Change is Inevitable. China is no exception.

After decades of progress, China’s economy is stalling. What will it take to achieve a revival?

By Darryl Lupton
 

China’s forty years of high-level economic growth are over. It was never going to be forever, but few imagined the convergence of negative factors would be so sudden. Economists know about bull and bear markets, but it took a black swan and a grey rhino to quell the Chinese economic juggernaut. In geopolitical terms, a grey rhino is a probable event with a high impact, and for China it was the property market bubble that finally popped in 2021. The black swan – an unpredictable event with potentially severe consequences – was of course Covid-19. These have seriously affected China’s economy and responsibility rests with the Chinese Communist Party (CCP) and the all-powerful leader Xi Jinping. In this piece we will evaluate the CCP’s economic performance and behaviour in other key metrics. The conclusion will be that the CCP is an out-of-date party that is rooted in a discredited ideology that is outmoded and no longer serves the people of China. Change is needed and a new generation of leaders is required to propel China forward to prosperity in the 21st century. President Xi is directly connected to Chairman Mao and that generation of communist leaders, which has strongly impacted on his thinking. In 2012, he had the choice to continue opening up and to further progress along the more liberal path that China was headed on. Instead of opting for the ‘Singapore model’, Xi doubled down on the Marxist-Leninist ideology that was instilled in him during the Cultural Revolution and his studies at Tsinghua University. This has had disastrous consequences for China in social, political and economic aspects. Let’s examine how they eventuated.

Under Xi, the CCP enabled the property bubble and implemented a harsh and debilitating ‘zero-Covid’ policy that took a heavy toll on the economy for almost three years. When these strategies are added to the one-child policy from 1980, only partly rescinded in 2016, and the obsession with targeting GDP numbers that don’t reflect the true state of the economy and cause massive, unsustainable local government debt, then the Party has much to answer for. After all, the unspoken ‘social contract’ that gives the CCP a modicum of legitimacy, is for the citizenry to keep out of politics and in return the government will provide the economic conditions to thrive or at least provide for their families. This contract, according to the New York Times, was broken from 2013 when the government began diverting funds to keep inefficient state-owned enterprises (SOE), termed as ‘zombie companies’, afloat instead of supporting private businesses and entrepreneurs. This approach culminated in late 2020 when Jack Ma disappeared after criticizing government regulators, who then prevented his company’s (Ant Group) stock market flotation. Critics have described the government’s actions as “excessive, and arbitrary intrusions” (Dr Adam Posen, president at Peterson Institute) or as “a growing incentive mismatch between the Party and the Chinese people” by Zongyuan Zoe Liu (Council on Foreign Relations), among numerous others. Yet, how did a triumphant China at the time of the global financial crisis, confident of its inevitable global leadership, manage to stall so dramatically?

An overview of the Chinese economy and its management by Beijing will help to understand the issues and solutions to resolving this predicament. After the reform and opening up of China’s economy by Deng Xiaoping in 1978, great progress was made in transforming a failed economy to one that helped uplift the hundreds of millions of Chinese that communist practices had mired in poverty after the Great Leap Forward and the Cultural Revolution. Capital, technology and skills were transferred from the West, Chinese diaspora communities in Asia and from Taiwan to the People’s Republic of China (PRC) that helped to accelerate its integration into the world economy. This culminated in China’s admittance to the World Trade Organisation (WTO) in 2001. Any economic graph highlights how this contributed to a skyrocketing boost to China’s exports and dominance in the manufacturing industry. With a huge working population that worked for cheap wages, China was following in the steps of the Asian Tigers that preceded its rise. To increase productivity and cement its competitiveness, the Chinese government heavily invested in infrastructure like ports, roads and railways that ensured world-class logistics would help build its central position in the world’s supply chains. Furthermore, with a hybrid economic system that comprised of a command economy with state-owned enterprises directed by the government coexisting with entrepreneurial market-based capitalist endeavours, this system served China well. This model that utilised investment-driven growth to supercharge the economy is not new and has been employed by developing countries in the past. However, economies evolve and progress and what once served their needs becomes outdated and only ends up impeding the next cycle of growth. To relinquish what no longer benefits the economy and pivot to a new economic model is a great challenge that most countries don’t succeed in overcoming. The result is getting stuck in the ‘middle-income trap’ (like Argentina and South Africa) and not transitioning to being more productive in higher value-added activities, like Taiwan has managed. It is also important for economies to wean themselves off addiction to ‘debt fuelled investment’ that produce impressive GDP numbers but end up with surplus and non-productive projects that aren’t paying their way. Instead, a circular economy where the service industry needs to be developed to supercede or supplement manufacturing, innovation promoted to produce high-value goods and for internal consumption to enable a more sustainable economy. The Chinese government has been well-aware of the steps necessary to achieve these goals. In 2015, it launched the ‘Made in China (MIC) 2025’ initiative – a state-led industrial policy that aimed to move China up the value chain. It received a wary reception from the US and Europe as this was their domain and China’s methods of achieving its goals have not always been above board. A European response was to publish a report calling for a trade policy that could ensure “a level playing field” for both EU companies operating in China and Chinese companies in the EU. As for Taiwan, it lost thousands of chip industry workers to MIC 2025. China’s ‘Thousand Talents program’ preceded this push to recruit mostly Chinese or overseas-Chinese tech talent that could be tempted with lucrative contracts and generous research grants. Results have been mixed and the US response to the programme by a senate committee deemed it “a threat to national security” with academics referring to it as a “reverse brain drain.”

