Without reforms, China can still afford the time to muddle through its economic problems

China won’t reach for harsh reforms, choosing instead to gently deflate its property bubble and absorb overcapacities as it waits for demand to return
This could take a long time but China has the luxury to dither: its manufacturing continues to gain in competitiveness and there is no real substitute for it

Andy Xie

Published: 6:15am, 9 Jul 2023

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China’s post-Covid economic recovery has disappointed the market – but the expectations were unrealistic anyway. Its economy, which is absorbing a deflating property bubble and various overcapacities, needs time and structural reform to regain healthy growth.

But, unlike Japan, which also faced property bubble woes 30 years ago, China’s economy is still gaining in competitiveness, and so has time to fix its problems.

For now, the biggest headwind for domestic demand is the deflation of the property bubble. Construction has slowed as China finesses a gradual deflation. At the end of last year, the still-vast areas of residential real estate, office and commercial space being built had shrunk respectively by 7.2 per cent, 7.4 per cent and 12 per cent from the year before. At this pace, and given the property sector needs to shrink by at least half, there will be headwinds for the next five to six years.

What China should do, but will not do, is introduce structural reforms. Overinvestment and the resulting overcapacity have been the hallmarks of China’s economy for the past two decades, as local governments were motivated to attract investments to quickly boost GDP. This incentive structure lasted so long because China’s growing share of global trade helped to pare back its overcapacity.

Yet China remains competitive. A big part of its manufacturing has upgraded to 5G and artificial intelligence-assisted systems (though this, of course, exacerbates overcapacity). Its electric vehicle (EV) industry is rising rapidly. Its solar power is becoming cheaper than fossil fuel. And its nuclear power industry is about to take off.

China’s green transition is ahead of schedule and making a strong economic case for itself too. No other country can say that.

Unlike China 1.0, which made products cheaply for global companies to sell for high profit, China 2.0 has cutting-edge technologies and markets its own brands. This threatens the rich in the Global North and looms large in its negative interpretation of today’s China.

China’s situation is different from Japan’s experience three decades ago. With Japan, it was not just the bursting of its property bubble. The Japanese economy was also becoming less competitive than its Asian neighbours – a slide that continues. Its last important industry, the automotive industry, faces a critical challenge from China’s EVs. Japan’s economic response was to depreciate the yen, rather than restructure – forcing Japanese people to accept a lower standard of living.

China has muddled through past episodes of economic overcapacity by waiting for demand to come, and is likely to do the same again. But it could take much longer this time, if it happens at all. The immediate opportunity is for China to expand its market share in the Global South at the expense of the Global North.

About half of China’s exports go to the Global South and a 10 per cent growth rate is sustainable. Besides, to slow its deindustrialisation, the Global North is likely to resort to trade policy, such as more actions to slow or stop Chinese imports in automotive and technological goods. In any case, the global economy is unlikely to absorb all of China’s overcapacity.

China may need to eventually write off its overcapacities and cut its losses. This is especially apparent in its carmaking industry. China’s capacity for making combustion engine cars is about 40 million a year, with sales about half that. Even its booming EV sector sees sales at below 60 per cent of capacity. With so many local governments supporting EVs, the industry’s capacity is rising rapidly.

Unless something is done soon, China’s automotive sector could have the capacity to supply the world in five years – things are very likely to get worse before getting better.

02:01

Tesla owners in China protest against price cuts as consumers tighten budgets

There are three things China should do. One, cut investment to 30 per cent of its GDP from 45 per cent, and expand consumption to fill this by raising the household disposable income to 60 per cent of GDP. Two, prioritise the development of big cities over towns in its urbanisation drive, to improve investment efficiency. And three, allow the yuan to strengthen against the US dollar by a third. But economic rebalancing is probably far from Beijing’s mind.

It is consumed by geopolitical struggle and will allocate more resources to achieving technological self-reliance. The Chinese economy is likely to become more unbalanced in the coming years.

But while slow growth is here to stay, it doesn’t mean a collapse. China sells goods of value and there are no significant alternative suppliers. Vietnam does not have the scale, India the system nor the West the grit. China’s place in the world isn’t being seriously challenged.

02:30

Millions of China’s fresh graduates enter bleak job market

China’s rising youth unemployment, which is being talked about as a trigger for its economic collapse, won’t cause serious instability. China has a surplus in potential entry-level white-collar workers but nationally, there is a labour shortage. This is the consequence of a rampant and unsustainable expansion of the higher education system in response to parents’ desire for their children not to get their hands dirty for a living. The solution is an adjustment in parental expectation.

Anyone arguing that China needs massive stimulus is doing so out of ignorance. The noise over China’s shrinking balance sheet is completely misplaced. The M2 broad money supply and aggregate financing, a broad measure of credit, continue to increase, rising by 11.6 per cent and 9.5 per cent respectively in May year on year. Households are merely preferring to pay down debt now, having overborrowed to buy property on the expectation that prices would rise forever.

China faces many economic challenges. Its best option is to restructure and rebalance the economy, though it won’t do so. Muddling through is still a viable option, though it will take longer this time. Luckily, China’s rising competitiveness gives it the luxury to dither.

Andy Xie is an independent economist