China: The giant with clay feet

Since the reforms and opening up began in 1978, China has had the benefit of a fast-growing economy on its side. The country was coming from such a low base, and its vast market had so much potential, that its leaders from Deng Xiaoping to Xi Jinping did not have to do much, besides get out of the way, to achieve impressive economic growth. Cyclical slowdowns, even severe ones, were always followed by a return to rapid expansion.

Unfortunately, the figure Xi Jinping has become gradually darker as he came to the ways of Mao Zedong as president, whose radical policies led to moments of crisis and great suffering for the Chinese people, such as the "Great Leap Forward" from 1958 until 1961, and the "Cultural Revolution" from 1966 to 1976, would resonate in Chinese politics and society for decades to come. We can review what happened, as a small example, at the recent 20th Congress of the Chinese Communist Party with the reaffirmation in perpetuity of Xi Jinping as president of the Red Giant, where the new club of seven is made up entirely of allies or loyalists of Xi Jinping and has seen political loyalty triumph over merit as a criterion for promotion, as well as witnessing the public purge of his predecessor Hu Jintao.??

President Xi has been more focused on controlling and repressing the so-called “insurgents” than on implementing social and economic policies that would favour China's economic growth while clinging to keeping the country confined even generating social unrest in the face of the incomprehension of a government blinded by the "Zero-COVID" policy that during this year 2022 has plunged the country into an unprecedented crisis.?

Will the end of China's Zero-COVID policy lead to a rebound in its economy in 2023??

Some economists believe so, and predict a solid recovery of the world's second-largest economy. The challenges and the way it tackles its government and economic policy will be crucial to convince governments, foreign investors and multinationals to be optimistic and believe once again in the Chinese miracle.?

However, storms of uncertainty are gathering on the Chinese economic horizon, which is why this reflection on China's growth prospects is worthwhile, in an attempt to avoid the apocalyptic vision that some media, especially American media, are trying to sell about the collapse of the Asian giant, even though, and several economists and statisticians agree, not even the best COVID endgame is unlikely to deliver a rosy 2023. While GDP growth above 4.5% seems reachable at first glance, the more one looks at the assumptions needed to achieve that level of expansion, the less realistic it seems.?

It is very difficult to predict what the future holds, especially in economic matters, in an optimistic scenario with GDP growth of about 4.5% or in a pessimistic scenario with a very low growth of 0.5%, is within the realm of possibilities. If Beijing starts crucial, long-deferred structural reforms in earnest, growth between 1-3%, in 2023 and over the medium-term, would be a reasonable expectation.

2022 in Review

Many analysts assumed that China would deliver its stated GDP growth target of “around 5.5%” in 2022. But both the downturn in the property sector and the draconian lockdowns of its Zero-COVID policy, while the rest of the world was opening its doors to "normality", have been a serious drag on China's economic expansion this year. As early as June 2022, reality had shown that the growth target set just three months earlier was already out of reach. Premier Li Keqiang then rushed to adopt pro-growth measures in an attempt to rush out pro-growth measures to prevent an economic contraction in the second quarter.?

Preliminary GDP data for 2022 will not be released until late January, but for the first three quarters, growth was reported to average 3% on an annualized basis, supported by modest increases in household and government consumption (+1.2%), business investment (+0.8%), and net exports (+1.0%). Some questioned whether this was an accurate reflection of the actual performance of the economy, but for the sake of fairness, let us accept this growth figure as real.

Given the serious worsening of economic conditions at the end of the year due to the Zero-COVID policy, which was extended until the end of the 20th Communist Party Congress in October to ensure stability, before being abruptly abandoned in December after the outbreak of social protests mainly in Shanghai over the lockdown measures, however, the results for the last quarter and for the year are likely to be lower than those observed in the first three quarters.?

In terms of household consumption, retail sales fell by 0.5% in October and again by 5.9% in November. Government spending is difficult to proxy but there is little reason to expect it to offset depressed household activity. If we conservatively assume a 2% contraction in fourth-quarter consumption, similar to what we saw in Q2, we could expect a full-year GDP contribution from households and the government of around 0.8 percentage points.

The lockdowns at the start of Q4, and the rampant spread of COVID thereafter, impaired business investment activity. New property starts plunged by a record 49.7% in November, and completions fell 18.3%. Industrial output fell for construction-related products, including cement (-3% y/y), asphalt (-7%), and UPR, a chemical used in roofing and piping in real estate construction (-39%). Given these indications, China will be lucky to report another 0.6 percentage points of GDP growth from investment for the full year of 2022.

China’s net exports (exports minus imports, the external component of GDP by expenditure), rose to an all-time high in 2022, above what was already an epic level in 2021. This surprised many analysts, who assumed there was nowhere to go but down. But by late in the year, with a global recession in the air because of rising global interest rates and inflation, the trend for China’s net exports finally turned. At best, there may have been a modest increase in the fourth quarter, resulting in a maximum contribution of net exports to 2022 GDP of 1.1 percentage points. However, it is just as likely that exports have been overstated this year by 10-15%, as companies inflated them in order to claim export tax rebates.

