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Chinese President Xi Jinping.
China’s economic woes, explained
After forty years of extraordinary growth, China’s economy may be entering an era of stagnation.
Youth unemployment just hit a record high of 21%. Manufacturing activity is contracting. Exports have declined on the back of sticky inflation and soaring interest rates in the US and Europe. Foreign investment has stalled. Capital outflows are accelerating. The property sector, which makes up a fifth of the economy, is crashing. Property development behemoth Evergrande Group filed for bankruptcy last month. China’s largest homebuilder, Country Garden Holdings, is on the verge of default. Headline growth has come in lower than expected, and the overall economy is flirting with deflation amid persistently weak consumer spending, faltering private investment, and mounting financial stress.
The economic and financial risks feel more urgent than ever as the limits of China’s growth model have become obvious. Gone are the days of 10% growth – the IMF now expects the Chinese economy to grow under 4% a year for the coming years, well below the government’s official target of “around 5%.” The slowdown is underpinned by structural challenges to China’s long-term economic prospects, including unfavorable demographics, high indebtedness, and intensifying geopolitical competition with the United States and its allies.
Crucially, the Chinese people seem to be losing faith in the government’s ability to fix the economy’s problems. The combination of Maximum Xi – the increasingly centralized, opaque, and capricious nature of Chinese policymaking under President Xi Jinping – and a recent slate of deeply disruptive domestic policies – like the tech crackdowns, the zero-COVID lockdown and pivot, and raids on foreign firms – has created uncertainty and undermined confidence in Beijing’s competence.
So how did we get here, and how is this going to end?
China’s original sin
China’s economic model is in trouble, and it has been for a while.
The basic story is that the tailwinds that turned China into the factory of the world and lifted a billion people out of poverty between 1980 and 2010 – including favorable demographics, large cost advantages, strong consumer demand from the US and Europe, hyper-globalization, and plenty of low-hanging-fruit technologies for China to copy or steal – ran out very early in China’s development. By the end of the 2000s, long before Chinese incomes had reached developed-country levels, exports and foreign direct investment had started to taper off, and with them so did the era of 10% growth.
Then, to keep the economy growing at a reasonable pace, Beijing turned to domestic investment, encouraging state-controlled banks to pump massive amounts of lending into real estate and infrastructure. This strategy allowed China to maintain 6-7% growth and avoid politically risky recessions in the decade that followed. But the unintended consequence was that real estate-related activities grew from about 10% of China’s GDP in 2000 to nearly 30% at its peak, becoming by far the country’s largest source of growth, investment, and jobs.
This shift from an export-led economy to a real estate-led economy was problematic, for several reasons.
For starters, real estate-related activities like construction have lower productivity growth than export-related industries like manufacturing, so allocating more and more resources to them led to a decline in China’s aggregate productivity growth – itself a key driver of long-term economic growth.
In order to keep growth going, China had to borrow and invest ever more capital into assets with ever lower returns, leading to a decline in the private sector’s return on assets. At first, infrastructure investment was profitable because China had to make up for decades of underinvestment. But eventually, China built enough apartment buildings, bridges, and airports to meet all its needs. Additional investments after that point were malinvestments – think ghost cities, bridges to nowhere, airports without planes – generating less and less growth for every yuan borrowed and invested. The more China used this playbook, the less potent and more costly it became.
But real estate wasn’t just the principal engine of growth. It was also (and still is) the main financial asset and store of wealth for regular Chinese citizens, who – lacking access to well-developed stock and bond markets and believing that prices would keep going up forever – spent their life savings on overpriced investment properties and took on loans (collateralized by the properties in question) to afford them. Real estate now accounts for nearly two-thirds of China’s household wealth and about 40% of the collateral held by banks.
To make things worse, because China doesn’t have a property tax, local governments had to rely on land sales to finance spending on public goods and services. This perverse incentive led them to shower property developers with cheap credit to invest in real estate, bidding up demand for land and property prices.
All these factors made China’s growth model predictably unsustainable – and a dual property and credit bubble all but inevitable.
What happens next?
