Another view on China.
China’s Leaders Could Stem the Economic Slide. A Desire for Control Is Getting in the Way.
About the authors: Charles Dunst is deputy director of research and analytics at The Asia Group and the author of Defeating the Dictators: How Democracy Can Prevail in the Age of the Strongman. Kurt Tong is a managing partner at the Asia Group and former U.S. ambassador for Asia-Pacific Economic Cooperation.
As much of the world battles inflation, China’s policy makers are trying to beat back a specter that may be more worrying: deflation.
Should China slip into a deflationary spiral like that of Japan in the 1990s, consumers would ratchet back spending and focus on paying back debt. The resulting fall in prices would prompt consumers to postpone other spending, further weakening the economy. Productivity growth would falter even more than is already anticipated. The traditional drivers of China’s growth, domestic and foreign investment in manufacturing, would wither.
Top Chinese policy makers could probably stop this cycle before it takes root by enacting meaningful, if wrenching reforms. But China’s leadership has demonstrated a clear preference for maintaining state control over liberalizing the economy. That positioning makes substantial reforms unlikely. Without them, the country may soon plunge into a period of sustained deflation, a development that carries consequences for the rest of the world.
The numbers coming out of China make clear the problem at hand.
Gross domestic product grew by just 0.8% in the second quarter of 2023 from the previous one. Consumer confidence remains weak; China’s average household lost 20% of its wealth in 2022 alone. The nation’s $65 trillion property sector is heavily indebted, while property-related loans and credit comprise 41% of the assets in China’s banking system. The country continues to age, productivity improvements are slowing, and a distressingly high proportion of young Chinese citizens are unemployed. In July, consumer prices fell into deflation for the first time in two years.
China’s top policy makers seem to appreciate the problem. Less obvious is how they deal with it—without creating too many rips in the political fabric of the country’s top-down, Leninist governance.
They must decide whether to bail out property firms and take on more government debt, which would worsen the nation’s already enormous debt burden. They must figure out how to level the playing field between state-owned and private firms, unwind the government’s heavy-handed approach to technology and finance, and rebalance the allocative relationship between central government revenue and provincial government expenditure.
China has made some adjustments to interest rates and reserve ratios and is also considering infrastructure spending that could boost domestic demand, although the country is already overinvested in infrastructure. Some good luck in its most competitive sectors, like electric vehicles, might allow China to lean on exports to muddle through with solid growth for a few more years.
But Chinese policy makers’ preference for what they deem national security concerns over economic growth suggests that they will probably rely on Keynesian measures or monetary policy shifts to try to re-engineer growth. They won’t question the fundamental inappropriateness of their economic policy model for the next stage of China’s development.
As for which “grey rhino” could actually trigger a deflationary spiral, China’s huge debt—currently around 280% of gross domestic product, a higher proportion than that of either Japan or the U.S.—seems likely to eventually weigh down the economy with “zombie” firms and un-payable loans. A drop in housing prices looks inevitable too, causing many of the loans held by state-owned enterprises and property developers to go into default. That also would degrade the wealth of a significant proportion of the population, whose wealth is largely held in property.
Like Japan in the late 20th century, China has sufficient funds and political wherewithal to avoid a debilitating financial crisis or balance-of-payments crisis. Using those strengths, China may provide enough stimulus in the near-term to avoid a technical recession.
But the Chinese government’s fear of expanding credit when it is already overleveraged, coupled with the inherent difficulty of boosting domestic demand as more and more childless consumers approach a frightening retirement, means that mere fiscal and monetary policy stimulus will probably fall short of the mark. The result would be a period of prolonged deflation and even lower consumption and borrowing.
A deflationary cycle in China poses economic risks outside its borders. The U.S. economy is diverse and has strong fundamentals, but a severe slowdown in China’s imports would weigh negatively on U.S. economic prospects, and even more so on advanced economies across Asia and Europe that rely more on China-bound exports, such as South Korea and Germany.
A sustained decline in Chinese consumption and business spending would carry even more drastic consequences for developing economies that depend on exports and investment from China—countries as far-flung as Brazil, Malaysia, and South Africa.
Geopolitical planners will likely also worry about a slowing economy making Beijing’s leaders even more adventurous in international affairs, or at least prone to double-down on domestic nationalism and military modernization.
Ultimately, those most affected by China’s slowdown will be its own citizens. But economic trouble in China could mean trouble—economic and otherwise—across our still-interconnected world.
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