China’s disappointing second-quarter economic numbers have triggered a widespread debate about the country’s economic future. GDP growth came in at a respectable 3.2% annualized growth rate. However, for some analysts, the property sector’s lackluster private investment, faltering exports, and declining prices signaled that China’s economic model was running out of steam. Observers used terms such as “the end of China’s miracle,” “a lost decade,” “Japanification,” and “a balance sheet recession” to describe the country’s current predicament.1 By contrast, some domestic observers argued that the current economic situation is a necessary side effect of the country’s transition to Chinese President Xi Jinping’s new development model, which would aim to drive growth through innovation and output in emerging sectors such as new energy vehicles.2 Others noted that China’s economy is doing much better than those of many Western countries, and saw a conspiracy in the negative reporting rather than problems in China’s economy.3 Some Chinese economists argued that the overall trend is negative and that the country needs to address it.4
August’s slightly better economic numbers may dampen the debate, but the question remains whether China can avoid the “regression to the mean” of 2-3% medium-term growth that Lant Pritchett and Lawrence Summers predicted almost a decade ago.5 This question is important for China as well as the rest of the world: After all, China now accounts for 18% of the global economy, and was projected to deliver more than one-third of global growth this year, according to the International Monetary Fund (IMF). The issue is also key for economic policy makers. If China is facing a cyclical downturn, an economic stimulus would shore up growth; however, if the country is experiencing a structural slowdown, reforms may be necessary to revamp growth.
Economic Headwinds
China’s economy has had a challenging exit from its zero-COVID policy. Whereas the first quarter of 2023 saw a sharp rebound of GDP growth (9% on an annualized basis), that number fell to 3.2% in the second quarter — still respectable in a global context, but less than many had expected. Though the government’s modest indicative growth target of “around” 5% for 2023 may still be met, private forecasters have downgraded their more optimistic predictions in recent months. The government increasingly worries about the consequences of the slowing economy, perhaps best represented by the rising unemployment rate for 16- to 24-year-olds, at a record 21.3% in June 2023. The government has since stopped publishing the number. Meanwhile, producer prices are falling, and real estate prices have weakened.
Short-term economic indicators in August were slightly better. Industrial production growth accelerated to 4.5% year-on-year (YOY) in August from 3.7% YOY in July; exports in renminbi (RMB) fell 3.2%, compared to a 9.2% decline in July; retail sales grew by 4.6%, compared to 2.5% in July; and the decline in property sales slowed to 12.2%, from 15.5% in July. Still, fixed asset investment weakened, growing by 1.8% in August compared to 2.5% in July. These data points, while encouraging, do not yet promise a recovery of growth to pre-COVID levels.
Many of China’s economic troubles have been induced by policy. China’s zero-COVID policy was initially successful, and the economy rebounded strongly in 2021, with 8% GDP growth. However, the highly infectious Omicron variant prompted a spike in lockdowns and increasingly restrictive measures on mobility. Accordingly, the economy slowed to a low of 2.2% growth in 2022. The sudden end to the zero-COVID policy in December 2022 initially boosted household consumption, particularly in services (such as domestic tourism); however, this growth petered out in the second quarter of 2023. The damage done to job creation has been large: In the years before the pandemic, the service sector created 10 million new jobs each year, absorbing a large number of college graduates, according to Xing Ziqiang of the China Finance 40 Forum, a Beijing-based think tank.6 During the pandemic, Xing said, the service sector created just over one million jobs per year.
A second brake on growth came from the property sector. That sector had been a major driver of investment demand since the 2008 global financial crisis; however, it had also accumulated debt and, in the eyes of authorities, become a source of risk to China’s financial stability. Xi Jinping frequently repeated the slogan, “housing is for living in, not for speculation,” which also appeared in many Party documents. To minimize risk, the authorities declared the so-called “three red line” policy in 2020, which effectively limited credit available to property developers. When advanced sales as substitute finance dried up during the COVID-19 pandemic, key developers ran into financial problems, triggering a sharp drop in property sales, new construction, and land transactions. In turn, this drop affected local government finances, which in recent years had increasingly relied on revenues from land sales. While stabilizing measures seem to have halted decline in this sector, the recovery remains wanting. Moreover, demographics and urbanization trends suggest that the property sector will likely slow the economy for several years to come.
