8. What are the core challenges facing China’s economy?

Key Point Summary

• Despite optimism as restrictive COVID measures are lifted, China’s economy faces a number of structural challenges that could dampen its growth in the long term. These include high debt, an inflated real estate sector and a declining working age population.

• Governments must assess what a slowdown in China’s economy would mean for their own domestic economies. Scenarios include a weakened Chinese consumer market, inflationary pressures and exposed financial assets.

• Commodities, luxury goods and higher education markets could all be impacted by a reduction in Chinese demand. Depending on the implementation of “common prosperity” plans, Chinese government stimulus packages could lead to inflationary pressures on Chinese-made goods.

• Businesses and investors can mitigate against these risks by avoiding high levels of dependence on the Chinese market. Governments can support businesses in these initiatives by strengthening trade and investment ties with alternative markets in the region.

What are the structural challenges to China’s economy?

China’s economy is set to rebound this year following the lifting of the country's severe COVID-19 restrictions. Many analysts predict that China’s economy will expand by roughly 5% this year. However, the fact remains that China’s economy still faces long term structural challenges that present difficult trade-offs for China’s policymakers. How the Chinese government chooses to navigate these problems will have ramifications worldwide.

Unsustainable Debt Levels

China’s levels of debt relative to the size of its economy match or surpass levels in much of the West. China’s non-financial sector debt was believed to be near 300 percent of China’s GDP in 2022. While wealthier countries can sustain higher levels of debt, China is not a high-income or developed economy. Yet in recent decades, China’s economic growth has depended on quickly rising levels of debt. During the pandemic year of 2020, for every 1 yuan increase in China’s GDP, China’s aggregate financing — a measure that roughly approximates total debt levels— grew by about 12 yuan. Eventually, extremely high debt levels may force a decrease in infrastructure and real estate investment, the key drivers of China’s growth in the last decade, and may even force a decrease in consumer and other government (especially local government) spending in order to stabilise debt levels.

Low Consumer Spending

China’s recent household consumption as a share of GDP is, by official counts, among the lowest ever seen in modern history for a major economy — even lower than reported levels in the US or Britain during the peak of World War II rationing. China must raise household spending if it is to stimulate sectors such as retail, healthcare, entertainment and other consumer services that can propel new growth and reduce debt pressures. Meagre wages for many workers, low state health and pension provision, uncertainty over the future security of wealth (much of which is stored in real estate) and high education and housing costs for children means many families are reluctant to spend their savings.

Sector Imbalances

Imbalances in China’s economy are most visible in the real estate sector, which contributes a quarter to a third of China’s economic activity. Yet much of this newly-developed real estate is not inhabited and has no sustainable market demand. Its construction raises debt and ties up China’s labour supply and financial markets, reducing the resources available for more efficient enterprises. Meanwhile, in many cities, house prices have become unaffordable for young Chinese people. There are no easy ways to resolve these imbalances. Curbing construction threatens the many workers and businesses that rely on real estate activity, while curbing prices threatens the balance sheets of innumerable businesses and the wealth of millions of Chinese savers, whose confidence and consumer spending could collapse alongside their house values.

Demographic Challenges

China’s working-age population has been in decline since at least 2013, and in January 2023, China’s statistics bureau announced that the total population had declined for the first time since the end of the Great Leap Forward in 1961. When Japan’s economic growth reached a precipice around 1989, 11 percent of Japanese were aged 65 or older. Today, 14 percent of Chinese are 65 or older, a share that could surpass 25 percent in the 2030s. Despite the relaxation of policies restricting births for Han Chinese, China’s fertility rate has fallen to 1.2 or less, below rates in rapidly ageing Japan and Russia. Unlike Japan, China still experiences substantial emigration of its citizens, estimated by the World Bank at 300~400,000 people per year. Many of the emigres are younger and better educated than the wider population. Thus, China’s labour force is shrinking, and becoming older and perhaps less dynamic, without showing any signs of improving. This shift will increase costs for China’s workers to take care of dependents, could add stress to industries that rely on large numbers of workers, and could leave an economy that is less entrepreneurial, risk-taking, or innovative.

