(Bloomberg) -- When China abandoned pandemic restrictions after three years of stringent controls, Nie Xingquan was expecting booming sales for his hand-made leather shoes. Instead, demand has been so poor that he’s had to cut prices 3% from a year ago and reduce his profits.

It’s an ominous sign of the deflationary pressure that’s hitting Chinese businesses as the economy weakens, and threatening to undermine Beijing’s stimulus plans if consumers opt to defer spending.

Nie said his Italy Elsina Group Co., which is based in eastern China’s Wenzhou city and caters to domestic retailers and consumers, has seen business tail off since February. Many of his clients are still scarred from the damage Covid did to their cash flow and profits. Some retailers, rather than putting in new orders, are trying to sell all the stock they accumulated while expecting sales to surge.

“Everyone is just hanging in there and doing their best to squeeze profits as much as possible so that they can still survive” and remain competitive, said Nie.

Instead of rapid price gains predicted by some economists at the beginning of the year, China is experiencing a rare period of falling prices. That’s a clear contrast to the rocketing inflation that followed the reopening of the US and other major economies, and is visible both at the factory gate and retail side.

Producer prices have been contracting on a year-on-year basis since October 2022, largely due to falling prices for commodities like coal and crude oil. Data on Wednesday will likely show consumer prices declined in July, which would be the first time since late 2020 that both consumer and producer prices register contractions.

Using the gross domestic product deflator — a measure of economy-wide prices — China is already in deflation. The International Monetary Fund defines deflation as “a sustained decline in an aggregate measure of prices,” such as the consumer price index or the GDP deflator. 

Chinese stocks led losses in Asia on Tuesday, with the MSCI China Index sliding as much as 1.9%. Marvin Chen, an equity strategist at Bloomberg Intelligence, said deflation is a significant risk that would impact corporate earnings in China. Falling producer prices have already been hitting industrial and upstream sector profits, he said, and declining consumer prices will now squeeze downstream sectors as well. 

Unlike the temporary decline in late 2020 and early 2021, the drop in consumer prices this time around is more cause for concern. Back then, falling pork prices were the main reason. Now, exports have plunged as consumers in some of China’s biggest markets, including the US and Europe, pull back on spending. A prolonged downturn in China’s property sector has cut prices for rent, furniture and home appliances. 

Also, a price war among carmakers triggered by Tesla Inc.’s reductions led other major brands to join in with steep discounts earlier this year.

If prices keep dropping across a broad range of goods for an extended period, consumers could delay their purchases, curbing economic activity further and forcing businesses to keep reducing prices. That, in turn, would cut into revenue and profits, prompting firms to curb investment and jobs — resulting in the kind of economic stagnation that Japan suffered for decades.

To be sure, China isn’t in the same boat. Not all prices are falling, with consumer spending on services remaining fairly strong. Tourism prices surged 7.1% in the first six months from a year ago, as hotels rates surged. Costs for services such as recreation and education, and medical care, are also still rising.

The problem of low or falling prices is most acute in the consumer-goods industries.

“It feels like people are no longer spending much on clothing like they used to,” said Chen Yubing, manager of the Jiayao Textile Co. Ltd., a maker of polyester and nylon fabric based in the eastern province of Zhejiang. 

“Competition has become fiercer and many factories are slashing their prices in order to sell, which led to a vicious cycle,” said Chen, whose factory lowered prices by 5% this year even though costs have risen by just as much. 

The government has been downplaying concerns about deflation, with officials from the People’s Bank of China, National Bureau of Statistics and other agencies repeatedly saying there’s no foundation for long-term price declines.

Talking about deflation publicly is also off-bounds for many Chinese analysts. One economist at a local brokerage said he was instructed by regulators not to discuss deflation. He was told to promote the narrative that China’s economy is steadily improving, he said, declining to be identified in order to discuss private information. Another China-based economist said they received guidance from regulators and their company’s public relations department not to discuss deflation publicly.

A big driver of low prices this year is the build-up of inventories over the pandemic, and in the first quarter, during a burst of optimism following the end of Covid restrictions. That has since reversed, with businesses cutting prices to reduce their stock. 

Vivian Feng is a Shanghai resident who purchases discounted goods, from farm products to Nike Inc.’s t-shirts, and sells them to neighbors in her residential community. She said her suppliers have cut prices significantly this year due to high inventories and soft demand.

“Some well-established apparel brands used to offer products for the group-buy channel at around 40% of the original prices in 2021, and they’re now selling at just 10% or even less,” said Feng.

Some economists expect consumer inflation to trend lower for a few more months before picking up toward the end of the year as the higher base of comparison with last year fades and domestic demand picks up. Economists surveyed by Bloomberg expect full-year inflation to reach just 0.8% in 2023, the slowest pace since 2009. 

Low inflation is driving up real, or inflation-adjusted, interest rates in the economy, pushing up businesses’ debt-servicing costs and undermining the central bank’s pledge to spur lending.

While that increases the case for the PBOC to add stimulus to the economy, the central bank is facing several constraints that’s making it cautious, including a weaker yuan and elevated debt levels in the economy. 

Central bank officials have hinted at some easing measures, such as reducing the amount of cash that banks must hold in reserves. Economists also predict a 10 basis-point policy rate cut in the third quarter.

“The ongoing weakness in China data will continue to dampen consumption, as households will remain cautious about making purchases of big-ticket items given the potential risks of job losses and salary cut,” said Ken Cheung, chief FX strategist at Mizuho Bank Ltd. “The uncertainties surrounding deflation may prompt the PBOC to implement additional monetary easing measures.”

--With assistance from Daniela Wei, Tom Hancock, Lucille Liu and Shikhar Balwani.

(Updates with market concerns.)

©2023 Bloomberg L.P.