China’s economic recovery is losing steam. There is a growing fear that the slowdown is not a temporary one that will reverse course with time and with some judicious government help. In fact, China’s economy is now burdened with structural factors which could depress growth for a while. Indications from policymakers that the government will step up its response have raised hopes for better times. But the structural nature of the slowdown makes it unlikely that the conventional policy measures that the markets are hoping for will suffice to return China to its pre-pandemic growth rates.
In the end, because of the low base from last year, the economy may well turn in a strong growth rate for the second quarter, which would make the government’s 5% growth target for this year achievable. But, after favourable base effects are no longer available, economic growth is likely to disappoint. We will all have to get used to a less vibrant Chinese economy.
The bounce-back after Covid controls were released has been weaker than hoped for
The purchasing manager surveys for June were discouraging. The manufacturing sector is barely expanding and the lead indicators point to further weakness. Business confidence has ebbed to the low point seen in October before the Covid controls were relaxed. The pipeline of new orders is weakening as well. While the services sector is doing better, there are signs of a slower pace of growth there as well.
The trouble is that virtually every engine of growth is in trouble. The recovery in retail sales slowed to 12.7% in May, after surging 18.4% in April, suggesting that the impetus to growth from the consumer is easing. Worse still, fixed asset investment slowed to 4% in May from 4.7% in April. Since investment accounts for around 45% of the Chinese economy, this is not good news. Within this, the really worrying dimension was the 19% fall in property-related investment, an alarming descent from the 6.2% contraction in April. In addition, the 0.1% decline in private sector investment was a turnaround from the 0.4% increase for the earlier month, suggesting that the once-vibrant private sector is too downcast about prospects to expand capacity. Exports have continued to expand, but its pace is easing as global demand slows — May exports were up by 7.5%, easing back from being up 8.5% in April.
There are very deep roots of this malaise
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The very basic issue is that for more than 20 years from the late 1990s, China has been borrowing growth from the future — and now it is payback time, so growth must slow down. Policymakers pushed the economy into over-drive through various ways. The cost of capital was kept low by state-owned banks lending at low rates while weak trade unions and restrictions on migrant workers limited wage growth.
Many input costs as well as the cost of land were subsidised. With costs kept low, returns on capital appeared very promising, spurring businesses into investing at a pace rarely seen in history, with the investment share of GDP approaching 50% for many years. With such a stratospheric investment rate, Chinese economic growth was concomitantly extraordinarily high.
But there is a price for everything, and now the over-investment has caused excess capacity which in turn is deterring new investment. This is particularly evident in the real estate sector which at its peak accounted for close to 30% of economic output. In addition, the low borrowing rates also encouraged excessive leverage which are now creating financial risks because the returns on capital have been reduced and firms in real estate as well as other sectors are struggling to repay their loans.
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Against this challenging background, there is now an additional constraint on growth in the form of many key economic agents suffering a severe loss of confidence.
• Consumers are in a funk: A recent survey by the central bank found that households were substantially increasing their propensity to save rather than spend or invest — 58% of those surveyed prefer to save, up sharply from the 2019 pre-pandemic 45.7% level. As China’s population ages, ordinary Chinese are getting more worried about the adequacy of retirement funding. The Chinese Academy of Social Sciences had warned in 2019 that China’s national social security fund would be depleted by 2035, just 12 years away. Chinese families have also been shaken by the downturn in the property sector and are hesitating to buy homes.
So, consumers are diverting money from current spending into a new pension scheme that the government has launched. They are also using cash to repay loans rather than buying consumer durables such as cars. And, in their urge to reduce their debt, many Chinese are paying back mortgages early as well.
• The once-vibrant private sector is in the doldrums: One reason is the uncertainty over the government’s ideological turn as seen in its harsh crackdown on big tech platforms and the decimation of the tuition industry. They are also not clear what President Xi Jinping’s signature “common prosperity” strategy will lead to.
• Local governments, which are responsible for county-level development and social welfare support, are in trouble: Their revenue base had been overly dependent on real estate, so that sector’s travails have undermined revenue collection. Pressed to rein in their deficits by the central government, local governments are increasing penalties, fines and fees paid by small firms as well as cutting back spending on social security.
• Foreign investors are increasingly nervous: The latest European Chamber survey of members reflects how foreign firms in China are troubled by the geo-political frictions and its ramifications. Like their Chinese private-sector counterparts, they are uncomfortable with the inward turn in policies which the current leadership favours. A faster pace of supply-chain reconfiguration is likely with smaller foreign investors in particular set to move production out of China.
