Is China’s economy hitting a wall?

Key takeaways:

• China has two main persistent systemic issues: the property sector and local government debts. They impact GDP growth, economic recovery and market confidence. These two bubbles are not popping (yet) as air is also steadily being let out of the growing bubbles.
• If we worry about China’s debt problems, we should freak out about the US debt. The main difference is trust. We all trust our own system more than the alternative system.
• Whenever bad data comes out of China, the world tends to read a downward trend, minimizing the structure and tools of the system and pragmatism of its leaders.
• The general sentiment that China’s economic problems are the result of bad policy, is not doing justice to Beijing’s plan in addressing China’s structural problems head on.

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Is China’s economy peaking?

Economist around the world seem to agree that China’s economy is in trouble. Even the most bullish China watchers have starting to doubt when or even if China’s economy will recover. Analysist have been echoing panic voices for six months that China’s economy is structurally failing and could even take the world into a downward spiral.

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But what if this economic ‘standstill’ was carefully planned by Beijing?‍

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That makes no sense, right? Why would any government want its economy to stutter? Could the Communist Party of China (CPC) be prepared to trump ideology and power above the economy? Isn’t that what most authoritarian regimes do? It makes for the most obvious explanation and reason for the economic challenges China faces today. The strict lockdowns in 2022 seem to confirm that Beijing’s priority is about keeping control prior to supporting business. 

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And yet, in my experience and point of view, …

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• It doesn’t rhyme with China’s cyclical governance model of control followed by initiatives.
• It doesn’t do justice to the intelligence of Beijing’s meticulously solid long-term planning.
• It doesn’t match the view of a country in constant transition towards broader prosperity.
• It doesn’t feel right when we think of China’s entrepreneurial spirit and national pride.
• It doesn’t make full sense in China’s relationship culture of collaboration and pragmatism.

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Besides the disappointing economic data, facts and predictions about China, let’s explore some alternative dynamics, trends, paradoxes and viewpoints to offer additional context. 

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To do that, let’s break down the most common arguments of why China’s economy will not recover, why it will not overtake the U.S., and why it could potentially even stagnate or fail.

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To simplify, we can categorize the many ‘China doom’ narratives in three separate themes:
Systemic Risks, Strategic Positionings and Societal Changes.

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In this first blog, we discuss five systemic risks that are causes for experts to claim that China’s economy will derail:

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‍ONE-PARTY SYSTEM, GDP SLOWDOWN, EXPORT DECLINE, DEBT LEVELS and REAL-ESTATE BUBBLES.

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In a second blog, we will cover Beijing’s strategic positionings fueling the geopolitical US- China tensions, Taiwan, global soft-power, and the new paradigms of Xi Jinping’s leadership. (yet to be posted)

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In the final and third blog we will elaborate on China’s societal changes such as China’s demography, political discontentment, youth unemployment, and weakened business and consumer trust. (yet to be posted)

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China’s Systemic Risks

A growing number of economists claim that the current Chinese system is reaching its peak and could break. Being educated in Western institutions, these experts trust that a one-party system that intervenes or even opposes normal market forces is unsustainable as a ‘system’.

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They argue that China’s economic miracle was mainly possible because…

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• As long as GDP growth remained strong, debt creation was like fuel for China’s fast engine.
• As long as Chinese consumers became richer, property markets and prices were booming.
• As long as the world was addicted to Chinese products, Chinese factories were expanding.
• As long as Beijing was making its ambitious plans a reality, Chinese citizens trusted the CPC.

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But isn’t all that now coming to an end?

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The strict 2022 lockdowns in China have left the population worried about the future for the first time in 45 years. Consumers are saving their money instead of spending it on goods or buying property. That does not help property developers who are buried in debts to survive. This doesn’t help local governments to sell land to these developers to get funds to recover from the exorbitant costs made during the pandemic. It doesn’t do any good to businesses, who often depend on local governments’ investments and infrastructure, especially now that exports are affected by global inflation, geopolitical tensions and declined confidence in China.

