It’s Grim out There: China’s Economy in the Year of the Dragon

I think we can all agree that China has followed an investment-driven growth model for over 40 years. It is never easy for a country to wean itself off this model, but instead of trying to do that, a few years back, China doubled down.

After the 2008 Global Financial Crisis, fearing a bank contagion and declining exports, leaders put the investment model on steroids. Under instruction from Beijing, banks threw caution to the winds. In five short years, Chinese banks added loans worth the entire value of the U.S. banking system—which had taken 150 years to create, in a country with a much larger economy. Those loans went to industrial schemes and much more infrastructure than the country actually could justify, but very largely, to real estate.

The property mania that followed, with years of rising prices that helped encourage consumers to keep buying, created Ozymandian blights on the landscape: replica cities including at least three “Little Manhattans,” three “Little Hong Kongs,” a mini-Paris, an “English village” complete with little red phone booths, replicas of Red Square, and many, many other toy cities, almost entirely unoccupied, as if re-creating the physical structures might magically bring to life the real thing, and Chinese people would find themselves living not in the dusty streets of Anhui or Hubei or Henan but among palm trees and burbling fountains in wealthy, leisured communities.

Not only did the construction fail to create wealthy communities, but the money invested in these projects has trickled away. Loans created deposits, and the stimulus generated cash. That cash, coursing through the economy, surged to crazy levels after 2009. People who had been farming barley or tending cows and seeing $10,000 a year in cash income suddenly had money to spend on cars and casinos and investment products.

But underneath the sudden wealth, basic incomes were not rising much, and investment in the intangibles that strengthen a population was neglected. China’s population, particularly in rural areas, has not benefited from the improvements in health and education that would have prepared them for a modernizing economy.

The illusion of property values that would rise forever was burst in 2021, and since then, China’s economy has weakened. What to do? The whole Chinese economy has kited atop property speculation, and no official dared allow it to stop. Now, banks say that 70 percent of assets are invested in the property sector. Bloomberg Economics calculates that a 5 percent fall in housing prices would equate a loss of 19 trillion renminbi (U.S.$2.7 trillion) in wealth.

Already, dozens of property developers have defaulted. Bank deposit rates have been pushed down, and the investment schemes that once offered better returns were swept away by regulators who want cash to return to the banks. Chinese consumers are becoming poorer.

To revive the old model and save the defaulting assets, the government would need to hose trillions on the economy. But all that cash would break the renminbi’s peg to the U.S. dollar, and that is a consequence the Chinese Communist Party cannot accept: It would mean massive capital flight, an angry populace, and the end of the dream of great wealth.

So, China’s leaders pace like caged tigers, lunging at half measures like new bond issues and a “stock market stabilization fund,” as if these efforts might bring back the glory days. But half measures will not work.

China has a huge economy, much of which is functional. Debt can be spread around for some time, and it is hard to say when the banks will demand massive cash injections to survive. But once that happens, the currency will deflate like an old party balloon, and the government will do its best to suppress dissent and close the borders. Those processes have already begun, and they foretell nothing good for 2024.

In the short run, China’s economic recovery in 2024 hinges upon four interrelated factors: property market stabilization, household consumption recovery, external environment improvement, and confidence in the economy restored.

The Central Financial Work Conference in October 2023 and the Central Economic Work Conference in December underscored the importance of risk prevention and resolution in three key areas: the property market, local government debt, and small- and medium-sized financial institutions. A necessary first step is stabilizing the property market by easing credit conditions to meet reasonable financing needs without fueling a new round of excessive borrowing.

Property market stabilization directly contributes to strengthening household balance sheets, creating a favorable environment to boost household consumption and expand domestic aggregate demand, all necessary to lift the Chinese economy out of the deflationary trap. Moreover, the property sector intricately links with local government off-balance sheet financing and small- and medium-sized banks’ lending. While the fall of Evergrande is not China’s Lehman moment and is unlikely to immediately spark a contagious wave of bank failures, its negative shock on the entire supply chain of the property sector, corporate creditors, and the small banks involved adds to the challenges facing China’s economic recovery.

