China’s economy faces a watershed moment. The old model of development, based on state-led investment, real estate, exports, and high technology has become deeply unbalanced.
Recognition of problems with the old model are not new. For more than a decade, policy-makers and analysts have advocated for a change to a more consumption-driven and domestic-oriented model for China’s economy. But unlike in years’ past, this transition will likely have to occur now, or never.
China’s economy has decelerated rapidly from its upward bump after the lifting of zero Covid restrictions in late November 2022. The second quarter saw the nation’s gross domestic product (GDP) grow by just 0.8 per cent over the first quarter. This data has increased concerns that the economy is losing steam too briskly.
Lackluster consumption and a slow-down in exports are only part of the problem. Most concerning is a rapid loss of momentum in the private sector. Profits of private-run industrial firms dropped by 21.8 per cent, year-on-year, in the first five months of 2023. More ominously, private investment from January to June fell by 0.2 per cent from a year earlier, compared with overall investment growth of 3.8 per cent, according to the National Bureau of Statistics.
Although some of the problems with private investment stem from a hangover caused by stringent zero Covid policies, the recent loss of momentum cannot be solely ascribed to the pandemic's effects. Structural challenges are ailing China’s economy.
At present, the economy is being propelled forward by just one of the four cylinders or dynamos that drove its stunning growth over the past four decades.
Beginning in the mid-1980s, Hong Kong manufacturers took advantage of new policies to relocate operations to Southern China. Soon, Taiwanese manufacturers followed. Chinese local governments became increasingly entrepreneurial and gave collective enterprises, including Township and Village Enterprises, more autonomy. China’s booming export economy was born.
By the late 1990s many of the nominally collective enterprises were privatized, while the domestic market started to grow quickly. China’s entry into the WTO ushered in an additional wave of Foreign Direct Investment (FDI), this time driven by globally dominant corporations domiciled in Europe, North America and East Asia.
In this process, China experienced export-oriented development similar to South Korea and Japan before. Exports not only drove economic growth, but also enabled a rapid upgrading of manufacturing capabilities.
While exports were a major factor driving Chinese growth, large-scale privatization of housing starting in the late 1990s was another. Real estate development picked up steam in the 2000s. In large part, Chinese cities, especially the largest, adopted the Hong Kong model, selling land at auction to supplement government finances. This created a virtuous cycle: higher real estate prices enriched not just real estate developers and a burgeoning Chinese middle class, but also cities.
The drawback to this arrangement, as in Hong Kong, have been spiraling real estate prices that increasingly price younger generations out of the dream of owning their own home or, then, force them to pool financial resources across generations. By now, high real estate prices can also be in part blamed for low birth rates, since housing a family has become very expensive.
During this twenty-year real estate boom, local governments grew rich, as did the central government. This created the preconditions for the third dynamo driving Chinese growth: large state investments, especially in infrastructure and industry.
Even during the Maoist period, the Chinese state undertook massive investment projects, but fiscal resources were constrained. This gradually changed in the 2000s after several reforms, including to taxation, increased state income.
What followed was a massive state-led investment boom in infrastructure. The emphasis is on state-led, since many projects incorporated private funding, and state investments were allocated by a variety of government agencies, including local, provincial, central, state-owned enterprises, and Local Government Funding Vehicles (LGFVs).
From high-speed rail to the largest freeway network on Earth, infrastructure investment both propelled economic growth and enabled other sectors, such as export industries and real estate, to thrive. This troika of dynamos finally got a fourth leg around 2010, when the Chinese Internet sector and other high-tech industries, such as solar panels and batteries, gained in importance. High-technology, both in manufacturing and services, became a fourth pillar of growth, making China an increasingly innovation-driven economy.
Right now, three of these cylinders are out of commission. Only state investment, as seen in the figures above, is holding up the ship. High-technology certainly still contributes and is in many instances tied to large state investment projects, such as in green energy generation. Indeed, green energy technology is one of the bright spots in the Chinese economy, with battery and electric vehicle production reaching global technology frontiers.
However, the crackdown on the Internet sector over the past two-and-a-half years and overall economic sluggishness are also holding high technology back. Even more importantly, real estate is in a slump, with many private developers hoovering on the brink of bankruptcy, while consumers lack confidence to spend, especially on large purchases.
Exports, which contributed much during the Covid era to China’s growth, are also slumping due to lower demand in most major economies as inflation and rising interest rates take a bite out of consumption. Finally, new FDI inflows remain weak.
The old economic model has thus become highly unbalanced, by far too dependent on state investment. And even state investment cannot steady it.
First, many local governments are experiencing financial duress due to high debts, the aftermath of zero Covid policies, and the loss of land sale revenue.
Second, even if the Chinese government could undertake another large stimulus like in 2009 after the Global Financial Crisis, its effects would likely be muted. Infrastructure investment in recent years has generated more debt than growth.
Given this backdrop, Chinese policy-makers face tough choices. Recent initiatives point in the right direction. Beijing, for example, has unveiled a 31-point action plan with a strong message of support to China’s private sector. The plan promises to create a favorable environment to unleash entrepreneurship, building a private economy that is “bigger, better and stronger.”
This pledge parallels one for state-owned enterprises made years ago. Even though these pronouncements come with force from the top, questions remain as to how much will be concretely done to improve conditions on the ground. Private firms, especially smaller ones, suffer from a lack of access to financing and require better protection, especially from predatory local government departments.
A shot in the arm for private sector confidence is much needed, but the broader structural problems of changing the model of development remain. Ultimately, a more rapid transition to consumption-driven growth is needed that includes better social welfare supports and, at this point probably, direct cash hand-outs.
A change in this direction of the required magnitude would likely siphon resources away from supporting technology and infrastructure spending. A large-scale fiscal stimulus would also require an increase in state debt. As a result, such bold steps are unlikely to be taken.
China’s economy faces its biggest challenge since the era of Deng Xiaoping’s reforms. Overcoming these challenges will decide whether the Chinese economy can escape the middle-income trap and get rich; or whether it might face Japan-style stagnation, working off the excesses of a housing bubble and over-investment, while still relatively poor.
