A slowdown with Chinese characteristics
or: how I learned to stop worrying and love the debt bomb.
Welcome to this week’s Not in Dispatches, where we take a closer look at the Chinese economy.
China has become indispensable to the global economy. Its incredible rise, fueled by massive capital investment and rapid productivity growth, has lifted millions out of poverty and spurred an almost insatiable demand for resources. Over the past 15 years, China accounted for 35% of global nominal GDP growth, according to the IMF.
Yet, on several indicators, China's rapid economic expansion is slowing, facing hurdles such as deflation, a debt-laden real estate sector, climbing government debt, currency challenges, and a shrinking population. The IMF forecasts a dip in growth from 5.2% in 2023 to 4.6% this year, further declining to 3.4% by 2028. The World Bank expects just 4.5% growth. Chinese economic sceptics – many of whom live on US television and have never actually visited China – are saying the country is already in recession.
Growing pains
Talk of China’s economic demise is often greatly exaggerated, but an immutable rule of development is that, as a country becomes richer on a per capita basis, GDP growth slows.
China’s growth, in broad terms, has mirrored that of previous rises by countries including Japan, Malaysia, Singapore and South Korea. It’s just that China’s rise, with its sheer number of people, and the pace at which it has risen, stands out.
Initially, developing countries grow by adopting existing production methods, institutions and technologies. They may quickly ‘catch-up’ but find it difficult to transition to innovation. So, we should expect a natural decline in raw GDP growth as China prospers.
Yet volatility within this natural transition looms. Past drivers of growth, including leverage and real estate, are now burdens. China is also still recovering from pandemic restrictions, while trade restrictions are continuing to hurt exports. Many of these restrictions are expected to increase as the US nears its November election and Europe worries about its car industry.
Further, the move to a consumer-based economy is faltering due to a crisis in household confidence, which dropped off a cliff in early 2022. China is characterised by a high rate of household savings – which is quite different to Western economies where consumers are more likely to spend even where they have fewer savings. Getting Chinese consumers to open their wallets is more challenging than in the West, or indeed elsewhere in Asia, such as Malaysia and South Korea.
There are several bright spots in the economy, including new world-class industries in electric vehicles, solar cells, and batteries, as well as in greener energy production such as hydro, wind and nuclear. Together, these industries account for around 11% of China’s GDP. And while it is likely to be some time, if ever, before they replace the huge growth previously created by the housing and construction sectors, they will increasingly account for more of China’s stock market, allowing it a narrative on which to recover, thus promoting the all-important psychological wealth effect.
China knows it needs to transition from a leveraged growth model to a more consumer-led economy seen in developed economies. But, heeding lessons from the West, it is conscious of not destroying its manufacturing base and the associated blue-collar jobs. It is also conscious of the security risks that a decline of heavy industry entails. Getting the balance right as it transitions will be a key test.
Debt spiralling
China’s provinces have recently submitted their 2024 growth targets, and they all hover around 5%, suggesting a national target around the same figure.
Yet, China is unlikely to meet those targets without stimulus and regulatory support. The problem is that China has a lot of debt, with a significant portion held at the local level (cities and provinces). While central government debt is only around 21% of GDP, local government debt is approaching 70% of GDP (~$12 trillion). At some point, the central government may need to step in to guarantee this debt, which poses a largely hidden, risk to the economy. The central bank has already set up an emergency liquidity tool in August for use by local governments.
This piling debt constrains both local and central governments, as well as the central bank, when it comes to stimulus support for the economy.
China is likely to run large fiscal deficits in the coming years. In fact, the fiscal gap (the amount between what the country spends and what it takes in through taxes and other measures), is ballooning. It will likely equal that of the US in the coming years.
Geopolitical Strategy is the advisory firm behind Geopolitical Dispatch. Our partners are former diplomats with vast experience in international affairs, risk management, and public affairs. We help businesses and investors to understand geopolitical developments and their impacts with clarity and concision.
But who will finance this fiscal gap? The United States, holding the world’s reserve currency, has the extreme luxury of being able to issue Treasury bonds at will to finance its debt. Faith in the US government's ability to repay its debt to investors is still high. Is the same true for China? Unlikely.
Meanwhile, the level of corporate debt is also concerning, at around 131% of GDP. This places many private businesses at risk of default, as is already occurring in the property sector.
Property crisis
The housing market is in crisis as property developers across China default. In the past three years, around 56 developers have defaulted on interest payments on their corporate bonds. Sales of houses are down, as are prices.
Over-leveraged developers were caught up issuing debt they could not service as the market slowed.
And yet, only eight of those 56 developers have completed comprehensive restructuring. The largest, Evergrande, reported over $456 billion in liabilities before it defaulted and was forced into liquidation.