These economic challenges take place within a worsening external environment. Deteriorating relations with its neighbours and the West constrain China’s opportunities for reviving growth through new export markets or foreign investments targeting higher-productivity sectors. China’s recent drive for industrial self-sufficiency also could hurt its trade relations and industrial efficiency, and raise costs at a time of already very high debt levels.

Could China face a major financial crisis?

China’s structural economic challenges do not mean it is on the brink of financial collapse. In most free markets, financial crises can erupt suddenly, giving governments and investors little time to react. In contrast, China's government already controls most banks and has more tools at its disposal to counteract a developing crisis. The Chinese government can not only leverage a large amount of state-controlled capital, but also has greater powers of repression – such as suppressing information or forcing firms to buy or sell. This does not guarantee that China will avoid a financial crisis, and this does not mean that China’s economy or financial system will be fundamentally healthier. Debts for bad investments still must be cleared in some way, but there is a high chance that China’s government can stop a large banking or bankruptcy crisis from breaking out.

What will be the global impact of China’s slowing growth?

A slowdown in China’s economic growth could filter to other countries through trade and financial flows. Dampened growth could lead to a number of scenarios with knock-on consequences for other economies.

Reduced Consumer Demand

Despite large overall trade figures, especially for intermediate-stage production, China is a major end user for a relatively narrow range of foreign-made goods and services. Among goods, these include luxury products such as high-end cars and designer clothing, and commodities, such as the coal and iron ore needed for China’s real estate and infrastructure boom over the last twenty years. Among services, the most prominent is higher education, particularly in Britain, the US, Canada, and Australia. These sectors could be hurt the most by stagnating or declining Chinese consumer spending.

Increased Manufacturing Competition

As China’s economy slows, China’s policymakers may seek to boost growth through increasing export levels. This may be achieved by substantial new industrial subsidies or by measures to keep wages low, which will in turn reduce household consumer spending. Such industrial support would likely be directed toward “cutting-edge” industries like electric vehicles or renewable energy equipment, seeking to undercut rival foreign firms. Therefore, a Chinese growth slowdown should not be treated as an omen of lightened competition for foreign manufacturers in the years ahead.

Inflationary Pressures

On the other hand, China’s policymakers may seek to jolt the economy out of its low-consumption malaise through redistributive policies like consumption vouchers, increased social security spending, or pressure on businesses to raise wages. These kinds of policies can be seen in the Chinese government’s ‘common prosperity’ plans. However, increased wages would almost certainly increase prices for China’s exports. Much of the West has experienced falling consumer prices over the last twenty years in part thanks to the boom in China’s low-wage manufacturing. A change in China’s economic policy framework in response to growing economic challenges could increase inflationary pressures and reduce the purchasing power of the West’s consumers.

Exposed Financial Markets

Given Chinese authorities’ restrictions on foreign ownership of businesses and assets, Western financial institutions generally have a limited direct exposure to Chinese financial markets. This exposure has risen steadily in the last decade and varies between firms, with J.P. Morgan and BlackRock taking full ownership of Shanghai subsidiaries in 2021 and several other Western firms following their paths. While the risks to the West’s overall financial system may be low, there can still be risks for particular investors with larger stakes in China-based or renminbi-denominated assets, offshore-listed equities of Chinese firms, or Western firms (such as iron ore miners) whose profits depend on China’s infrastructure and investment spending.

Recommendations

While China will continue to present a significant trade and investment opportunity for the foreseeable future, governments and businesses must take steps now to mitigate against the risks posed by the structural challenges in China’s economy.

• Reduce reliance on China’s market. Businesses in industries reliant on high levels of demand from China must seek to diversify their customer base to mitigate against the risk of reduced demand. Commodity markets could be hit by reductions in China’s infrastructure spending, while higher education and luxury goods could be impacted by a reduction in household disposable income.

• Diversify investment portfolios. Investors that are highly reliant on China based or RMB denominated assets should seek to diversify their portfolios, as should those investing in industries whose profits depend on high levels of infrastructure spending in China. Governments should review levels of financial support and investment guarantees to private companies investing in China in light of these risks.

• Access new markets. Governments should seek to deepen trade and investment partnerships with actors in the Indo-Pacific Region, to provide viable alternatives to firms looking to diversify markets away from China. This can be achieved through joining regional trade initiatives such as the CPTPP, funding for trade offices in the region, and greater support for new infrastructure projects and market reforms in South and Southeast Asia.