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Acknowledging all this, and the bad data behind it, it is easy to see the creation of a domino effect leading to China’s shrinking economy like we’ve seen before with Japan in the 1990s. The longer the CPC delays firm actions with more financial stimuli and new fiscal policies, the bigger and faster the downfall could be. Right? So, why is Beijing not yet panicking?

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GDP Growth 

China will contribute about 35% of the world’s GDP growth in 2023. An economy the size of China is like a container ship that is slowing down, but needs more than a rough sea to stop it. China is still growing its GDP at 5+% this year, adding about the GDP of the Netherlands every year. When was the last time that the U.S. GDP grew above 5%? It was in 1984! Back in 2014, the U.S. had the same GDP as China will in 2023. Since 2014, the US economy grew annually at less than 3% and it is expected to hover around a baseline 2% GDP growth until 2030. At this U.S. growth rate, China will not overtake the U.S. GDP by 2030 or even 2040, even if China maintains a yearly GDP growth of 3 to 4 percent as most economists predict.

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But what happens if the GDP growth of the U.S. falls further due to new conflicts, inflation, debt creation, or dollar exodus? What is fascinating to watch is how economists rarely use the same ‘doom’ lens on the American economy as we do on China’s economy to conclude that China is economically in trouble and will not overtake the U.S. economy any day soon. We still trust the greenback more to keep America and the western world strong and rich.

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China’s past decades of infrastructure investment ‘grow that any cost’ model created the factories the world wanted, the roads, harbors and airports businesses required, the houses the new middle-class needed, the returns investors aimed for, and land sale revenues local governments enjoyed. It made sense for four long decades. Today, China has a construction overcapacity. As China still enjoys a growing trade surplus, excess USD funds are invested in the rest of the world through the Belt and Road Initiative to export its building overcapacity. Many Chinese believe however that Beijing should put that money to use in China instead. 

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Domestic infrastructure investment today creates less economic value than before. China is loaded in debts that aren’t yet generating higher productivity or more consumption to make the economy grow faster. An economy as big as China, cannot keep growing in GDP mostly from the supply side by creating more debts! China now wants to transition to a healthier, environmentally friendly and higher-productivity society instead of its traditionally quantity and scale driven expansion model at any costs. There is very little wrong with that aspiration.

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But you can’t make an omelet without breaking the eggs first.

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The reality today is that the world pays a lot more attention to what China is breaking instead of what it is baking.

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Xi Jinping used the phrase “China’s New Normal” already back in 2014 to describe China’s shift to an expected gradual GDP growth decline. The plan has been out there for a decade. China is transitioning its GDP growth to be driven by innovation and domestic consumption instead of primarily input and investment driven.  That said, reducing China’s unproductive investments is easier than getting consumers to spend more. Beijing provided stimuli this summer, but still limited, as the central government remains confident consumers will start spending again in 2024 – one year after the pandemic measures were lifted. This is similar to the one-year timeline outside China of an increased consumer spending post-pandemic.

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Why would we assume that Beijing is totally taken by surprise of an economy under stress? Their planned transitionary reform is hurting China’s economy today, but in the long-term Beijing’s plan wants to make China a lot more balanced economy with healthy debt ceilings. As no other major economy in history has ever gone through a similar profound and swift transition of its economic model, there is no real reference point to check if Beijing’s plan will work. If the plan works, China’s economy could potentially outgrow the US by far. At the very minimum, we should consider a ‘worst’ as well as a ‘best’ case scenario.  

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Exports

Exports account for about 20% of China’s GDP. During the pandemic (2020-2022), China’s exports kept growing with the biggest increase in 2021 when China’s factories were open for the world that was still in partial lockdowns. With the re-opening of China in January 2023 Chinese exports took off once again, but for 5 consecutive months since May 2023, Chinese exports dropped. The popular conclusion was that the world lost its appetite for Chinese products. The question remains whether that was due to a lackluster to buy Chinese goods or whether it was mainly due to the world’s global economic slowdown to buy from China? China’s latest export data is still in decline, but looking much better than originally expected.