While a large portion of this debt was held by foreign investors, a substantial portion of Chinese households and businesses have also been impacted, with unfinished projects for households, as well as unpaid creditors.
The impact on confidence in China has been extreme, with both households and businesses being hit, and many losing their savings. Chinese people have fewer options as to where to put their savings, and there are fewer investment vehicles compared to the US or Europe. Roughly 70% of Chinese household wealth is invested in real estate, double that of the US.
The impact on confidence can be seen in both the tourism numbers, and per capita spend, over the recent Chinese New Year, which were still down compared to 2019. Green shoots have popped up in certain areas, like spending at casinos in Macau, but this may just as likely represent a desire to convert yuan to US dollars, or otherwise get savings offshore.
Foreign exchange and currency issues
While the government is becoming less interventionist in the foreign exchange regime, currency stability is still a core objective. President Xi often says that a strong renminbi is good for China.
The renminbi is also becoming increasingly important in global trade. In 2010, it was the 33rd most used currency to settle SWIFT transactions. In 2023, it was the fourth.
A lower yuan would mean more expensive imports and challenges paying China’s offshore debt.
But the issue is not just domestic. China continues to have a massive trade surplus with both the US and the EU. Allowing the renminbi to lower would risk retaliation from trading partners, particularly the US, which has accused China of keeping the renminbi artificially low to boost exports. Meanwhile, strategic trade competition and restrictions including, but not limited to, semiconductors, are hurting China’s exports.
The government also has an eye on capital flight out of China. The government controls much of China’s banking system and it can cut off, and has, attempts at large capital outflow. Nonetheless, last year around $150 billion left China in net outflow of foreign direct investment. The number of people seeking to leave China has also risen, as those watching crossings at the US southern border can attest.
Demographics
China’s population is shrinking. It reached a peak in 2022. Importantly, its labour force is shrinking too. As a result, businesses will struggle to get the labour they need, and business investment will likely decline unless productivity can somehow be increased.
But China needs access to overseas technology to do that, and tensions with the US and Europe could limit its ability to get those technologies.
Of course, artificial intelligence could play a role in bridging that gap, and boosting labour productivity, but this relies on the development of an uncertain technology, with the leaders in the field still based in the US. China is trying to catch up, but the obstacles are huge.
Emailed each weekday at 5am Eastern (9am GMT), Geopolitical Dispatch goes beyond the news to outline the implications. With the brevity of a media digest, but the depth of an intelligence assessment, Geopolitical Dispatch gives you the strategic framing and situational awareness to stay ahead in a changing world.
Outlook
Economic weight in the modern world is largely aligned with population size.
Whereas the Industrial Revolution broke the historical nexus between demographics and economic might – allowing technology to power European countries to economic and global dominance – that nexus is slowly being restored in a globalised world where information, know-how, labour and technology are more evenly shared (and stolen), like never before.
According to the IMF, at market exchange rates, China’s GDP was $18.3 trillion in 2022, about 73% of the United States.
Despite the worries over real estate and debt, China will still likely become the world’s greatest economic machine, overtaking the US, in the medium term. With per capita income sitting at just $13,000 compared to the US at $76,000, it is a matter of how quickly per capita incomes increase in China, reducing that gap.
If per capita incomes rose to just $30,000 – not a lot by Western standards – the Chinese economy would double its current size and well surpass any other nation on earth.
But with so many headwinds, such as demographics, local government debt, deflation, plunging consumer confidence and a legacy housing crisis, there are significant challenges in the short term to overcome.
Ironically, as the Chinese economy underperforms, some of its previous hubris has gone, and there is also more appetite to open up to foreign investors. In addition, the impact of geopolitical tensions, including trade restrictions and the threat of conflict over Taiwan, means it needs to try harder to attract external capital. The quality of China’s economy will, in the medium term, likely improve.
Financial or economic collapse, however, remains unlikely. A serious hot war over Taiwan remains, for the time being, unlikely too. Talks of China’s demise are, as always, overstated. And China will continue to be one of the two dominant economic machines for the foreseeable future.
In sum: China has problems, but most countries would kill to have the problems it has. The short-term outlook looks difficult and the challenges are significant, but the resources at Beijing’s disposal are significant too, as are the policy levers it can employ. Unlike more purely market-based economies, China can centrally manage its way out of a property crisis or debt deflation. The laws of economic gravity still apply, but with a Marxist-Leninist hovercraft of sorts, the impact will look rather different than the US in 2008, or Japan in the early 1990s. Stagnant? Yes, in relative terms. Catastrophic? Probably not.
We hope you are enjoying Geopolitical Dispatch, as well as these weekly essays. Please feel free to share with a friend or colleague, or leave a comment below.