Now that the real estate boom has gone bust, China’s economy is unraveling under the weight of its contradictions.
Property prices are crashing. Household wealth is getting wiped out. Borrowers are defaulting on their mortgages, in turn leading developers and lenders to default. Credit is flatlining. Revenues for local governments are drying up at the same time as their debt servicing costs rise. Domestic demand is plummeting as all these economic actors hunker down and go into deleveraging mode, causing a growth slowdown.
In the past, Beijing would’ve responded by injecting debt-financed stimulus into the property sector. But that strategy has reached the end of its rope. Large-scale bailouts by the central government to distressed developers, shadow banks, and local governments are also off the table for now.
The obvious thing Beijing could do to stimulate growth in the short term would be to give direct fiscal stimulus to consumers (especially the poor and unemployed, who have the highest propensity to spend). Consumer stimulus would also be a step in the right direction toward the kind of structural reform China needs to achieve more balanced and sustainable growth in the long term: shifting economic activity from investment to household consumption, which at 38% of China’s GDP is extremely low compared to the 60% global average and about 70% in the US.
But Xi is ideologically suspicious of consumption, both as a policy lever and as a driver of so-called “high-quality development.” The concern is that stimulating consumption would either exacerbate the property/debt bubble or be ineffective as households use the money to repay debts or save rather than spend. More broadly, Xi fears that the redistribution of resources required to give households a larger share of the pie could generate social unrest and undermine his and the Chinese Communist Party’s political control. And if there’s one thing you should know about Xi, it’s that he prioritizes social stability and political control above all else – including economic growth.
This is the sort of policy bind that would pose an urgent political crisis in any democracy. But China is no democracy. After his extreme consolidation of power post-20th Party Congress, Xi has the unique political ability to ignore the slowdown if he so chooses. And that is exactly what he’ll do unless his hand is unexpectedly forced by systemic financial contagion or mass protests – at which point the response could be too little, too late. Which means Chinese growth is going to be slower for longer, with the bigger structural challenges remaining unaddressed for the foreseeable future.
To be clear, China remains a highly competitive economy, with enduring advantages in manufacturing, renewable energy, and electric vehicles as well as leading-edge innovation in frontier industries such as advanced computing, AI, biotechnology, and the like.
Yet outside these clusters and absent a more decisive rebalancing from Beijing, China’s economy could soon begin to look like Japan’s in the 1990s, which suffered a “lost decade” of prolonged deflation, stagnant growth, and high indebtedness on the back of a stock market and property crash. The difference being that this “Japanification” would hit China at a much lower level of development, long before it can close the gap in living standards with rich countries.
Could a chronically weaker economy chip away at China’s social contract, undermining popular support for Xi and the CCP and weakening their grip on power? Could it tank the global economy? Could it prompt Beijing to become more aggressive abroad, making a conflict with the US over Taiwan more likely or imminent?
I’ll tackle these questions in future newsletters.
Workers work on a production line at a silk workshop in Haian, Jiangsu province, China.
China is open for business
In an uncharacteristic acknowledgment of weakness, China on Sunday announced a plan to attract more foreign investment and boost its stagnating economy. The 24-point plan aims to improve the climate for FDI, which has taken a hit from the Communist Party’s unpredictable and occasionally hostile policies towards foreign companies.
New foreign investment in China fell to its lowest level in 25 years in the second quarter of 2023. At the same time, China’s economy is also suffering from deflation, local government debt, and a declining real-estate sector. For more on China’s economic woes, watch Ian Bremmer’s interview with Shaun Rein, founder and managing director of the Shanghai-based China Market Research Group, on this week’s GZERO World here and read our explainer here.
Beijing’s new plan targets key industries, such as biopharmaceuticals and telecommunications, offering tax deductions and incentives. It also makes it more convenient for foreign companies to apply for visas and residence permits.
But this comes at a time when foreign investors increasingly see China as an unsafe place to invest their money, especially since new anti-espionage laws give authorities sweeping authority to access and control foreign business data.
Meanwhile, US companies are pulling out of China in droves over fears for employee safety and amid rising tensions between Washington and Beijing after a series of US-based consulting firms were raided in China this spring.