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I don’t see the world getting over its ‘buy from China’ addiction any day soon. Especially now that Chinese brands introduce their higher quality products globally as the domestic market is still in recovery. In markets like electrical vehicles with oversaturated Chinese capacity the European market that transitions to more sustainable products attracts all Chinese vendors. Western markets and governments should be more concerned with the tsunami of Chinese competitors coming to our shores than whether Chinese export slows down their economy.

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As interesting to note is that the China’s trade surplus kept growing up to 2022. In 2023, imports are down due to weakened domestic demand, but also due to export restrictions such as chips. The trade surplus with Europe has reached historic levels today, which shows how dependent Europe has become on Chinese products. If Europe follows the US model, we can expect an EU-China trade war to emerge with protectionist barriers against Chinese imports to create a moat around the free markets of Europe.

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As developed countries seek to de-risk more from China, Chinese exports to the West could decline, but so will imports into the Chinese market. Huawei has shown how Washington woke up one dragon. What is less talked about is how Huawei has refocused its attention to countries outside of U.S. and its geopolitical allies. For all China’s exports, exports to the Global South have already overtaken exports to the Global North. Within the Southern hemisphere, Asia Pacific has the world’s fastest growing economies, and China intends to make clients in its own backyard. Even the gloomy cloud hanging over China’s exports has a silver lining.

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Real-Estate

For over two decades, China created a vast property bubble. China’s real-estate contributes about 25-30% of China’s GDP. In 2021, real-estate developers such as Evergrande started to falter on their debt repayments. The company accumulated a staggering debt of 300 billion USD. As the news broke, economists were quick in predicting that China’s financial system would fail and take the world into another financial crisis like back in 2008. Two years later, China’s financial system has not collapsed. Is the timebomb still going to explode or not?

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In 2020, Beijing implemented a ‘liability-to-asset ratio’ loan approval system for property developers to limit creation of new bad debts with Chinese banks. In 2021, 90% of China’s real-estate companies were not in the ‘red-danger-zone’. But it did trigger some developers like Evergrande to get cut off from new loans, which accelerated their downfall. More than 60% of China’s property developers have hit at least one debt threshold, but most of them still operate in the ‘safe’ zone. There are quite a lot of small timebombs, not one big bomb.

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More than 90% of Chinese families own a home and do not have a mortgage on their first house. More than 20% of Chinese households own multiple homes. Buying a house was the ideal investment in a country where capital markets were underdeveloped and real-estate was booming. It was the safest investment. In 2023, prices have dropped about 15% in many cities and investments have dropped about 9% compared to 2022. The bubble is becoming smaller, but it is still a huge bubble as far as sky high prices compared to average salaries and too many empty properties – even ghost towns. It could take China at least a full decade to defuse the real-estate timebomb.

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The ‘red-zone’ real-estate developers like Evergrande and Country Garden are not getting rescued by the government. Assets of failed property developers are getting restructured; running projects are being completed by local governments or ‘green-zone’ developers; and the remaining skeletons are getting nationalized. This summer, Beijing has allowed for more flexibility for developers to get new loans and for consumers to purchase a second home to avoid a hard downfall. Beijing is giving some room to breathe to avoid the bubble to pop.

This control followed by release, followed by control again, cyclical governance model is one advantage of China’s financial system. Beijing is at any time able to issue new directives to state-owned banks, state-owned enterprises and local governments. They have to comply. But pleasing Beijing today typically benefits them tomorrow during the release cycles. It’s a game of carrot and stick. During a control cycle, the yo-yo model does not aid state-owned entities to become more productive and competitive. But that is of lesser priority in the case of containing bubbles. Beijing has more ‘guidance’ tools to avoid a housing crisis than other governments in completely open financial markets. But even with the of best tools, one still needs to be a good plumber to fix a leak. This is where China’s pragmatism kicks in. Only fix what is broken – and until proven otherwise - the system itself is not to be considered as broken, but evolving over time.‍

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Time will tell.