Tensions with the United States are the top external challenge for China’s economic recovery in 2024, but not the only one. Complex global supply chain disruptions pose risks to Chinese exporters that are already operating on thin profit margins. The Red Sea crisis has disrupted the main shipping route between Asia and Europe, causing delays and raising shipping costs, lowering the profitability of Chinese exporters. The Suez Canal is a primary route for China’s westward goods shipments, including around 60 percent of its exports to Europe. A prolonged Red Sea shipping crisis would pile pressure on Chinese exporters and challenge the Chinese economy that is already battered by a looming property sector crisis, weak consumer demand, a shrinking population, and sluggish global growth.

Additionally, over 70 countries and over 4.2 billion people worldwide will hold elections this year, including major economies such as the United States, Russia, and India. The election results may affect and change the global business environment and market landscape in which Chinese companies operate.

In the long run, Chinese economic growth faces the challenges of the “4 Ds”: debt, demand, demographics, and decoupling (which some prefer to call “de-risking”). The first three Ds suggest that the Chinese economy is exposed to the risk of a Japan-style stagnation: Debt is soaring while growth is slowing down, and sluggish demand cannot catch up to overextended supply and adverse demographic trends. However, these risk factors do not necessarily suggest that the decline of the Chinese economy is inevitable. An improvement in the external environment combined with domestic structural reform can still boost the growth of the Chinese economy.

However, structural reform takes more than fiscal and monetary stimulus; it requires political incentive alignment that is hard to obtain.

China’s economic malaise results from a combination of political decisions, structural factors, and policy mistakes. The central reason for it is that Xi Jinping has decided to make national security and technological upgrading—not economic growth—his policy priorities.

The broadening definition of national security, and the increased influence of security interests in economic policy, have soured private investor confidence. The focus on technological upgrading has led to an economic strategy that relies almost exclusively on industrial policy. This means that the government devotes most of its attention to the supply side of the economy: boosting production of semiconductors, clean energy equipment, electric vehicles, industrial machinery, ships, and other products seen as needed to increase the country’s technological capability and self-sufficiency. Virtually no serious effort goes into figuring out how to unlock domestic demand—especially from households, which now save about a third of their income, one of the highest savings rates in the world.

These policies mean that China’s economy will have two faces in the coming years. The chronic shortage of demand will mean disappointing GDP growth—probably 3-4 percent on average over the rest of the decade—and a constant struggle to shake off deflation. But at the same time, its technology-intensive sectors will thrive, thanks to both government support and China’s uniquely competitive manufacturing ecosystem. The result will be persistent high trade surpluses and, probably, a strong wave of protectionism from countries that want to preserve their own industrial capacity.

This policy stance also makes it very hard for China to solve two of its biggest structural problems: the collapsing property market and the huge and growing debt burdens of local governments. The last time China faced a challenge of this scale was the late 1990s, when nearly half of all bank loans went bad. At that time, it responded with a combination of financial engineering to postpone the reckoning of bad debts, well-targeted infrastructure stimulus, and aggressive deregulation of manufacturing and housing which unlocked huge new sources of entrepreneurship and household demand. As a result, China grew out of its problems and by 2010 became the world’s second-biggest economy.

A similar approach today would recognize that deregulation of services—which account for more than half the economy, and all net new employment—is the main path to boosting consumer demand and accelerating economic growth. Too much of the service economy is either in state hands, or burdened by stunting regulations. But such a policy would conflict directly with Xi’s desire to keep the state’s finger on all economic levers. So we need to brace for the consequences of the Xi model: slower growth in China, a big rise in Chinese technology exports, and more protectionism in the rest of the world.

The zodiac animal may have changed, but the Year of the Dragon is likely to be another Year of the Grind for the PRC economy.

In spite of the exhortation from the December Central Economic Work Conference (planning for 2024) to “strengthen economic propaganda and public opinion guidance, and promote a positive narrative about the bright prospects for the Chinese economy,” it is very hard to build a case that the economy is doing well or that 2024 is going to be a smooth year for the economy and consumers.