We’ll be watching to see whether Beijing does anything to relieve these fears underlying the decline in Chinese FDI.
A worker works at a workshop of a textile company in Binzhou city, East China's Shandong province.
China flirts with deflation. Why is that a bad thing?
Times are tough in the world’s second largest economy. After several years of on-and-off-again pandemic lockdowns, China’s economic rebound remains limp. Even the notoriously tight-lipped politburo of the Chinese Communist Party recently nodded to the economy’s “tortuous progress.”
While much of the rest of the world contends with inflationary pressures, many economists say China is tussling with the inverse phenomenon: deflation.
What’s deflation, and what are the implications at home and abroad?
China’s economy, worth a whopping $18 trillion, is a dynamic one, and so multiple factors are contributing to its current anemia.
Beijing’s flirtation with deflation is linked, in large part, to the plunging cost of goods and services due to weak demand at home. Simply put: Chinese consumers are spending less, which is putting downward pressure on prices. A steep dip in imports last month – 12.4% year-on-year – signals that demand remains sluggish six months after President Xi Jinping ditched the growth-stifling zero-COVID policy.
But aren’t low prices a good thing?
Not quite. Falling prices do not necessarily mean that Chinese consumers are buying more stuff at a cheaper price. In fact, many economists say that deflation often sparks deep anxiety about the state of the economy, causing consumers to cut back on spending in order to stash more away in a rainy day fund.
Said another way: Perception of the strength of the economy is almost as important as economic growth itself. As a narrative takes hold – at home and abroad – that China could be entering deflation territory, many Chinese are concerned with taking on new debt, causing a downturn in investments.
What’s more, deflation can eat into companies’ bottom lines, leading to belt-tightening and job losses. The latter is a particularly big concern as youth unemployment in China continues to reach new records. In fact, in a sign of how bad things have gotten for young Chinese entering the workforce, one university president recently advised graduating Chinese students not to be picky about which jobs they accept. The world is my oyster?Not so much in Xi’s China.
Why is this happening now?
Global lockdowns and work-from-home policies were great news for China, dubbed the world's factory. But as American and European consumer trends have rapidly evolved (out with the expensive ergonomic chair, in with the trip to Burning Man!) Beijing has been left with a bloated manufacturing sector and too much inventory. The hope was that domestic demand for stuff would make up the difference, but that hasn’t been the case due to a number of factors.
One key issue impacting consumer behavior is the tumult of the real estate sector. For the most part, housing sales have been depressed since the early days of the pandemic. As we recently wrote, the collapse of real estate giant Evergrande in late 2021 freaked out both developers and buyers, so now the former can't get loans to finance projects, and many have been forced to default on their debt, leaving projects incomplete.
What’s more, the oversupply of houses in many cities as a result of demographic shifts (the Chinese are not making enough babies!) has also put downward pressure on home prices.
The world is watching. Dwindling demand in China, the world’s largest importer of food and fuel, is bad news for the many countries that rely on China to buy what they’re selling.
For example, commodity-exporting countries, like steel giants Australia and Brazil, are particularly sensitive to China’s infrastructure slump, while tech-exporting countries – like Taiwan and South Korea – are feeling the burn of China’s retail and manufacturing contraction. (China’s goods imports dropped 6.7% year-on-year in the first five months of this year.)
What’s the government doing about it?
The People’s Bank of China cut interest rates back in June in a bid to stimulate growth and has also released small stimulus packages to help boost spending and consumer confidence – though not nearly enough to move the needle. In the meantime, true to form, the CCP is tapping into its culture of fear, warning economists that they better stay mum about negative economic trends.- Ian Explains: Why China’s era of high growth is over - GZERO Media ›
- China's COVID lockdowns made its people depressed and hurt its economy - GZERO Media ›
- Podcast: China's great economic slowdown - GZERO Media ›
- China’s economy in trouble - GZERO Media ›
- Davos 2024: China, AI & key topics dominating at the World Economic Forum ›
- China's economic slowdown is dragging down the rest of the world - GZERO Media ›
- Podcast: Trouble ahead: The top global risks of 2024 - GZERO Media ›
Has China’s power peaked?