Put together, the official data and our observations of fourth quarter performance suggest full-year 2022 GDP growth of about 2.5% or 2.7% if we believe the IMF's proposal, with numerous reasons to suspect that the real performance was even weaker. In fact, the economy is likely to have grown by less than 2%, and possibly not grown at all.

2023 Outlook

With a 2022 baseline to work from, we can look ahead to 2023. While the zero-COVID millstone around the neck of the Chinese economy will be cast off over the course of the year, the sudden, chaotic way in which pandemic policies have been changed means that growth will be hampered in new ways. Importantly, the economic headwinds that are unrelated to COVID are likely to persist or even worsen. We look at each in turn.

Investment

Diminishing property sector investment will continue to be the main structural drag on growth in 2023. New construction starts, which presage the volume of real estate activity to come, fell by 44%, 36% and 50% in September, October, and November, respectively.?

Yet even after the 2022 downturn, property is still running too hot for underlying real demand. We estimate a “sustainable level of demand”—a level consistent with buying houses to live in, rather than for speculation—at 550-750 million square meters annually. China’s annualized housing sales are still at 1.24 billion square meters after peaking at 1.73 billion in June 2021. To reach sustainable levels, construction will need to continue contracting at the current rate for four to six more quarters.

This is difficult to achieve considering the safest and most productive way of investment in China is to buy a house, which is also part of its own idiosyncrasy.

Infrastructure investment is likely to be a drag as well. Local governments are under financial pressure due to declining revenue from land sales. Local government financing vehicles—LGFVs, the primary mechanisms for implementing infrastructure projects—are in the midst of a credit crunch, and are likely to see defaults in 2023. Policies have been geared toward reducing the number of low-return investment projects, though rules were loosened somewhat in April 2022. Policy bank lending has been used to close the worst gaps, but these spigots cannot match last year’s 1.4 trillion yuan in quasi-fiscal lending. Put together, these constraints mean that infrastructure will probably be a modest drag on growth in 2023, rather than a positive.

Finally, it is hard to imagine private sector investment—in new factory lines or retail spaces, for instance—driving growth given the current COVID-19 chaos and ongoing confusion about the state’s attitude toward market forces. Private firms often take their cues from foreign consumers rather than Beijing. The IMF expects global trade growth to fall from 5.5% in 2022 to 3.8% at best in 2023, or as low as 1.2% in a global recession scenario. Under these conditions, China’s export-oriented manufacturers will be wary about investing in new capital stock and facilities.

In typical pre-COVID years, the investment would contribute between 2 and 4 percentage points a year to China’s headline GDP growth. Given the headwinds buffeting the investment climate in 2023, China would do well to match or slightly exceed last year’s pace, wringing out ? to 1 percentage point of additional investment growth, at best. A deeper property contraction, local government financing vehicle defaults, or a bigger hit from a slowing global economy could easily lead to a weaker investment or a drag on GDP growth of 0.5 to 1 percentage point.

Net exports

Exports were an important growth driver for China during the pandemic. In pre-pandemic years the contribution of net exports to GDP generally ranged between -1 to +1 percentage point, but net exports contributed 1.7 percentage points to growth in 2021, propelling the nation to reported growth of 8.1% in that year. With China enjoying a record trade surplus, net exports will probably account for one-third of 2022 growth.

But in 2023, we can expect external demand to be weaker. In addition to weaker global conditions, policy confusion at home is likely to hamper export performance. Manufacturers had developed “closed-loop” systems to keep employees isolated from the virus. Now, in a rush to get past lockdowns, there are reports of employees with COVID being told to come to work. In a chaotic environment of high infections and worker absenteeism, it is realistic to expect production to be hampered for a substantial part of 2023.

For net exports to contribute to 2023 growth, an already historic surplus would have to expand further despite these conditions. In theory, this may be possible, but we consider it unlikely. Perhaps if China’s terms of trade shifted heavily in its favour—with import prices for oil and other commodities falling and export prices holding up—an additional 0.5 percentage point GDP contribution from net exports might be possible. However, it is more likely that China’s export growth continues to slow and net exports act as a drag on the growth of about 0.5 percentage points.

Consumption

In GDP accounting, total consumption demand is made up of two sub-components: household and government spending. The biggest wildcard for overall growth in 2023 is household spending. Households were heavily constrained in 2022 due to lockdowns and travel restrictions, and hopes for a consumption rebound in 2023 hinge on a surge of pent-up demand being unleashed in response to the zero-COVID exit.

