Nearly nine months after China’s reopening, warning signs about the economy are piling up. Rosy expectations at the start of the year have given way to a tepid recovery in retail spending, hampered by a slump in manufacturing output, a deepening real estate crisis and record youth unemployment. Now there is another worry.

After several months on the cusp of dangerous territory, the country’s consumer price index fell 0.3 percent in July raising the spectre of deflation. If prices continue to fall in the months ahead, people may postpone purchases with the expectation that products will become cheaper. The concern is that a spending and investment pullback can result in businesses laying off their staff or lowering salaries which, in turn, becomes a damaging cycle that is hard to reverse.

The CPI decline was driven largely by food, specifically pork, prices. Apparel has maintained a moderate 0.5 to 1 percent inflation thus far in 2023, and the category had a CPI reading of 1.0 percent in July.

“It is still early to say China is going through ‘deflation’,” said Daniel Zipser, McKinsey’s Asia consumer and retail lead. “Normally, CPI needs to show three to six months of negative data consecutively for it to be considered deflation.”

While there is “no clear evidence that the retail sector has already been impacted,” Zipser said, he acknowledges that “domestic [consumer] demand is relatively weak now.”

The outlook for the second half of the year is now muted for some of the country’s leading mall operators. Swire Properties, which operates Taikoo, a nationwide portfolio of high-end malls whose diverse tenants include Lululemon, & Other Stories and Dover Street Market, said in its first half earnings announcement that it is only expecting a “stable” second half to this year. It anticipates better demand for luxury retailers in Guangzhou and Chengdu, whereas Shanghai will be less robust, and Beijing will need time to recover.

Hang Lung Properties, which owns a collection of high-end malls around China including Plaza 66, a prominent luxury mall in Shanghai where brands like Prada, Dior and Louis Vuitton operate stores, reported a noticeable slowdown at the end of last month when it published earnings.

“Chinese consumers are becoming more conservative due to macroeconomic uncertainties; hence they are saving more. Their expenditure is 20 to 30 percent less than before. It is not a matter of lacking money but adopting a ‘wait and see” attitude,” said Bernstein analysts in a recent note about Hang Lung.

Challenges in the housing market and with unemployment would have to be assuaged for subdued consumer sentiment to shift. While the national unemployment rate has remained steady at around 5 percent, youth unemployment hit a record 21.3 percent in June. In a sign of how sensitive the topic has become for the government, the National Bureau of Statistics stopped breaking out the numbers for those aged 16 to 24 in July. One Peking University professor wrote for Caixin business magazine earlier, estimating the real rate of unemployment could be around half, before the article was removed.

“For decades now, they’ve had trouble sustaining employment in the manufacturing sector in China,” Brian Ehrig, partner at management consultancy Kearney’s consumer practice, said. “There are jobs available but they aren’t really interested in those jobs anymore because they’ve had such a growth in the middle class.”

A Bank of America survey which polled 1,022 people across China in August showed a small improvement in consumer sentiment from the month prior, which the bank said was likely helped by rising services demand during the summer. Although 37 percent of the respondents plan to spend more over the next six months, versus 35 percent in June, even more (56 percent compared to 46 percent in June) said they had increased savings since the start of the year. The willingness to spend in the future seems to strengthen in tier-two cities and below, while softening notably in tier-one cities mainly due to increasing caution over future income prospects.

Being able to earn a better income was cited as the number one factor that would lead to a higher spend over the next six months (66 percent), followed by disbursement of consumption coupons or subsidies (41 percent) as second. According to the bank, luxury remained the key area to downgrade, mainly watches and jewellery, but less so with bags, apparel and footwear.

Pent-up travel demand may be contributing to some of the spending weakness in other categories domestically, with people shopping outside of China to enjoy duty free prices and fresh retail experiences. In addition, travel costs remain inflated leaving less wallet share for categories like fashion. In a further boost to outbound travel, the Chinese government recently announced a third round of group tour resumptions from August 10 to popular destinations like South Korea and Japan, as well as the US and Australia.

The risk of deflation is just the latest macroeconomic headwind facing companies exposed to China’s consumer market. In July, manufacturing activity contracted and growth in services also slipped. The “data provides little encouragement that the economy is turning the corner,”, wrote Robert Carnell, head of Asia-Pacific research at bank ING, in a note at the time. Since then, August figures were released showing a contraction for the fifth straight month, according to an official survey.

Meanwhile, a deepening real estate crisis looms as the country’s largest property developer before this year, Country Garden, is now at risk of defaulting on its debt, triggering fears of contagion two years after another giant, China Evergrande Group, defaulted. There are also serious concerns over the levels of debt that Chinese provinces and other municipalities have racked up in recent years through opaque local government financing vehicles.

In response to the long list of negative news, there has been growing concern and, in some cases, panic in corporate boardrooms. But some analysts believe concerns are overblown over China’s slowing economic growth and the government target of 5 percent GDP expansion this year.

“We have a tough time explaining to people why this is actually a perfectly reasonable growth rate which doesn’t require a panicked response,” Carnell said. Previous GDP growth came disproportionately from debt-fuelled construction, some years up to nearly three percentage points, and was ultimately unsustainable.

“If we can no longer rely on construction to power the economy ahead, then growth will likely average something closer to 5 percent than the 6 to 8 percent China averaged pre-Covid,” Carnell said. “And in our view, that is surely superior to faster debt-fuelled property-led growth for a few years, followed by a Japan-style collapse. Because while China’s current situation is far from that of Japan in 1990, that is not to say that that future could not have happened if things had run on unchecked as before.”

For fashion brands, a slowing economy combined with the fact that Chinese brands have been maturing and are now competitive in many categories against foreign products means that brands are being challenged to get to know the Chinese shopper in a deeper way, said Kearney’s Ehrig.

Companies like Adidas and L’Oréal have been investing heavily in local R&D and manufacturing centres to create more localised products that fit Chinese customers’ needs better. “For the last probably, I would say 18 months to two years, there’s been tremendous energy that’s gone in from these brands to try to understand the Chinese consumer,” he added.

However, if China experiences several months of falling prices into official deflation status, there could be an impact further afield. For fashion companies and consumers in export markets that buy Chinese-made goods hoping that lowered input costs along with a sliding yuan (the currency has lost 6 percent this year against the dollar) will help them battle record inflation, there will probably be disappointment, said Ehrig.

“Even if we would feel it [materially], if [companies are] booking something now, it’s for things that are going to be delivered next summer,” he said. “It wouldn’t be anything that would give us any relief [immediately].”