Is China’s Economy Broken?

Summary

• Recent stimulus measures are struggling to support China’s slowing economy, raising growing doubts over their effectiveness.
• China’s strict zero-Covid policy, power outages and droughts could be to blame in the short term.
• However, China also has deeper structural problems such as income distribution and a low consumption rate that hinder stimulus efforts, according to expert Michael Pettis.

Market Implications

• We are bearish on the Chinese economy and CNH as short- and long-term issues continue to slow growth.

Little Response to a Lot of Stimulus

Cracks continue to appear in China’s economy, with GDP growth seen slowing to 3.5% in 2022. Factory activity is down two months in a row, export growth slumped in August, and even consumer inflation – which has plagued the US and EU this year – came in weaker than expected as lockdowns inhibited spending.

To support the flagging economy, China’s State Council announced another round of stimulus measures in August. The 19 new policies included increasing quotas for infrastructure spending and investment by policy banks by CNY300bn, bringing the total allocated financing to CNY1.1tn since June. These stimulus efforts follow several supportive policies, including a surprise 10bp interest rate cut from the PBOC in mid-August and a 33-point package in May that included tax cuts and rebates.

Yet the response from iron ore and steel markets – previously beneficiaries of real estate and infrastructure growth – has been underwhelming. And on 8 September, Premier Li Keqiang called for further efforts to fix the ‘key problem of insufficient demand’, including ‘multiple measures to stabilize growth, employment and prices’.

In this article, we turn to our archives and resurface a podcast from 2020 with Peking University Professor of Finance Michael Pettis to explore the longer-term, structural issues with China’s growth model – and learn why further stimulus may fail to support it.

Triggers and Causes

Explanations for the slowdown mainly focus on short-term causes such as recent power outages, a deepening property crisis, and the country’s strict zero-Covid policy. Some 35% of Chinese cities are now in lockdown – more than at any time since the early months of the pandemic. As Navigate Commodities Managing Director Atilla Widnell argued, ‘construction and infrastructure markets know that unless the Chinese economy opens properly, stimuli would not do much to alleviate slow consumption and activity on the mainland.’

Indeed, many of the recent stimulus measures target such short-term issues. To secure energy supply, the State Council announced government-run power generation companies will get support to sell CNY220bn in special debt. And the ailing property sector will see city-specific credit policies for local governments to support demand for homes.

However, as Pettis recently pointed out, ‘it is easy to confuse triggers for causes’. And many of the recent issues mask a ‘systemic problem that has been brewing in China’s economy for more than a decade’.

The Underlying Problem

In a Macro Hive podcast episode in 2020, Pettis argued that China’s growth model over the last few decades has been driven by high rates of savings and investments. It is based on precedents set by other development success stories such as Germany in the 19th century and East Asian growth miracles such as Japan and Korea. To free up resources for investment, household consumption is suppressed. However, the resulting growth more than offsets the decline in living standards that comes from lower consumption.

China adopted this model when it began its liberalising reforms in the ’80s. The country has taken the model to an extreme, though, with some of the highest savings rates ever recorded.

Pettis explains that China transferred income from the high-consuming part of the economy – households – to the low-consuming part of the economy – the wealthy, businesses and the government. To achieve this, wages have been suppressed relative to productivity growth, and a weak currency subsidises exporters at the expense of ordinary Chinese consumers by weakening their purchasing power for imports.

The result is a large trade surplus with the rest of the world. Pettis challenges the view that a trade surplus is a reward for a successful economy:

‘The reward for efficiency is that for every unit of exports you can buy more imports. You improve the terms of trade. Export surplus countries are actually suppressing their workers’ purchasing power.’

The Problem With China’s Growth Model

High rates of investment have worked well for China. The country has experienced unprecedented growth for almost three decades, rising from around 1.3% of global nominal GDP in 1990 to 15.5% today.

When catch-up growth is in full swing, productivity gains drive enough wage growth to more than offset the squeezing of household income through financial repression. As a result, developing countries have plenty of investment opportunities. Often, only a lack of capital for investment constrains their growth. By contrast, most developed countries have excess capital. For example, developed nations such as the US and UK receive a large proportion of the world’s savings because of their deep and open markets.

China’s problem is that as it runs out of catch-up growth, the opportunities for profitable investments decline. As a result, ever greater investment has diminishing returns. As Pettis argues, it is not just the quantity of capital that matters but also its scarcity relative to household purchasing power. Without rising purchasing power for households, the opportunities for profitable investment are limited.

‘If you increase the savings rate, which is another way of saying reduce the consumption rate, it actually reduces growth – because if you reduce consumption, you reduce the incentive to invest.’

A short-term solution is to increase household debt to boost consumption without increasing households’ share of national income. The ratio of Chinese household debt to GDP has risen from just under 20% in 2008 to over 61.6% at the beginning of this year. But this strategy of debt-fuelled growth is not a long-term solution, as China has recently discovered with its ailing property sector.

In other words, Pettis says that China does not lack capital; it lacks opportunities to employ that capital. According to this view, then, stimulus efforts that increase investment or demand through issuing debt are only papering over the cracks in the Chinese economy. Until China undertakes deeper structural reforms that give households a greater share of national income, further stimulus will have a muted effect on economic performance.

What Does the Future Hold for China?

In our original podcast in 2020, Pettis argued that this development strategy can end in one of two ways – a debt crisis or a long period of stagnation. For China, he still thinks a debt crisis is unlikely. It has a relatively closed economy with capital controls, preventing a sudden drying up of funding, and Chinese regulators hold a great deal of control. In the medium term, he predicts property prices will keep declining and insolvencies continue emerging as the economy stagnates.

What Are the Market Implications?

• The combination of short- and long-term issues hindering growth underlines our current bearish position on the Chinese economy and CNH.
• Chinese infrastructure stimulus may have limited impact on commodities such as iron ore and steel in the immediate future.
• China’s dependence on finding foreign demand for its products is particularly vulnerable to the growing risk of recession abroad.
• Less effective stimulus will also reduce the government’s ability to prop up Chinese demand, with particularly negative consequences for countries such as Germany that export to China.
• Returns to investments in China may be lower in the foreseeable future.

Matthew Harris is a research intern here at The Hive.