Will policymakers step in to help the economy?
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There are growing indications that the government is now worried enough about the economy that they want to step up policy responses. It is reported that Xi has been pressing his lead economy manager, Vice-Premier He Lifeng, to turn the economy around more aggressively.
The news that central bank governor Yi Gang will soon be replaced by his deputy, Pan Gongsheng, is noteworthy in this regard, as such leadership changes often precede significant shifts in policy. Indeed, recent weeks have seen the central bank cutting lending rates and providing additional channels for loans to be made to credit-constrained parts of the economy such as small businesses. Also, the media has reported that since mid-June, officials have been urgently surveying business leaders and economists on how they can turn around the economy.
However, there are many reasons why the policy response is likely to be restrained.
• The first reason is how the leadership views the trade-offs it has to make between its conflicting policy objectives. There is nothing to suggest that Xi or his close aides believe that the economy is in such difficulties that a sharp policy U-turn is needed. Judging by official statements, they appear to believe that the short-term headwinds can be managed through selective and incremental moves. They still want to remain focused on the longer-term objectives of building resilience against a hostile America through greater self-reliance in important areas of technology.
Xi fervently believes that China’s resilience against foreign pressures cannot be assured unless internal weaknesses such as corruption are vigorously pursued. Thus, there is no let-up in anti-corruption crackdowns even though such drives slow the economy by deterring local officials from signing off on contracts or issuing tenders. Xi is a determined man who resists being distracted by short-term fluctuations in the economy.
• A second reason is that China’s leaders rightly assess that demographic headwinds and other structural factors such as greater protectionism against Chinese exports by the US and its allies will keep economic growth lower than in the past. Thus, it makes little sense to them to keep artificially boosting economic growth. They are probably not as worried as foreign observers are that lower growth will somehow upset the longstanding social contract in China — that the people support the strict rule of the Chinese Communist Party in exchange for rapid growth and improvement in their living standards.
With Chinese citizens now much richer than in the past, the social contract does not require such rapid growth rates. Rather, what citizens want from their leaders is assurance that their wealth will be preserved and the needs of an ageing population will be provided by the state.
Finally, what should we expect from policymakers then?
There is a growing debate in China as to whether the economy is in a similar position to that of Japan in 1990 when the latter’s property bubble burst and ushered in decades of deflation and mediocre economic performance. Some economists such as the respected economist Richard Koo argue that such a “balance sheet recession” risk requires aggressive fiscal spending as monetary policy is usually ineffective in such circumstances.
However, there are many stark differences between China now and Japan in 1990. For one, China’s potential economic growth is still much higher than that of Japan in 1990. Another fact is that the property bubble in China has not burst as dramatically as in Japan. China’s banking sector — overwhelmingly state-owned — is also in a much better shape to deal with the fallout.
Thus, while there is some merit in the balance-sheet recession argument, we have more sympathy for the argument that the structural nature of the drags on China’s economy requires bold policy reforms aimed at overcoming some of these deep-rooted problems and unleashing growth that way.
In the end, we think that the authorities are likely to veer to the cautious approach:
• There is not going to be any big-bang changes in policy such as the astounding and sudden U-turn in Covid controls we saw last December.
• The authorities will probably step up fiscal spending, but it will be targeted at specific areas and limited in scale. Xi’s allies keep warning against the kind of “flood irrigation” measures pursued by previous governments.
• The central bank will keep cutting policy rates and reserve requirements — but in steps rather than in leaps. It will push the big state-owned banks to lend more — but again only to selected areas. There will be measures to limit the risks from defaults by local governments or by property developers but here, too, policymakers will be calibrated in their approach.
• China’s leaders are not likely to proclaim any hugely ground-breaking reforms in a hurry. Restrictions on migrant workers will be relaxed but only gradually. The financial sector will be progressively opened up to the outside world. However, we do not expect even bolder moves that are needed, such as allowing market forces to play a bigger role in allocating capital.
• Policy support will, however, be aggressive in strategic areas. Significant increases are likely in government spending on developing new technologies that are central to a more sophisticated military capability. China will continue to spend massively on the green transition and provide ever more generous subsidies to buyers of electric vehicles and the like.
In short, enough will be done to keep the economy growing at around 4% a year in the coming years. That is a step-down from the heady double-digit growth of recent decades, but it is not a bad outcome for a country whose population is no longer growing and given the less supportive global environment.
Manu Bhaskaran is CEO at Centennial Asia Advisors