Low confidence within the private sector generates a third headwind to growth. The recent clampdown on internet platforms, as well as the perception that the current administration favors state-led development, has made private entrepreneurs wary of new investments. Aside from the sharp contraction in investment in the property sector, diminishing growth prospects, and ample available production capacity amid sagging demand, have also reduced the need to invest in new capacity. As a result, private investments are shrinking, further slowing economic growth. Most of the decline is from a fall in property investment, however, and private investment in manufacturing is still growing.
Foreign investors face particular challenges in the new era. In addition to COVID-19 restrictions, they have to manage an environment dramatically changed by new cybersecurity and data security laws, amendments to anti-espionage laws, and the possible repercussions of great power competition. While total foreign direct investment (FDI) numbers held up in 2022, the first quarter of 2023 saw a sharp decline. Moreover, the nature of foreign direct investment (FDI) is changing. According to a study conducted by the Rhodium Group, investment has become concentrated in big firms, with a growing share coming from Hong Kong and Singapore, indicating that these funds are in fact Chinese firms repatriating offshore funds.7 The outlook of foreign investors has become increasingly subdued. Some have called it quits: When the European Union Chamber of Commerce in China conducted its 2023 Business Confidence Survey, 11% of respondents said they had moved investment out of China.8 A survey asking members of the American Chamber of Commerce in Shanghai about business prospects in China yielded the worst results since the organization started the survey in 1999.9
Efforts to stimulate the economy are constrained by high levels of debt, in particular of local governments and households. According to the Bank for International Settlements (BIS), the total debt-to-GDP ratio reached close to 300% by the end of the third quarter of 2022, twice what it was before the global financial crisis. China’s debt-to-GDP ratio now exceeds that of most advanced economies and all emerging market economies. Of that debt, household debt-to-GDP stands at about 60%, which equals the household income share in GDP. Government debt is now some 75% of GDP; when including debt incurred by local government financing vehicles (LGFVs), that figure approaches 100%.
Debt of nonfinancial corporations increased more modestly in the past 15 years, especially when the numbers are adjusted to omit debt incurred by LGFVs, which is included in the statistics for corporations. The central government still has abundant capacity to take on additional debt, even though policies intended to support the economy through COVID-19 have eroded the tax base. Moreover, the central government has maintained its deficit at a conservative level of about 3%, conforming to now-discarded limits of the Eurozone.
A final headwind for China’s growth is the state of the global economy. China’s exports did very well during the COVID-19 pandemic, in part because the zero-COVID policy initially succeeded in keeping the economy open while most major economies were still struggling. Since last year, however, tightening monetary policies in other major economies have triggered a slowdown, which has in turn affected China’s exports. In June, the total value of exports was down by 8.3%, although the numbers are less dire in terms of volume.
Growing Policy Concerns
While authorities are concerned by slowing growth, they have not yet opted for an all-out stimulus. Rather, the July 2023 Politburo Meeting on economic work in the second half of the year reiterated a commitment to “proactive fiscal policy and prudent monetary policy,” a phrase already included in the December 2022 report of the Central Economic Work Conference (CEWC).10 The Politburo readout attributed the slowdown to “new difficulties and challenges, mainly due to insufficient domestic demand, difficulties in operating some enterprises, many hidden risks in key areas, and complex and severe external environment.” According to the Politburo, the solution lies in restoring confidence, promoting domestic demand, stimulating innovation, speeding up construction of a modern industrial system, increasing “high quality” growth, and focusing on emerging industries such as electric cars.
The sustained emphasis on “high-quality growth” signals that the authorities remain cautious about an all-out stimulus. “High quality” is shorthand for growth that the economy can achieve without additional policy stimulus, and is part of Xi Jinping’s “New Development Philosophy.” The concept recognizes that the relentless pursuit of growth in previous eras has created inefficiencies and wasteful investment; the concept has inspired measures such as the “three red line” policy in real estate, and heightened central government reluctance to stimulate the economy. But the readout also suggests that several efforts to revamp growth are in progress or forthcoming. They include measures to promote consumption, including the recent decision to extend the tax credit for electric vehicles; measures to address local government debt; and an acceleration in the issuance of local government bonds, which would increase availability of financing for infrastructure The private sector, however, will have to drive a true revival in growth.