Xi and the leadership are very serious about transitioning from the old growth model to the “New Development Concept” with high-quality growth. That transition would be painful even in the best of times, but it is now more difficult in the wake of the pandemic hangover, the huge debt problems throughout the economy, employment challenges, the recent stock market meltdown, and a growing loss of confidence in the economy and the competence of policymakers.

Those hoping for more robust “stimulus” and a return to more “pragmatic” policymaking will likely be disappointed again in 2024. There has been lots of targeted stimulus, but the goal has been to manage the debt crises and prevent a sharp decline in economic activity and employment, rather than massive, indiscriminate 2008-like stimulus. As for a return to “pragmatism,” Xi Jinping Economic Thought is the chart for navigating the rough economic seas to higher-quality growth, and so far we have no indication that the top leadership, or at least the top leader, believes there is any need to deviate from that.

Other hopeful events for change we often hear about are the March National People’s Congress (NPC) and the oft-rumored but so far not convened Third Plenum. The hope is that Premier Li Qiang, in his work report to the NPC, will outline more stimulative policies and that the Plenum perhaps will shift back to a more “pragmatic” approach to economic policy. I am skeptical. The policies for 2024 were likely set at the Central Economic Work Conference in December, and other than the stock market decline over the last several weeks it is not clear anything else in the economy has materially worsened since then, so why would they suddenly shift policies so soon after?

Both the Central Economic Work Conference and the October Central Financial Work Conference, the first held in several years, raised hopes of more comprehensive measures to resolve some of the massive debt problems. Meaningful and credible steps to materially resolve the real estate and local government debt crises would be very positive, and also very painful.

It makes sense that so many inside and outside the People’s Republic of China want more robust stimulus. I believe the top leadership, however, is willing to endure much more pain than investors and citizens expect, and that it will continue to harden the system to be able to withstand significantly more difficult times.

Two competing extreme views of China’s economy historically have vied for dominance. Not too long ago we witnessed a plethora of “China miracle” theories. Now we find ourselves in the era of its antithesis: the narrative of China’s economic collapse, which casts the country as “uninvestable.”

Leading this story are the systemic issues plaguing the property market, intricately intertwined with local debt. The immediate impact of the property sector’s decline is undeniably severe. Analysts highlight the looming specter of defaults on property developer debt, the staggering sum of which threatens to unsettle economic actors from homeowners to local governments. But it’s crucial to differentiate between “policy failure” and “policy choice.” In the context of China’s real estate market, Beijing’s leadership views the market’s downturn not as an oversight but as the result of a deliberate decision to curb an unsustainable surge in property prices and overdevelopment. This strategic pullback aims to stabilize the market after decades of rampant growth. However, several analysts and rating agencies expect that stabilizing the property market’s decline and restoring a new equilibrium will be a lengthy process, possibly stretching to the decade’s end. Any misstep in management threatens to transform this calculated choice into a considerable failure.

Adding to the malaise of its property market, the dismal performance of China’s stock market and the alarming outflow of funds underscore investors’ waning confidence. Recently, Beijing has embarked on active measures, ranging from personnel reshuffles to market-stabilizing interventions, in a bid to avert further decline.

In contrast to the widespread pessimism, an alternative narrative celebrates China’s burgeoning economy, spotlighting its prowess in advanced manufacturing across sectors such as domestic chip production, artificial intelligence, electric vehicle manufacturing, and the expansion of 5.5G networks and infrastructure projects in the Global South. These sectors are the pillars of Xi Jinping’s economic strategy, designed to secure China’s position as a global economic juggernaut over the long term.

Xi’s faith in this strategy might stem from a conception that China has a unique capacity for long-term planning and is willing to invest heavily in future-oriented projects. This approach positions itself in contrast to what Xi reportedly perceives as the short-sightedness of capitalist societies, where the focus often skews towards immediate gains rather than sustainable growth. Furthermore, Xi argues the cycle of elections in such societies tends to prioritize voters’ short-term desires at the expense of long-term strategic imperatives.

Considering both viewpoints, what is my prediction for 2024? The answer largely depends on the ability of Beijing’s policymakers to precisely calibrate and modify their policy approaches.

