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China’s economic situation is unlike any other. While its growth over the past four decades has been unparalleled, its current challenges – though not quite a crisis – are truly unique. It is distinct from the scenarios faced by Japan in 1990, Korea in 1997, or the US in 2008. China is not grappling with a financial crisis or a balance sheet recession. In fact, with a growth rate on track to reach 5% this year, it is not experiencing a recession at all. Nevertheless, the situation is grave, and the Beijing authorities must once again display great flexibility and ingenuity to maintain growth.
The current state of affairs is characterized by a chronic lack of demand despite economic growth. Two key statistics illustrate this. First, the consumer price index is on the verge of deflation, with prices in June remaining flat year on year and showing a 0.2% decline compared to the previous month. Second, youth unemployment reached 21.3% in June. It is evident that spending in the economy is insufficient to utilize all available productive resources, leading to what can be termed as “recessionary growth.”
The danger that looms is a downward spiral of deflation, which is compounded by the fact that no sector in China is well-positioned to increase spending. Consumers are still recovering from the repercussions of last year’s zero-Covid policies, which resulted in lockdowns in China’s wealthiest cities. Unlike the US, Japan, or Europe, the Chinese government did not provide significant transfer payments, leaving exposed households in dire financial straits. This experience has had a lasting impact on consumers who were accustomed to continual growth, introducing them to job insecurity and its bitter taste. Furthermore, China’s structural barriers to consumption, such as a weak social security system that necessitates saving for self-insurance purposes, will slow down the recovery of spending.
In the realm of private corporations, investment potential exists in a few favored sectors, particularly electric vehicles and the green energy supply chain. However, other sectors face a gloomy outlook. The recent regulatory crackdown, export controls imposed by the US, and the effective closing of foreign capital markets have severely impacted the technology industry. Service industries also lack motivation to increase output due to regulatory uncertainty and subdued consumption. With the authorities hesitant to lower interest rates out of fear of capital outflows, business sentiment remains low.
Housing and infrastructure investment, which are typically relied upon for stimulus, have become a concern due to a potential balance sheet recession. In this scenario, a sharp decline in asset prices would leave households and companies insolvent, prompting them to prioritize debt repayment. While China’s overleveraged property developers, exemplified by Evergrande, fit this narrative, a broader balance sheet crisis is not the unfolding reality.
Property prices have not significantly fallen, and efforts are being made to stabilize the market. A crash in property prices would have severe implications for both financial and social stability, as property comprises a significant portion of household wealth and serves as a crucial source of local government revenue. To prevent prices from declining, municipalities in China have implemented measures such as setting minimum sale prices, resulting in a decrease in transactions. While this poses a problem in terms of activity, it does not lead to default.
Another major concern lies with local government financing vehicles, which borrow funds for local infrastructure investment. Some of these vehicles are struggling to repay their debts and require restructuring. However, as they are state-owned entities with debts owed to state-owned banks, which are funded by Chinese households’ substantial savings trapped within the country due to capital controls, a crisis can be averted through careful management and the reshuffling of assets and debts within the system.
Instead of existing debts, the primary issue lies in the potential for new economic activity. Aging demographics and outmigration have led to a saturation of housing demand in many parts of the country. While allowing more construction in major cities like Beijing, Shanghai, and Shenzhen could inject vitality into the sector, it would also entail uncomfortable and politically destabilizing trade-offs. Incremental infrastructure spending remains an option, albeit with diminishing returns and the accumulation of further debt for the future.
Therefore, two sources of demand remain: trade and government spending. China’s current account surplus already indicates weak domestic demand and should serve as a warning to the rest of the world regarding a potential influx of highly competitive Chinese exports, including high-end products like electric vehicles. While China exporting deflation could help alleviate inflationary pressures in Western countries, it would come at a significant long-term economic cost.
Ultimately, everyone, both inside and outside of China, should favor the final option. The Chinese central government possesses one of the lowest levels of debt globally and has the capacity to provide financial assistance to households, boost consumption, and stimulate economic activity. However, a recent politburo meeting presented a lengthy list of policies without concrete indications of immediate financial support. If China wishes to sustain its longstanding economic success, the ball is now in Beijing’s court to take proactive action.
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