Re-Engaging the Private Sector
In recent months, Chinese authorities have demonstrated renewed affection for the private sector in order to bolster confidence. Meeting with leading private sector representatives during the Two Sessions in March, Xi Jinping assured them of his “unwavering support” for the private sector. The “two unwavering” is Party language for support of both the public and private sectors, and was reiterated in a document jointly issued by the Central Committee of the Communist Party and the State Council in support of the private sector.11 Chinese Premier Li Qiang followed suit in July by meeting with technology entrepreneurs and pledging support for the “platform economy” previously weakened by the regulatory crackdown.12 The National Development and Reform Commission promised support to the private sector as well, and set up a department to implement new measures.13
The Central Committee/State Council document pledged to make the private economy “bigger, better and stronger,” with a series of policy measures designed to help private businesses and bolster the flagging post-pandemic economic recovery. At the same time, the document reaffirms the government’s measures against monopolies, non-market behavior, and corruption. It also promises plenty of guidance for the private sector (the word “guide” appears 22 times in the document), and refers to the “traffic light” system for private investment, which was first articulated during the technology crackdown to control the “excessive expansion of capital.”14
The Ministry of Finance extended the tax-relief program, initially scheduled to expire at the end of 2023, until 2027. Private companies will enjoy a simpler process to obtain research and development tax deductions and a shorter wait to receive export rebates. China’s central bank, the People’s Bank of China, pledged to steer more financial resources towards the private economy, including extending debt financing tools to firms that requested broader bond financing channels.15
Whether these measures and policy statement suffice to restore the confidence of the private sector remains to be seen. Without such confidence, a strong rebound in the economy is hard to imagine. Since the onset of “reform and opening” in 1978, the private sector has steadily become the mainstay of China’s economy. According to government sources, it now contributes about 50% of the country’s tax revenue, 60% of its GDP, 70% of its technological innovation, and 80% of its urban employment.16
Officially, China has recognized the importance of the private sector since former President Jiang Zemin articulated his “three represents” theory in 2000 and the government enshrined private property in the state constitution in 2004. Well before that, former Chinese Communist Party (CCP) leader Deng Xiaoping’s “cat theory” had given the blessing to the private sector after decades of focus on state planning. At the same time, the “basic economic system” considers the public sector to be dominant, so the private sector is acutely conscious of changes in political winds. Many such changes have occurred in recent years, including the crackdown on the technology sector and the potential implications of Xi Jinping’s “Common Prosperity” strategy and “New Development Philosophy.” More broadly, the political changes in Beijing — namely, the growing focus on national security, Xi Jinping’s consolidation of power, and the increasing dominance of Party over government — have created a less predictable environment for the private sector, despite the authorities’ stated objective of “rule by law.”
Boosting Consumption
A second plank in the government’s strategy to counter the ongoing slowdown is to increase domestic demand, particularly regarding consumption. In December 2022, the government issued a strategy for increasing domestic demand, though specific measures have yet to follow.17 Hardly new, this strategy has been integral part of the “dual circulation” approach intended to lessen China’s dependence on foreign demand. That objective dates back to the administration of former President Hu Jintao, when then-Premier Wen Jiabao cautioned that “the biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated, and unsustainable.”
Since then, China’s household consumption has increased as a share of GDP, but only slowly. Rising from 35% in 2008 to 39% in 2018, that share fell back to 38% during the COVID-19 pandemic. This is not only of significance for China: Globally, China’s consumer market is far less important than its weight in world GDP suggests. Whereas China’s GDP now approximates three-fourths of that of the United States, its consumer spending is equal to only 40% of U.S. consumption. Nevertheless, China’s consumption has been growing at a respectable rate, outpacing GDP growth for most of the past 15 years. The question is: Can consumption save growth going forward? And if so, how?
There are two schools of thought as to why consumption is so low in China. One view, promulgated by economists Michael Pettis and Zhang Jun, among others, argues that China’s household share of national income is too low to make consumption a vehicle for growth.18 Others claim that Chinese households are saving too much for a variety of reasons, including a weak social safety net, high costs of education, and high down payments on property. This is not a trivial difference among academics: In order to implement effective policies for economic growth, leaders must interpret consumption patterns correctly.
Compared to the United States, China’s disposable household income as a share of GDP is low — 60% in China compared to 77% in the United States, according to Organization for Economic Co-operation and Development (OECD) data for 2019, the most recent available for China (Table 1).19 This share is not too different from that in the EU (also 60%) and Japan (59%). The main difference between China and the United States is that entrepreneurial income is much higher in the United States, due to friendly tax treatment. Another difference is that Chinese households receive hardly any dividends from enterprises (0.4% of GDP), less than 10% of what households in the EU and the United States receive. Finally, China’s statistical bureau underestimates imputed rents (the amount of implicit income an owner-occupier receives from not having to pay rent). This could add as many as four additional percentage points of GDP in disposable income — and, by definition, the same amount of consumption.