It’s imperative that Xi recognizes that the current instability in Chinese markets extends beyond transient fluctuations driven by capricious investor sentiment or alleged “malicious external forces” seeking to sow discord. The market unrest reflects more profound systemic challenges. The recent downturn is a vivid warning of the risks posed by declining consumer confidence and eroding investor trust, the consequences of Beijing’s overly aggressive emphasis on security, ambiguous regulatory measures, and the economic strain caused by stringent pandemic lockdowns.

Furthermore, the leadership in Beijing must recognize and address the intrinsic risks in state-led investment initiatives. Ostensibly designed to catalyze economic vitality, these initiatives frequently precipitate inefficiencies and misallocate resources, thereby intensifying predicaments such as overcapacity and the erosion of profit margins. Additionally, these state-driven investments have proved unable to tackle one of China’s most urgent challenges: escalating unemployment. Absent a recalibration toward solving these critical issues, the robustness and prospects of China’s economic framework remain uncertain.

Investors are eagerly anticipating fiscal and structural reforms from Beijing, with a particular interest in measures that support households. They may be disappointed. Xi appears resolved not to “hollow out” the Chinese economy through excessive financial stimulus, a pitfall Beijing views as a fundamental flaw in the U.S. economic paradigm. Instead, the Chinese leadership is placing its faith in strengthening the economy’s foundations through non-financial means, such as advanced manufacturing and technological breakthroughs.

The critical challenge for Xi in 2024 will be his capacity to manage the equilibrium among divergent perspectives and to incorporate feedback promptly. Unfortunately, Xi does not have a good track record at this.

2024 is shaping up to be another challenging year for China as the economy stutters under the burden of mounting debt and deepening deflation. My firm, Enodo Economics, estimates that the likely overall credit losses amount to between 37 percent and 42 percent of GDP while deflation is the worst it has been since the 1997 Asian Financial Crisis.

In the mid-to-late 1990s, China had to deal with a serious debt problem, much like now. But then it was on the cusp of entry into the World Trade Organization, and the subsequent exploding growth helped the debt shrink away rapidly. This time around, China is in the midst of the “Great Decoupling,” with foreign capital pulling out of the country, U.S. tech restrictions impeding China’s technological development, and Chinese exports and capital less welcome in the West. Deflation is set to persist this year, and strong growth is unlikely to help shrink China’s bad debt away.

Premier Li Qiang praised the government for not having sought “short-term growth while accumulating long-term risk.” True, just throwing money at the economy without structural change would not have been beneficial. Xi Jinping and his economic team are focused on pouring much more resources on “high-grade growth,” a reference to technology-intensive industrial sectors dominated by state-owned enterprises. Xi said in a lecture to the Politburo on January 31 that “we must keep in mind that high-quality development is the absolute principle of the new era, fully implement the new development concept, accelerate the construction of a modern economic system, [and] promote self-reliance and self-reliance in high-level science and technology.”

But while China has been transforming the production side of its economy, it has neglected the demand side. The leadership seems incapable of instituting the structural changes that would help it fuel a consumer-led recovery. Instead, Beijing appears more amenable now to a credit-fueled stimulus, although this is unlikely to yield the results it hopes to achieve.

Both fiscal and monetary support are in the cards, and with government debt at around 80 percent of GDP, China has the scope to ramp up central government borrowing. But this model for growth only doubles down on the issues that have dogged the economy for years: overcapacity, low returns on investment, and ballooning debt.

Meanwhile, Beijing has proven far less adept at stimulating more demand from its 1.4 billion people, the true engine of growth for the vast country, and remains committed to “common prosperity.” Xi’s redistribution drive and focus on frugality have depressed consumer sentiment among the urban middle classes. It’s difficult to see consumption turning into a growth engine. Exports remain the only viable route to access genuine demand, but slowing global growth is set to be another headwind for China’s battered economy.

So far, all these are China’s problems, or at least a problem for companies trying to sell into the China market. But deflation in China will soon become a problem for other key markets—which the U.S. will have to address multilaterally, or suffer a bruising race to the bottom that will damage America’s biggest corporations and American workers.