I had a fascinating debate on this question a few months ago with political scientist Michael Beckley, who wrote a thoughtful and compelling book arguing that China’s relative rise is over and, therefore, that the United States will remain the world’s sole superpower for the foreseeable future.
This isn’t a new claim. In fact, every few years going back decades we get a new big article or book saying China’s power is peaking and its decline (or even collapse) is imminent. So far, they’ve always been wrong. But could it be true this time?
Let’s break down the strongest arguments on both sides and decide (spoiler: I say “not so fast”).
Why China has peaked already
The exceptional rise of China over the past 40 years was just that – exceptional. It relied on a lucky combination of unique and irreplicable tailwinds that are rapidly turning into headwinds. By almost every metric, things have already stopped getting better and are starting to get worse for China.
China’s economic slowdown is structural. As China has grown wealthier, its labor force has become more expensive, diminishing the country’s attractiveness as the “factory of the world.” Official GDP growth had already dropped to 6% before 2019, despite government stimulus masking even weaker underlying growth, and three years of COVID-19 lockdowns only made it worse.
Not only has growth slowed every year for a decade, but most importantly, the quality of China’s growth has deteriorated. Infrastructure has been overbuilt to juice up growth, with dozens of “ghost cities” outfitted with new apartment buildings, roads, and bridges … and no people – the definition of growth without productivity. All this stimulus has been financed by an explosive debt bubble that Beijing has shown little willingness or ability to deflate.
Meanwhile, China’s closed political system and Xi’s statist economic preferences hinder technological innovation, the most reliable engine of long-term growth. While China’s research and development spending has increased massively, the Chinese Communist Party’s increasingly heavy-handed interventions in the tech sector are chilling entrepreneurship and technological experimentation. Many of China’s best and brightest have already left the mainland for more welcoming environments, taking their talent and capital with them. Add to that Western export controls on semiconductors and other dual-use advanced technologies, and China’s tech capabilities will face major binding constraints soon.
China faces the worst demographic trajectory of any country we’ve seen in peacetime. Its 1.4 billion population peaked last year and is now starting to shrink, owing to aging and plummeting birth rates. By 2035, China is estimated to lose roughly 70 million working-age adults and add 130 million seniors. Studies put its total population in 2100 anywhere between 700 million and 475 million (!), at which point one in three Chinese citizens will be over the age of 65. President Xi Jinping’s decisions to end China’s one- and then two-child policies have failed to reverse these trends, and in all likelihood, so will any new policies to boost birth rates short of liberalizing immigration (something Beijing is loath to do). The fact that the demographic implosion has hit China before it’s had a chance to grow wealthy makes its economic and political implications all the more dire.
China faces an increasingly hostile external environment. This is embodied by the United States’ explicit policy of containment of China’s tech sector as well as China’s growing strategic encirclement in its own backyard – where Japan and South Korea are increasing their defense spending, Taiwan grows more defiant by the day, and new anti-China alliances like the Quad and AUKUS are blooming like algae. Relations with India, meanwhile, have become more competitive on the back of military clashes on the shared border, causing Delhi to draw closer to Washington. Anti-China sentiment more broadly has increased as China’s global footprint has expanded, with more than 10 countries having suspended or canceled high-profile projects funded by the Belt and Road Initiative. Meanwhile, China’s closest allies are imploding, with Russia now a pariah in the West, Pakistan’s economy in tatters, and North Korea having gone fully rogue.
China is ruled by an error-prone and capricious dictator who’s unfettered in his ability to pursue his statist and nationalist policy agenda. Much like Russia under Vladimir Putin, the unprecedented consolidation of power under Xi means less transparency and debate, less feedback flowing to the top, more arbitrary decisions, and more policy volatility. Dramatic shifts like the haphazard exit from “zero COVID” are inevitable in an environment of poor information and blind loyalty, radically increasing the risk of miscalculation and accidents and further undermining China’s growth and stability.