But there are several reasons to be cautious about a surge in consumer demand in 2023. Households are putting money into savings at record levels, particularly in time deposits with 3 to 5-year maturities that are expensive to redeem in the short term. Unemployment rates among workers aged 16 to 24 reached nearly 20% earlier this year and are still high at 17%. The global slowdown is likely to affect employment in China’s export-oriented manufacturing sector. China’s property sector slowdown will continue to hurt job prospects in construction and related sectors, affecting employment and income. The government is trying to stabilize expectations about property values, but housing prices in the less-regulated secondary market are already falling in Tier 2 and Tier 3 cities. Falling home values typically weigh on the propensity to consume, because a substantial share of household wealth is tied up in real estate. In this way, China faces growing deflation risks as demand is crumbling under the weight of an ongoing real estate crisis in contrast to other major economies.

A rebound in consumer spending in 2023 would require a successful rollout of consumer stimulus measures, but Beijing has few tools at its disposal to achieve that. Individual income taxes are already very low, at around 1% of GDP. Tax breaks on autos and subsidies for rural purchases of durable goods are already in place. One possibility is consumption coupons, though prior programs have been limited in scale. More widespread deployment of coupons would require both new programs taking advantage of ubiquitous digital payment platforms like WeChat and a major paradigm shift away from a supply-side-focused stimulus.

Household consumption growth approaching pre-pandemic trends would mean a 2 percentage point contribution to 2023 GDP growth. An outcome between 2022 levels and pre-pandemic trends would be closer to a 1 percentage point contribution.

Government spending is constrained by the same fiscal headwinds that are undermining infrastructure investment: weak local government revenues from taxes, fees and land sales. A return to pre-pandemic “normal” would mean a 1 percentage point contribution to 2023 GDP growth from government spending, while a continuation of the constrained government spending growth seen in 2022 would result in a 0.5 point contribution at best. As 2022 comes to an end, government budget deficits are hitting record highs. In that environment, more debt is not a prudent solution. But local government obligations have nowhere to go but up, as they are forced to assume “quasi-fiscal” debts run up by nominally private, but in reality state-directed, LGFVs.

Several organisations and economists are predicting growth levels I think may be true if all goes well for China, hence the need to establish a range of GDP growth that will oscillate significantly depending on the policies adopted by the Chinese government and by the rest of the financial players, both local and foreign.?

The era of the Chinese slowdown

China’s highly restrictive COVID policies played an important role in its weak economic performance in 2022, and the end of these policies should provide a boost once disruptions associated with the rampant spread of the virus begin to ease. But zero-COVID was just one of many brakes on growth, and the others will not vanish with a wave of Beijing’s policy wand.

Demographics are a persistent, long-term drag. The National Bureau of Statistics (NBS) reported a population growth of only 480,000 people (+0.03%) in 2021, meaning China’s demographic peak has arrived. The working-age population has been declining for several years, with fewer young people entering the workforce and more people retiring. Moreover, there are serious concerns about the educational preparedness of tens of millions of young, rural Chinese who are entering a 21st-century economy.

After a decade of credit-fueled growth, China’s financial system has reached its limits. Banks are saddled with a decade of unrecognized non-performing loans that must be rolled-over year after year. As that pool has grown, banks have had to employ an ever larger share of new credit to keep the engine going at the same speed. Unable to grow its way out of these liabilities, China must gear up for a wave of new financial risks, which will test the credibility of the country’s technocrats.

Productivity growth should be a driver of economic expansion at the middle-income stage in which China finds itself. But the wellsprings of productivity are not flowing as they used to. The economic reform agenda has stalled or shifted into reverse in some areas. Beijing continues to push expensive industrial policy programs with little to show for them in terms of productivity or self-reliance. Private sector and foreign firms are increasingly wary of regulatory directions and ideological signals.

As China’s leaders consistently point out, external conditions are becoming more challenging as well. Geopolitical headwinds are constraining China’s access to foreign capital, markets, technology, and talent. Permissive access to foreign consumers has allowed China to achieve economies of scale and scope in the past. This is changing, especially in important sunrise sectors. Rather than add to China’s growth, the external dimension may increasingly act as a drag.

Finally, China faces formidable challenges related to climate change. While the green transition will affect all developed and developing economies, China’s reliance on heavy, carbon-intensive industries makes its burden heavier than most.

Given the stack of structural constraints that China faces, adjusting expectations for 2023 and beyond is necessary. Lower expectations are critical to re-establishing credibility and justifying painful, but necessary policies to shore up China’s economic potential. Slower growth is the new normal for this decade. Lower but sustainable growth in the 3% range per year would still amount to $600 billion in additional output annually. That best case long-term growth rate is substantial and it is achievable. While it requires sacrifices and concessions to the need for political and market reforms in the near term, it would mean less sacrifice down the road. The reform work involved is not new to Xi Jinping or the Party, nor is a tough period of adjustment. Acknowledging lower growth potential in 2023 would be a signal that China is ready to get started today.