Debt

China’s total debt reached almost 300% of its GDP. China’s central government debt-to-GDP ratio is merely 21.3% compared to the US level of 119%, and the Eurozone average of 91.6%. China’s real debt risk is not located in Beijing, but in China’s many local governments. China does also not owe much money to other nations. On the contrary, a still growing number of countries, including the U.S. are indebted to China. China’s debt load is mostly internal and primarily towards Chinese state-owned banks. It means that it does not put high repayment pressures on China as long as the country’s growth (~5%) is higher than interest rates (4,2% on 5-year loan). China also benefits now from a period of disinflation. It does add pressure on economic growth, but does not inflate the national debt to cover older debt costs – as is the case in the United States. All bubbles are equal, but some are more equal than others.

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China’s debt needs to be urgently restructured. In the late 90s, Beijing started limiting local authorities to collect taxes and prevent them to raise money independently for investment. The idea was to avoid overspending and inflation trends. Beijing then transfers central tax money to local governments to meet their local spending needs. So, if Beijing has all local governments on a tight leash, how did 12,8 trillion USD local debts happen unnoticeably?

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The unconventional answer is that China is much more decentralized than often perceived; and local authorities have been very inventive and pragmatic to find smart work-arounds. Local government financing vehicles (LGFV) have enabled local governments to raise money indirectly with the sale of land to property developers. This created both the excessive debt and real-estate bubble. They are interconnected. The LGFV cash-cows are now put under a microscope by Beijing, and local governments can’t milk the shadow-bank system as easily anymore. They need to become much more responsible in government spending. This will all slow down infrastructure projects further, adding to the pressure on economic growth.

It shows how Beijing - as a conductor who directs its orchestra - gets local governments to always keep the music playing. At certain times local governments are expected to do more investments to achieve the GDP growth numbers or deal with a crisis; and at other times, they need to slow down projects to deal with an overheating the economy. In recent years they have been directed by Beijing to spend exorbitant amounts on fighting the pandemic. Some cities are now literally on the verge of bankruptcy. This might well be the biggest problem China has to face today. As such, Beijing is now telling state-owned banks to roll-over existing local government debts with longer-term loans at lower interest rates to avoid municipalities to default.

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Often, we don’t understand why Beijing doesn’t take initiatives sooner to get the economy back on track. The thing to notice isn’t that Beijing is oblivious to address a crisis. Quite the opposite. Let’s not forget that the world was saved by China’s massive debt creation in 2008 to keep factories running and help the world out of an economic crisis. China’s government however can wait longer to react because new policies have a much shorter process to get implemented as we saw with the sudden pandemic lockdowns early 2020 and as even more sudden release of measures this year. Beijing has more tools available to guide the economy.

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Beijing has however identified the local government debt problem as the biggest systemic risk to its financial system and economy, and is using all levers to balance the ‘new normal’ GDP growth of economy with financial controls. In contrast to Washington, Beijing is taking its debt problem as the no. 1 risk – even when we don’t feel they are always on the ball.

One-Party System

A common saying is that the real problem for China’s economy is not the Chinese people, but the one-party system and control of the Party. Mike Pompeo, the U.S. secretary of state under Trump said it clearly for the world to hear. But if the CPC would be all about control, how do we explain that they could not avoid the local debt problem and real-estate crisis?   

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Is the CPC considered a systemic risk because of too much control or because of a lack of full control? Is the CPC said to be a risk for China’s economy because of its rigid policies or are there too many grey zones?