Why China hasn’t peaked yet
It’s true that unprecedented headwinds make China’s continued growth more challenging. It’s therefore possible that China will never surpass the United States economically or become a global superpower. But the question is whether China’s power has already peaked, and that’s just not the case.
Yes, China’s economy is growing slower than it used to … but it is still growing faster than America’s. You’d expect growth to slow in any low-income country that has become middle-income in the span of a generation. Still, the IMF projects that China will continue to narrow the gap with the US in the coming decade – growing from 73% of US GDP today to roughly 87% by 2027 and achieving parity around 2030. Chinese labor costs remain dramatically lower than in advanced industrial economies, and China’s already deep integration into global value chains means any decoupling will be slow and incremental rather than sudden and absolute.
As for quality, China’s growth hasn’t been primarily stimulus-driven since shortly after the global financial crisis (except for the COVID reopening period). And while infrastructure spending used to be unproductive, eventually that led to fiscal reforms imposing stricter profitability conditions. Indebtedness is admittedly a huge issue that Beijing has delayed dealing with through the pandemic, but the government remains committed (at least in principle) to getting it under control.
Xi is ideologically committed to a statist economic agenda that will drag on Chinese growth, but he also understands that he shouldn’t kill the goose that lays the golden eggs (the private sector in general, the tech sector in particular). China continues to invest massive state resources in advanced technologies, and it has already achieved parity or surpassed the US in many fields (e.g., voice/facial recognition, smart infrastructure, telecommunications, and electric vehicles). If AI ends up becoming the new commanding height of the global economy (as I think it will), China’s data advantage and strong AI talent pipeline will make it competitive if not dominant.
Demographics are an undeniably real and massive challenge for China … but not a near-term one. And there are plenty of things Beijing can do to kick this can down the road. For example, China’s retirement age is low by international standards (60 for men, 50-55 for women) and hasn’t changed in decades despite big jumps in life expectancy. China can halve its demographic tax by 2035 by bringing 40 million more people into the workforce – a reform Xi flagged in his recent Party Congress report.
Moreover, China’s educational system has only recently seen dramatic increases in funding, with the associated improvements in labor force quality still to come (especially in rural areas). China can further boost productivity by increasing urbanization (now at 65%, compared to an average of 80% in developed countries) and, in particular, moving workers out of low-productivity agriculture (still 25% of the workforce, compared to 3% in most industrialized countries). All this room to grow its labor force participation and productivity gives China a minimum of 10-15 years of runway to address the more stubborn challenge posed by low birth rates.
China’s external environment has become hostile … but no one really wants a “cold war” with Beijing. While the US-China relationship is tilting more antagonistic, Biden (and Xi for that matter) wants to put a floor under it. His containment policy seems to be limited only to narrow sectors deemed critical to national security. And while most US allies want a stronger security relationship with Washington and they’ll abide by any potential US sanctions, none are prepared to decouple economically from China as they have from Russia. China continues to be by far the most important trade partner for nearly all the world’s developing countries – most of whom are sympathetic to Beijing’s prioritization of economic development over ideological alignment.
China has the largest diplomatic network in the world, and its global soft power projection is just getting started. Increased hostility toward Beijing among most wealthy countries doesn’t change the reality that for much of the world, there simply are no feasible economic alternatives at scale. Despite all the talk about decoupling, even the US remains happy to continue selling record levels of agricultural exports to China.
Xi isn’t Putin. His decision to shift away from his zero-COVID policy in response to public demonstrations was clunky and poorly executed, but it was a better choice than cracking down on demonstrators or doubling down on a failed policy – which is what the Russian dictator would have done. Xi remains considerably more risk-averse than him.
My take
This is a dramatically more challenging domestic and global environment than China has experienced in decades … and it’s only going to get worse. But while China faces “stormy seas,” I think on balance it still has substantial upside. That’s why things like AUKUS and the Quad keep popping up: not because the US and its allies think China’s power has peaked, but because they know that it will continue to increase.
A “Chinese century” may not be in the cards, but another decade of reasonably robust economic growth and increased international influence is very likely.
Readers, tell me what you think: Has China’s power peaked already or does it still have room to grow?