Is the Chinese Miracle Over?

China’s economic performance over the last year has been disappointing – so much so that some observers argue that growth has already peaked, and that it is all downhill from here. But it is far too soon to write off China’s economic resilience.

As 2023 began, the lifting of draconian “zero-COVID” restrictions fueled a kind of domestic euphoria, reflected in soaring consumption. But the picture soon darkened, with the second quarter bringing declining exports, stagnating retail sales, shrinking corporate profits, local-government spending cuts, and a weakening housing sector. Chinese business confidence plummeted, and foreign businesses were spooked. In November, China recorded its first-ever quarterly deficit in foreign direct investment.

Even so, China’s economy will probably grow by at least 5% this year – a respectable rate, by international standards. More important, China’s economy still has a lot of fuel in the tank: a record-high savings rate means that it still has plenty of cheap finance for investment and innovation.

Already, China is investing heavily in the technologies – such as renewable energy, electric vehicles, and artificial intelligence – that will shape the global economy in the coming decades. China is also rapidly developing its capacity in emerging technologies like fusion nuclear, quantum computing, quantum communication, and photonic semiconductors. We know that this strategy works: other successful economies, such as Japan in the 1970s and 1980s, have proved as much.

But China does face growth headwinds. Geopolitical tensions – in particular, the United States-led effort to “decouple” from China economically – are discouraging FDI and spurring companies to diversify their production away from China. But rather than leaving China altogether, many foreign firms are adopting a “China+1” strategy, opening new facilities in a third country, while maintaining their Chinese operations.

The reason is simple: with 30% of the world’s total manufacturing value-added – about the share of Germany, Japan, and the US combined – China still offers firms a massive cost advantage. Add to that huge excess capacity, and China’s manufacturing sector will continue to thrive. In fact, the only thing America’s decoupling effort will ultimately achieve is to spur China to accelerate the development of its own overseas manufacturing capabilities, much as Japan has done since the 1980s.

The likely impact of unfavorable demographic trends on long-term growth is similarly overstated. Yes, China’s population is aging and shrinking rapidly. But as AI enables the automation of a growing number of tasks, productivity will increase, and demand for human labor will fall. Together with improved education, this should more than compensate for the contraction of the labor force – possibly even creating the opposite problem: too few jobs.

So, what explains China’s slow recovery from the COVID-19 pandemic? The answer lies in government policy.

Over the last several years, the central government has been working to tackle imbalances that threaten China’s long-run growth prospects – beginning with massive debts held by state-owned enterprises, private companies (such as real-estate developers), and local governments. If China has learned anything from the US, it is that excessive financialization can destroy a country’s manufacturing sector. That is why the Chinese authorities are committed to deleveraging.

Local governments are a top priority on this front. Since 2010, China has pursued two major rounds of fiscal and monetary expansion, each of which led to a surge in the commercial debts of local governments. After the first round, in 2014-18, the central government allowed local governments to issue long-term bonds worth CN¥8 trillion ($1.1 trillion), so that they could repay their commercial debts – a kind of debt-swap program. But local governments were again forced to borrow heavily during the COVID-19 pandemic, accumulating yet more debt that the authorities are still working to address.

Another priority for the central government is unwinding the excessive commercialization of some sectors. Consider the tutoring industry: families pay private education companies for after-school classes, in the hope of giving their children an advantage over their peers. But these companies charge high prices, which parents struggle to pay, and provide little benefit to students, who are already working hard in school. So, in 2021 – with the private tutoring industry having ballooned to $120 billion – the authorities banned for-profit after-school tutoring in core subjects.

The third key imbalance that China’s government is attempting to reduce lies in the real-estate sector, which is simply too large, accounting for about a quarter of all fixed investment between 2013 and 2021. With some major property developers now struggling to service their debts, stabilizing the sector has become a top priority for policymakers.

None of these imbalances poses an imminent threat to Chinese growth. But reducing them will bolster China’s long-term economic health. That is why China’s government is taking bold action, despite the short-term costs. For example, housing sales have plummeted by about 40% since mid-2021, owing largely to government efforts to rein in the sector.

The good news is that the government has set growth as its main goal for this year and has rolled out new expansionary monetary and fiscal policies. Notably, with the monetary authorities encouraging banks to resume lending to real-estate developers, it is hoped that the housing sector will return to normal this year.