Depending on which topic is discussed, commentators unconsciously or not pick what fits best the narrative. Strict lockdowns = too much control. Real-estate problem = not enough control. Foreign investment (FDI) decline = too rigid policies. Debt = too many grey zones. GDP growth = data is false.  Export decline = data is solid. Solar subsidies = CPC is protecting Chinese companies. Regulations = CPC is cracking down on Chinese tech giants. Domestic financial stimuli = CPC is too passive. Belt and Road investments = CPC is too assertive. …

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Whenever Chinese data and CPC actions make China look good, people easily undervalue and distrust the information. The global tendency is to claim that this is an anomaly caused by external events, not a systemic upward trend. For example, when China’s exports are now recovering, the argument is that it is due to the export of electrical vehicles. It is a one-off event, or blamed on an external event such as unfair subsidies from Beijing. The fact that Beijing has had sound and clear policies since 2015 to upgrade the electrical vehicle sector to be more quality-driven and productive through innovation and automation in order to reduce carbon emissions of its polluted cities is regularly omitted from the discourse. This trend could potentially propel China into another economic miracle. Why not mention it?

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When data and policies coming out of Beijing makes China or the Chinese economy look bad, we regularly overvalue and magnify them. The habit is to declare that China is on a downward trend, usually caused by CPC leadership. It is not seen as cyclical or passing event. For example, as foreign companies leave China, the reason is said to be because it the new CPC regulations has made it more difficult and riskier to do business in China. The fact that CPC has implemented many strict regulations that Europe had already (like data-, cyber- or anti-monopoly laws) and that they also apply to Chinese companies are valuable insights to consider. The reality on the ground that fiercer Chinese local competition has filtered out many foreign companies that were unsuccessful in China is less a topic of public interest. Most global brands that have cracked the Chinese market are not leaving and even dare to double down on their investments right now. China has become a more mature market.

Viewing the Communist Party of China as systemic challenge for China’s economy is missing half the story: The initiatives that the CPC has taken to make the economic miracle happen is the other half. It is the CPC’s adaptability, not its rigidity, that has guided the Chinese to build the second largest economy. When we reflect on Chinese policies from the past 40 years, Beijing has likely done more reforms and changes, some drastic and sudden, than most modern economies have done: fiscal, trade, markets, environment, social, labor, industrial, covid, regulations, governance, … the only constant in China has been change – including its policies. That trend should at least give us the benefit of the doubt that the CPC is also able to fix its economy.

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The CPC biggest challenge is to keep a very decentralized and ultra-pragmatic nation stable. This problem is not new to China’s leaders, it has been around for 2500 years. If we look at how Xi Jinping has been fighting corruption with iron fist for 10 years, one realizes how hard China is to control. It makes it harder to understand a conforming China and a disobedient China at the same time. This is the paradox of China. It is cultural. A collective society that protects each other and a more individualistic pragmatic civilization hungry for ever more.

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China’s one-party model only works for China, and would not work elsewhere. But it could be exactly what China needs to deal with the current volatility of its economy. Imagine for a minute if China were a company, not a country. Would we prefer a democratic board with many different voices to debate how to navigate through a major crisis of the company? Or would we be more confident to rely on a strongly aligned and pragmatic board to get us through a pressing crisis? Think of the CPC as the board of a company to appreciate why so many Chinese people still trust their leaders, even though that same board has made very unpopular and far-reaching decisions during the pandemic that have negatively impacted many Chinese people and businesses.

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China’s economic challenges are real, very real. But the one-party system and CPC could be viewed as a systemic risk as much as it can viewed as China’s systemic opportunity to deal with or at least soften the real-estate challenges, GDP decline and growing debt problems.

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The elephant in the room that however still needs to be addressed, is how Xi Jinping has fundamentally changed China these past ten years. Is Xi’s governance model becoming much more Leninist and his economic model much more Marxist than his predecessors? Could this explain why we generally are more inclined to believe that Xi Jinping will not continue to build on China’s past successes? Is this new paradigm from Xi Jinping a sign that China’s economy is a systemic risk in terms of societal stability? All these and more questions on trust in China’s leadership and new social contract model will be covered in the next two blogs. So, stay tuned …