There is very little doubt that the Chinese economy is currently in dire straits. Not only have property prices fallen for two years now, but there are also concerns about the economy entering a period of deflation (or persistently falling prices). A deflationary spiral works in the same way as an inflationary one, except in reverse. As prices fall, households cut back on spending in anticipation of prices falling further; firms cut back on hiring and investments in expectation of future reductions in wages and other costs. Such decisions may be individually rational, but they are collectively irrational as they make deflation a self-fulfilling prophesy.
In contrast to the developed world, which has been grappling with inflation for almost two years now, monetary conditions in China have been eased repeatedly since the end of 2021. But weak household and corporate demand for credit means that a lower cost of borrowing has had relatively little impact on aggregate demand.
Faced with this liquidity trap, the only viable alternative is to rely on fiscal policy to stimulate domestic demand. This would entail not just transfers to households in the short term to boost consumption, but also structural reforms to pensions and health financing in the medium term to reduce the very high levels of precautionary savings in China. One would expect a self-proclaimed socialist regime (that cares about common prosperity) to have no objections to these economically sensible ways of reducing inequality. But such expectations have, so far, been wrong: The Chinese government remains as adamant as ever in resisting calls for more social spending.
China’s current economic malaise is, of course, very similar to that faced by Japan in the early 1990s. A “balance sheet recession” in which firms and households sought to reduce their debts even as interest rates were very low meant that the Japanese state had to compensate for the shortfalls in private demand. What makes it difficult for the Chinese authorities to copy the Japanese model is that public sector debt, at just over 100 percent of GDP, is much higher in China today than it was in Japan at the start of the 1990s.
Seen in this light, Japanification is by no means the worst scenario for China. After all, Japan avoided a financial meltdown and a full-blown debt crisis; growth also resumed after a decade of stagnation.
The reversal in China’s (near-term) economic prospects in the last few months has, quite predictably, led to a chorus of voices declaring the end of the Chinese growth story. But to paraphrase Mark Twain, reports of the demise of China’s growth are greatly exaggerated. Just as China’s rise to become the largest economy in the world was never pre-ordained or inevitable, neither is the end of Chinese miracle a foregone conclusion. Both the China bulls and the China declinists may be wrong.
Three Scenarios for China’s Economy
In thinking about the future, it is always useful to develop a few plausible scenarios. The first is one in which expansionary fiscal policies and social security reforms are adopted, and they succeed in reviving the Chinese economy by transferring resources away from the less productive, state-owned parts of the economy to households and the private sector. Recent investments in green technologies, artificial intelligence, quantum computing, and a wide array of new technologies also bear fruit, putting the Chinese economy firmly on a more productive, innovation-driven path. Over time, higher incomes enable domestic consumption to replace investment and exports as the main engine of growth. One might call this the “China Reinvented” scenario.
The most pessimistic scenario sees the current property debt crisis becoming not just chronic, but reaching an acute, critical point in which rising levels of non-performing mortgage loans cause the financial system to seize up. This leads to a wider, more severe credit crunch, not unlike what the United State experienced in the 2008 financial crisis. While this scenario is unlikely – as the Chinese government controls the major banks and would prevent this “China Meltdown” scenario from materializing by ensuring the availability of cheap credit – it is not implausible.
A third scenario is a “middle” one between the China Reinvented and China Meltdown scenarios that sees the Chinese economy muddling through its current debt problems. Like Japan in the 1990s, China avoids a full financial meltdown. But its economy is not significantly reformed even as segments of the private sector become world-beaters – just as Japanese vehicle manufacturers and electronics producers remained highly competitive and profitable throughout the country’s lost decade.
In this scenario, the successful parts of the Chinese economy are not able to raise domestic demand significantly. The lack of social security reform also means that China’s savings rate remains stubbornly high, and private consumption continues to play a limited role in sustaining growth. One might call this the “Muddling Through” scenario. Incidentally, this is exactly what Japan experienced in the 1990s; Japanification most closely resembles this “Muddling Through” scenario. In my view, this scenario is the most likely.
Why the China Bulls Got It Wrong
Finally, it is worth highlighting why the China bulls failed to see the problems that currently beset the Chinese economy, even though many of these were apparent during (and indeed, well before) the pandemic.
The first is that many China bulls conflated desirability with probability, even inevitability. For many of them, China’s rise was highly desirable not just because it would lift millions out of poverty, but also because it would enable China (and the rest of the Asia) to converge with the developed world. China’s rise would challenge U.S. hegemony, creating a fairer and more just global order. But just because something is highly desirable, that does not make it any more probable, much less inevitable. Conflating desirability with probability usually leads to wishful thinking.
Far too often among China bulls, there is an almost religious fervor attached to the inevitability of China’s rise. A well-known China bull used to say that between the years 1 AD and 1800 AD, China and India were always the two largest economies in the world. The last 200 years of Western domination were therefore a historical aberration. He would then add that that historical aberrations do not last.
There are many things wrong with this line of “analysis,” not least the fact that there is no iron law of history which says that historical aberrations do not last. When it comes to economic development, the more well-known law is “demographics is destiny,” so if one were to subscribe to these supposedly immutable laws of history, one should be terribly pessimistic about China.
The second cognitive mistake of many China bulls is their failure to revise their predictions in light of new evidence. As it became increasingly evident that the zero COVID policy in China was causing long-term harm to the Chinese economy, many analysts at the time highlighted the risks and pitfalls ahead even if China abandoned zero COVID.
For instance, I predicted in early January this year that “while domestic consumption is likely to grow strongly this year, it could be held back by at least two constraints: income growth has been weakened by higher (youth) unemployment and the job losses caused by zero-COVID, and the property sector remains depressed.”
I also pointed out a greater concern: “[W]hether and how quickly the scarring done to parts of China’s supply chains can be repaired. The capriciousness with which the Chinese authorities imposed lockdowns that disrupted delicate supply chains have made many foreign investors more amenable to the idea of moving away from China, even if this entails higher costs.”
These predictions have come to pass. But what took me by surprise at the start of this year was how, in the face of growing evidence to the contrary, many China bulls remained stubbornly wedded to their story that the Chinese economy would come roaring back to life in 2023.
Neither China’s rise nor its stagnation is written in the stars. The Chinese people – and the rest of the world – need a China that is growing at a healthy clip again. What they do not need are these self-appointed China bulls who create a sense of misplaced optimism and a Panglossian disregard for the many problems that beset China’s economy today.