China's Factory-Gate Deflation Deepens: Trade War and Economic Fallout

China’s manufacturing sector is grappling with its longest period of deflation in decades as the protracted trade war with the U.S. exacerbates economic headwinds. The Producer Price Index (PPI), a key gauge of factory-gate inflation, fell 2.7% year-on-year in April 2025—the steepest decline in six months—marking the 29th consecutive month of deflation. This persistent downward pressure, driven by punitive tariffs and domestic price wars, is reshaping investment landscapes and testing policy resilience.

The Deflationary Spiral

China’s PPI decline reflects systemic challenges. The April drop worsened from March’s 2.5% contraction, with the National Bureau of Statistics (NBS) attributing the slide to the trade war’s impact on export demand and domestic overcapacity. Industrial purchasing prices for raw materials also fell 2.7%, underscoring a broad-based slowdown.

The prolonged deflation has eroded corporate profit margins, particularly in export-reliant sectors. Meanwhile, core inflation (excluding food and energy) remains stagnant at 0.5%, signaling weak domestic demand.

Trade War Escalation: Tariffs and Transshipment

The U.S.-China tariff regime has reached historic extremes, with U.S. levies on Chinese goods hitting 145%—a rate that threatens to permanently disrupt global supply chains. Beijing retaliated with 125% tariffs on U.S. imports, slashing bilateral trade volumes. In April 2025, Chinese exports to the U.S. plummeted 21% year-on-year, while U.S. imports from China fell nearly 14%.

To circumvent tariffs, exporters resorted to transshipment via third countries, temporarily boosting April’s total exports by 8.1%. However, this surge was unsustainable, as seen in the sharp decline of freight traffic to the U.S. post-April.

Economic Consequences: A Fragile Recovery

The trade war’s fallout extends beyond manufacturing. Urban unemployment is projected to average 5.7% in 2025—exceeding the official 5.5% target—while Goldman Sachs warns of 16 million jobs at risk in export-dependent industries. Domestic markets are now flooded with discounted goods originally destined for the U.S., fueling price wars and pushing CPI into negative territory for three straight months.

Small and medium enterprises (SMEs), particularly those reliant on e-commerce platforms like Shein and Temu, face existential threats as the U.S. ended its “de minimis” exemption, eliminating tariff-free shipments of low-value goods.

Policy Responses: A Delicate Balancing Act

Beijing has deployed targeted measures to stabilize growth, including lowering interbank interest rates and injecting $138 billion into the financial system. However, policymakers remain hesitant to unleash aggressive fiscal stimulus, fearing inflationary pressures or debt overhangs.

Trade talks in Switzerland in late April offered glimmers of hope, with U.S. President Trump suggesting tariff reductions to 80%. Yet China’s insistence on a full rollback of U.S. tariffs before negotiations stalled progress, leaving both sides entrenched.

Investment Implications: Navigating the Fallout

Investors must tread carefully in this environment. Key sectors to monitor include:
1. Technology and Semiconductors: China’s export controls on critical minerals (e.g., rare earths) could disrupt global supply chains, favoring companies with diversified sourcing.
2. Domestic Consumption Plays: Retail giants like JD.com and Alibaba’s Freshippo, pivoting to domestic markets, may see short-term gains but face margin pressures from price wars.
3. State-Owned Enterprises (SOEs): Infrastructure and energy sectors could benefit from targeted fiscal support, though profitability remains constrained.

Conclusion: Risks Outweigh Rewards, for Now

China’s deflationary spiral and trade war dynamics present a challenging outlook. With Goldman Sachs revising 2025 GDP growth to 4%—well below the official 5% target—the economy risks prolonged stagnation. While tariff reductions or a breakthrough in U.S.-China talks could stabilize markets, the structural issues—overcapacity, weak demand, and geopolitical tensions—remain unresolved.

Investors are advised to prioritize defensive strategies, such as high-quality bonds or sectors insulated from trade volatility, while avoiding overexposure to export-dependent equities. The path to recovery hinges on de-escalation, but with both nations entrenched in a high-stakes game of economic brinkmanship, patience—and caution—will be critical.

Data sources: National Bureau of Statistics of China, Goldman Sachs Research, Morgan Stanley, and U.S.-China trade data.