the early days of the Iran crisis, it seemed that China might finally get involved in the global reflation trade. Yields on 10-year Chinese government bonds rose from 1.83 percent on February 27 just before the US-Israeli attack on Iran to 1.90 percent on March 9 – a move in line with the broader trend in global bond markets due to renewed inflation fears.
For once, traders treated China like everywhere else, but they did it wrong. Within weeks, these yields had resumed their modest rise, returning to 1.82 percent on April 3. This quiet reversal is a more eloquent piece of economic commentary than almost anything published in official communiqués. The market’s assessment is that China’s deflationary undercurrent remains dominant – and that assessment deserves to be taken seriously.
The mechanics are simple. Reflation, properly understood, requires one or both of two things: a meaningful easing of monetary conditions or a significant expansion of fiscal stimulus. China has neither on the scale required.
On the monetary side, the People’s Bank of China has not eased an inch after leaving key interest rates unchanged in March, meaning they have been stable for 11 months in a row. Real borrowing costs remain high due to very low, if not negative, inflation, depending on which index you use. Credit demand from households and small businesses is weak, not because there is no money available, but because confidence is lacking and real interest rates are simply too high.
Fiscal policy tells a similarly limited story. China’s central government still has the balance sheet capacity to stimulate boldly, but has shown little willingness to deploy these resources in ways that reach consumers. Spending on infrastructure – the traditional lever – pushes money into the capital stock of an economy already burdened by overcapacity. Local governments are now making cuts and are still processing the accumulated debts. Voucher programs to stimulate consumption and subsidies for households have been too modest and too targeted to shift aggregate demand.
The oil shock adds a further complication specific to Chinese conditions. Conventional wisdom holds that a rise in commodity prices is inflationary: it increases input costs and, in an economy operating near full capacity, feeds into final prices. But China is nowhere near its capacity. It runs far below that, across steel, chemicals, solar panels, electric vehicles and a dozen other industries.
The problem with an oil shock for China, then, is not that it fuels inflation at home—domestic demand is too weak for that transmission to function normally—but that it stifles the one engine that has kept China’s factory sector from outright contraction. External demand was the outlet for Chinese overproduction. Higher energy prices will inevitably have a negative impact on global growth and on the purchasing power of many Chinese trading partners. This means that export orders are likely to slow, making the Chinese economy’s overcapacity problem more acute.
More capacity to chase less demand is by definition deflationary. It drives down factory prices, puts pressure on margins, discourages new investment and perpetuates the wage and income stagnation that China has suffered for years. Already in 2025, when China’s GDP growth managed to reach the 5 percent target, wages for urban private sector workers barely rose by an estimated 1 percent, which explains why consumption remained so weak. In other words, the oil shock paradoxically threatens to deepen China’s deflationary trap rather than offering an escape from it.
There is a scenario in which this picture changes. A real pivot in Beijing’s approach to fiscal policy: one that involves direct and substantial transfers to households, a credible restructuring of local government debt, or a sustainable program of social safety net expansion sufficient to reduce precautionary savings. Likewise, a more aggressive monetary framework, willing to accept looser financial conditions in exchange for nominal growth, could shift expectations. Neither is on the immediate horizon.
While the rest of the world faces higher yields on inflation fears, Chinese long-term interest rates remain subdued, even lower than before the shock. That is not the mark of an economy on the brink of reflation. Even a major shock to the global oil market is unlikely to change China’s deep-seated problem.
