What’s driving China’s economic weakness?

After a highly anticipated reopening, China’s economy should have been back with a bang this year. So far, it has been more of a whimper. Gross domestic product growth (GDP) growth slowed to an annualised rate of 3.2 per cent in the second quarter – far below the government’s (unambitious) growth target of 5 per cent. Things look even worse when you consider that the base effects from last year’s Covid disruptions should have flattered this year’s figures. 

Retail sales growth has crumpled to 2.5 per cent, while the unemployment rate has reached 5.3 per cent. Youth unemployment stands at 21 per cent, although analysts report that the National Bureau of Statistics will not publish further releases amid a “recalibration” of its methodology.

Then there is deflation to contend with: Chinese consumer price index (CPI) inflation declined by 0.3 per cent in the year to July. Although the figure moved back into positive territory in August, and part of the drop was due to temporary factors – analysts single out lower energy and pork prices – some of the drivers are more worrying. Pimco economist Tiffany Wilding notes that falling prices for household furnishings, equipment and routine maintenance all reflect the fact that the Chinese property sector continues to struggle.

All the while, concerns mount that beleaguered Chinese property companies will struggle to meet debt repayments, leaving thousands of unfinished apartments – bleak news for the owners who have already taken out mortgages on them. Year-to-date fixed asset investment undershot expectations last month at 3.7 per cent, reflecting this deepening property investment slump.  

Pandemic legacy lingers 

China’s reopening may have underwhelmed, but it is worth stressing how different it has been from our own. Western economies re-emerged from the pandemic facing a heady mix of excess demand and constrained capacity, which contributed to spiking inflation rates. By contrast, China – the world’s manufacturing hub –  is currently battling excess supply. 

When global goods demand surged during the pandemic, Chinese factories invested heavily in expanding capacity to meet demand. But as the Chinese economy reopened, global consumption patterns started to return to normal. According to Julian Evans-Pritchard, Capital Economics' head of China economics, “the recovery in domestic demand has been too modest to absorb the additional capacity created by the decline in foreign demand”. Chinese companies are now slashing their export prices, which is having a knock-on effect on domestic prices.

Some economists also question whether the length and severity of Chinese pandemic restrictions have exerted a lasting impact. Meghnad Desai, emeritus professor of economics at the London School of Economics (LSE), said last month that “the controls required during the pandemic were overextended”, making it harder for the Chinese economy to bounce back. In an article written for think tank The Official Monetary and Financial Institutions Forum, he noted that president Xi Jinping has acted to “restore physical controls and change the nature of the Chinese economy, particularly during the Covid-19 pandemic”. 

Signs of structural decline? 

There are more structural issues to worry economists, too. China faces some of the same challenges as many advanced economies, including slumping productivity and an ageing population. But the economy also faces a host of less familiar problems.

Analysts highlight slowing rural-urban migration levels, a policy focus on party control and national security and the pernicious impacts of fracturing global trade links. After all, being the world’s manufacturing hub isn’t much good if no one wants to buy your goods. July data revealed that China’s exports had fallen 15 per cent on a year ago, undershooting market expectations. Exports to the US fared even worse, slumping by 23 per cent. 

These longer-term problems could have a profound impact on growth. According to Nicholas Lardy, an economist and senior fellow at the Peterson Institute for International Economics (PIIE), structural challenges mean that “China’s growth will not return to anything close to the dazzling pace of 1980-2010, when annual growth averaged close to 10 per cent”. Even this year’s 5 per cent growth target looks as though it will be a stretch (see chart). 

…or just a bump in the road? 

But structural problems alone don’t explain today’s economic malaise. Richard Flax, chief investment officer at digital wealth manager Moneyfarm, noted to the IC that “China faces a combination of cyclical and structural issues”. More immediate issues such as weakness in the property sector and its impact on sentiment and on local government financing are significant.

So we might be too quick to diagnose the Chinese economy with a case of terminal decline. 