China is pursuing its national interests in order to become a developed, high-income level country. Few societies manage this transition and China’s challenges are legion. It is facing a demographic catastrophe that will see it growing old before growing rich – something that Japan achieved before its population slide. China’s local governments are greatly indebted, as they have carried out Beijing’s edict to achieve GDP targets, thereby ratcheting up the often-hidden debt needed to achieve the numbers required. This has been compounded by the housing bubble that valued apartments at astronomical figures while average salaries didn’t reflect a realistic chance of being able to afford a dwelling. The government crackdown in 2021 using the ‘three red lines’ exposed the property developers as essentially running Ponzi schemes that were using future money to build current projects. The subsequent indebtedness and bankruptcy of many major developers has put a strain on multiple players, including local governments that relied heavily on land sales (or 70-year land usage leases) for revenue, banks with now bad loans similar to Japan in the 90s, and contractors upstream and downstream of property developers, like white goods retailers or suppliers of steel, aluminium, glass, carpentry and so on. Efforts to ease strict regulatory measures have been implemented but land and house sales are slow and this sector representing over a quarter of the economy will never fully revive as an oversupply of overpriced homes is a reality that investors can’t ignore. In addition, the PRC’s ‘zero Covid’ response severely hampered the economy, exacting a heavy toll on small and medium sized enterprises who don’t get the cheap or ‘free’ credit that SOE’s can access. A government campaign targeting the tech and private education industry resulted in tens of thousands of jobs being cut, which didn’t help the record numbers of students graduating from universities. Youth unemployment is now over 20% and could be far worse, given that authorities have stopped reporting official figures. These economic issues have led to a lack of confidence in the economy with people choosing to save their money instead of using it to boost domestic spending. Household spending is also low because of a lack of decent investment opportunities and because the government doesn’t provide a comprehensive social net, thereby encouraging people to rather save their money for an uncertain future. Householders are precisely the sector of the economy that Beijing needs to protect and stop exploiting. The share of national income in China is disproportionally low for householders with businesses, especially compared to the overly large share of SOE’s and local governments. To balance this out and allow householders to participate more fully in the economy, which would boost internal consumption, asset transfers and higher wages are needed. However, this would result in local governments giving up economic power and allowing more economic independence, which is a political choice that the Party is reluctant to make. This would also help to increase the very low consumption rate in China that contributes to China’s very high trade imbalance, that is the persistent trade surpluses, especially with Europe and the US. If householders in China had a higher percentage of what they produced, China’s imports would be larger and Europe could make more from exporting services and high-quality products and the EU deficit would be lower. By fixing its own economy, not only would China benefit but its trade partners would be able to export more to a Chinese society that could afford foreign imports (and to purchase local manufacturing), thereby being more balanced and less mercantilist, which is what the EU wishes to address. Low wages, an undervalued currency, and direct and indirect subsidies are contributing to an unlevel playing field that disadvantages foreign firms. Michael Pettis, a Peking University Finance professor sums this up: “In the past two decades, investment in China has continued to rise as rapidly as ever, even as it has progressively generated less and less value for each dollar invested. Overall growth has increasingly been driven by asset bubbles, especially in real estate, and an unsustainable rise in debt. Worse, over this period, business investment has become constrained by China's extraordinarily low consumption rate, as shaky domestic demand discouraged private businesses from expanding production."