Since the Covid-19 pandemic, China has been experiencing something unfamiliar: deflationary conditions. At this stage in China’s economic development, potential GDP growth is probably in the 5-6% range. But, relative to productive capacity, aggregate demand is far too low to realise this potential.
It is not difficult to identify factors that might have weakened external demand. Developed economies, especially the US, have imposed high tariffs on Chinese goods and introduced export restrictions on certain advanced technologies to China. Meanwhile, broader trade frictions are growing, driven partly by sanctions imposed in response to Russia’s 2022 invasion of Ukraine. The re-election of former President Donald Trump likely portends more trade and other restrictions, and another step toward nationalism, unilateralism, and fragmentation in the global system. This is not necessarily a sea change in US-China relations, though 100% tariffs would be. Reassembling some version of a multilateral order, however, seems considerably less likely in the near term.
That said, China has reached the stage of development where domestic, not external, demand – especially in the non-tradable service sectors – should account for the bulk of aggregate demand. With a GDP of $13,000 per capita, China has become an upper-middle-income economy approaching high-income status. So, the non-tradable part of its economy should be approaching the size seen in high-income countries: two-thirds of GDP.
This means that even very strong demand for China’s exports, or strong tradable demand more broadly, could not offset a large shortfall in non-tradable demand. The barriers to Chinese growth primarily reflect weak aggregate domestic demand, largely owing to a shortfall in household consumption.
Relatively high unemployment, combined with uncertainty about the economy’s prospects, has encouraged Chinese households – already big savers by global standards – to double down on precautionary saving. More importantly, the declining value of real estate, which accounts for an estimated 70% of Chinese household wealth, has significant negative effects on consumption. As the US learned after the subprime mortgage crisis of 2007-10, repairing balance-sheet damage in the household sector is no easy feat, let alone one that can be achieved quickly.
Subdued real-estate activity has also affected local-government finances, which have long depended heavily on land sales and real-estate revenues. Rising fiscal distress among local governments compounds deflationary pressures.
A second reason for China’s domestic-demand shortfall is low investment in the private corporate sector. Weak domestic demand for final goods and services is one underlying factor; declining confidence, rooted in a lack of clarity about the relationship between the private sector and the large state-owned corporate sector, is another. Inward foreign direct investment has also declined, owing to trade and investment restrictions and geopolitical tensions, though the impact on China’s economy is less significant.
In the past, public investment has been a major engine of Chinese aggregate demand. During China’s three decades of very rapid growth, gross capital formation – much of it government-directed – amounted to upwards of 40% of GDP. But fiscally strained local governments have less room to pursue the kinds of massive investments seen in the past, and a recovery in investment would have only a limited impact on future growth. Overinvesting solely to fill a gap in aggregate demand is unwise, as Chinese policymakers well know.
Today’s deflationary conditions might be unfamiliar to China, but they are not entirely surprising. The transition from an export- and investment-led growth model to one based on domestic consumption and innovation amounts to a fundamental structural transformation. It would be more shocking if all components of this shift were perfectly synchronised.
In any case, the policy response is already underway. For starters, the government is pursuing a set of measures aimed at stabilising the real-estate sector without fuelling a new bubble. For example, China will nearly double credit lines for unfinished housing projects, in order to enable their completion and protect households that have pre-purchased apartments from losing their entire investment. Since excess capacity cannot be reversed, the best option is to write it off quickly.
At the same time, the Chinese government has been working to clarify the roles of the private and state-owned sectors. Over time, this should restore confidence and stimulate private-sector investment (provided the messaging remains consistent). Recent efforts to encourage the public and private sectors to adopt a more entrepreneurial mindset will also help to invigorate parts of the economy and bureaucracy that are being held back by a fear of making mistakes.
A comprehensive assessment of China’s economic prospects should not focus solely on its weaknesses. The economy has many important strengths, not least abundant scientific, technological, and entrepreneurial talent. This has already contributed to China’s progress – and, in some cases, leadership – in a number of advanced technologies, including artificial intelligence, quantum computing, electric vehicles, batteries, solar energy, and some areas of biomedical and life sciences. It will bring even greater benefits once the current imbalances are addressed.
China has another important advantage. Many developing economies fail to realise their growth potential, because government policies do not support – and, in some cases, actively resist – structural change. China does not have that problem. Its government recognises the importance of technology-driven structural transformation, and devises policies (and directs investment) accordingly.
In this sense, it can be considered good news that the growth headwinds China is facing today are not primarily the result of a more hostile external environment (though this does not help). Rather, they stem largely from internal imbalances and policy-induced uncertainty – problems the Chinese government has the skill and capacity to address. For example, fiscal stimulus focused on supporting consumption can help to smooth out the rebalancing process and prevent a self-reinforcing downward spiral.
The challenges China faces are daunting, but not insurmountable. With a clear and well-targeted policy approach, growth momentum can be restored within 2-3 years. – Project Syndicate
lMichael Spence, a Nobel laureate in economics, is Emeritus Professor of Economics and a former dean of the Graduate School of Business at Stanford University and a co-author (with Mohamed A. El-Erian, Gordon Brown, and Reid Lidow) of Permacrisis: A Plan to Fix a Fractured World (Simon & Schuster, 2023).