According to the PIIE’s Lardy, the idea that China’s growth has been “gripped by a severe cyclical downward spiral that will persist for several years” could be overdone. In an August article, he said that import data signals increased domestic demand, while rising personal incomes and a falling savings rate could mean higher household consumption growth ahead. He concludes that a fragile economic recovery “may have begun”. 

Marty Dropkin, head of Asia Pacific equities at Fidelity International, also thinks that “China’s growth story remains intact”. In a late August note, Dropkin said that “certain sectors and companies are more resilient than broad macroeconomic indicators suggest”, adding that “the country remains a fertile ground for investment over the long term, driven by an expanding middle class, rising incomes and technological innovation”. 

Crucially, he added that the Chinese government has previously “shown its commitment to instilling investor confidence and supporting the economy with continued and wide-ranging measures”. This “suggests a potential floor for market weakness and prospects for recovery”. But how far policymakers will go to bolster the Chinese economy this time round remains a huge unknown.

The case for targeted measures 

Tackling the property meltdown seems an obvious place to start. Policymakers have so far made some efforts to bolster the market by loosening down-payment requirements and reducing existing mortgage rates. It is not clear that this will be enough. 

In August, analysts at Société Générale said that “at this point, any solution short of a bailout of large developers might still fail to stabilise housing anytime soon”. They added that a central government-backed consumption stimulus measure might be necessary in order to revive demand quickly. Moneyfarm’s Flax thinks “policymakers have a pretty good track record in terms of managing economic challenges”, including stimulus packages focused on investment and real estate. 

But the Chinese government faces a dilemma familiar to policymakers everywhere. Capital Economics’s Evans-Pritchard thinks that “policymakers appear concerned that their traditional policy playbook would lead to a further rise in debt levels that would come back to bite them in the future”. Moneyfarm’s Flax told the IC that “it may be that Chinese policymakers would rather focus on making structural improvements to the real estate market, rather than simply throwing more money at the problem”. 

Matters are complicated by the fact that the Chinese government must balance a short-term growth target with a long-held desire to change the fundamental drivers of economic growth. According to Fidelity’s Dropkin, more targeted economic support aligns with plans to shift the economy away from infrastructure and property, and towards manufacturing and consumption. He said that “stimulus is unlikely to arrive in substantial scale” as a result. 

Are policymakers doing enough? 

Yet the costs of inaction could be huge. Pimco's Wilding says “the risk of more pronounced deflationary pressure depends crucially on the government’s policies in the coming months”. This increases the risk of the property ‘bubble’ bursting, unleashing a crash on the same scale as the crisis that faced Western economies in 2008. In the UK, this episode saw the Bank of England (BoE) cut interest rates to near-zero levels, and triggered the first tranche of quantitative easing (QE) in 2009. This raises an interesting question: would Chinese policymakers use the same playbook? 

It seems unlikely. In late August, the People's Bank of China lowered its key one-year prime rate, but only by 0.1 percentage points – leaving the rate at 3.45 per cent. The five-year loan prime rate, to which mortgage rates are pegged, remained unchanged at 4.2 per cent. The LSE's Desai speculated that there might be some “inner party debate” about the merits of QE and loose credit policies in general. He added that “it may be Xi’s orthodox attitude that is slowing the economy down as monetary expansion is lacking”.

Evans-Pritchard said that although wider stimulus efforts finally seem to be gaining momentum, the economy is still facing some “major challenges”. Although moves to shore up the property sector could improve confidence, especially in the housing market, the impacts are hard to predict. He added that if the latest measures can bring back enough deferred demand “then they could kick off a modest cyclical recovery in home sales and wider economic activity”.

But expectations for economic growth remain underwhelming. Barclays forecasts an expansion of 4.5 per cent this year, as “growth drifts further away from target”, while TS Lombard expects sub-5 per cent growth throughout 2024. This would be a triumph for many advanced economies (as the second chart shows), but for China, it will prove a sharp shock.