A woman sits at a bus station in Beijing on December 15. China’s growth prospects are dim not because of its changing demographics, but because its investment-led growth model has run out of steam. Photo: EPA-EFE
Beijing is ditching its zero-Covid strategy. The move should halt the contraction of China’s economy from numerous lockdowns. But the economic headwinds that existed before the pandemic remain.
Only profound structural reforms can reverse China’s growth trend, and Beijing is unlikely to pursue such reforms. It will instead go down the path of least resistance and deal with the fiscal and debt crises piecemeal along the way.
Phasing out zero-Covid isn’t a strategy to end the pandemic. It’s a recognition of the policy’s ineffectiveness and an attempt to converge China with the rest of the world. As the Chinese population lacks the immunity that others have built up in the past three years, it still faces massive waves of infection to catch up.
China’s pandemic will then resemble that of other countries. In the meantime, people are shying away from social gatherings, which will keep the service sector depressed for the foreseeable future.
From a cost-benefit perspective, zero-Covid was a good choice in 2020. But as the virus became more transmissible and less virulent, right before the Shanghai lockdown, it stopped making sense. During the past eight months, China has wasted trillions of yuan and antagonised the population by sticking with an unworkable policy. The silver lining from this tragedy is that China’s political system has shown its flexibility in making a U-turn under popular pressure.
Still, China’s real economic challenge is that its investment-led growth model is running into severe diminishing returns. For a decade, the interlinked property bubble and an undervalued exchange rate subsidised capital cost. The low or negative real interest rate due to an undervalued exchange rate partly offset declining return on fixed investment.
People ride the train in Beijing amid a rise in Covid-19 infections, on December 19. Photo: AFP
Property sector revenue, accounting for around 10 per cent of GDP, provided local governments with cash for direct subsidy in capital formation. Local governments offered free land, and sometimes built factory buildings and paid for equipment to entice investors. Such distortions came at the expense of a declining share of consumption in GDP and rising household debt.
Nowadays it is popular to point to demographic trends in China as a reason to be bearish on its growth. This is just wrong. China’s growth engine is closing its productivity gap with that of the developed world. Three decades ago, China’s per capita GDP was less than 5 per cent of the latter. Now it is one third of Europe’s and Japan’s and one fifth of that of the US.
Of course, the gap is still very large. Growth comes from identifying system inefficiencies. Japan, South Korea, and Taiwan have all climbed the income ladder to the top. With greater economies of scale, mainland China is well positioned to do the same and some.
China’s deflating property bubble signals the end of the subsidy-based investment-led growth model. Obviously, to revive growth, the economic model needs to lift efficiency, so that investment makes up a smaller share of GDP and consumption a larger one. Yet so far, China has not shown a desire to change course. That is the reason its growth will be low in the coming years.
In addition to the structural bottleneck, a looming global recession may shut the only engine of growth: exports. Despite a four-year trade war, a chip embargo, and talk of reshoring, China’s export machine has kept humming. Only the zero-Covid lockdowns have dented it. Therefore, export performance is likely to improve quickly in the coming months.
However, the global economy is facing a prolonged inflation challenge, owing to a monetary overhang from quantitative easing measures rolled out during the pandemic. Removing the excess money supply will lead to a global recession, especially in Anglo-Saxon economies and the EU.
That recession is likely to be the longest in four decades. Global trade may stagnate or contract. The Chinese economy would struggle to generate growth in such a global environment.
The shadow from a deflating property bubble looms large over China’s financial system. Local governments would resort to squeezing businesses to keep them afloat. This represents a potential flashpoint between the rulers and ruled. The solution would be to shrink the government in most cities, an unlikely prospect.
Property developers have struggled to pay off debts amounting to tens of trillions of yuan. Though they can get creditors to agree to extending payment timelines, these loans are non-performing. Extending the date for repayment can be good only if the property market returns to peak form, which is not a realistic prospect. As such, most of the non-performing loans will need to be written off.
The financial system can’t function properly under such an ominous shadow. It’s likely that the government will keep the system going by defining more and more liquidity carve-outs, like special tranches for finishing pre-sold projects.
There could also be new tranches for nearly finished projects, or critical urban projects. Basically, the financial system could function on administrative edicts. But it won’t be efficient.
Residential buildings under construction in Beijing on December 16. Beijing has offered some support to struggling property developers to complete pre-sold homes. Photo: Bloomberg
The failure of developers to pay their debts affects millions of savers who have bought wealth management products in the shadow banking system. Desperate savers may resort to protests to get their money back.
The government’s main strategy for handling this is to convince people that they will get paid in the future. Yet only the most insistent will get some money back, as the government tries to balance funds and social stability. Angst among savers represents another flashpoint.
China’s reforms are crisis-driven. Time will surely slow them down and may even reverse them, yet the sluggish growth trend is likely to continue until some sort of blow-up.
One trigger could be a total collapse of global trade. That would force the authorities to make the domestic economy work. It will get worse before it gets better.
