China’s Great Economic Rebalancing, Part 1: The Problems
China’s economic rise over the past four decades has been nothing short of remarkable. With economic growth averaging nearly 10% annually since 1980, Chinese policymakers have proved adaptable and effective, in part due to China’s state-capitalist economic system. This system offers a closed capital account, extensive state ownership and a prominent — even dominant — government position in the economy. As a result, policymakers can intervene forcefully and quickly to safeguard financial stability and maintain high economic growth.
However, China appears to have changed tactics and strategy. Instead of forcefully kickstarting the country’s economic growth following the COVID-19-induced slump, the government has primarily limited itself to microeconomic reforms. Since then, most economists have downgraded China’s growth potential to well below 5%, China appears to be on the verge of sliding into deflation, and recent defaults of major real estate developers have raised concerns about financial stability.
This shift in strategy is part of a broader rebalancing of China’s economy as the country aims to stave off even greater economic and financial problems in the future. While policymakers have the tools to avoid a financial crisis as they manage this rebalancing, it remains risky, and it is far from clear what policies will replace China’s defunct economic model in the coming years.
The problem of overinvestment
One major problem Chinese policymakers are trying to solve is the issue of overinvestment in unproductive sectors. This problem begins with China’s high savings rates, which have underpinned the country’s economic model for the last several decades and are currently at 45% of gross domestic product. By comparison, America’s savings rate has not exceeded 20% of GDP in the past two decades.
In national accounting terms, savings are the share of national income that is not consumed. Savings can be converted into investments or exported in the form of current account surpluses. Since peaking at a massive 10% of GDP in 2007, China’s current account surplus has declined to around 2% of GDP or less following the massive stimulus program launched at the height of the financial crisis in 2008. This leaves 43% of GDP (savings minus China’s current account surplus) to be converted into investment.
China has invested most heavily in real estate and productivity-enhancing infrastructure projects, which boomed during the government’s aforementioned stimulus program in 2008. For a while, China supported this boom, as housing and infrastructure projects were necessary parts of the country’s urbanization. However, demand for real estate and infrastructure projects has since declined, leading to dangerous overinvestment.
Financially, overinvestment in real estate and infrastructure projects has increased financial risks. For example, excess apartments in cities with undeveloped real estate markets will remain unoccupied, at least for now, resulting in financial losses for investors and real estate developers. Additionally, unused real estate will not increase the productive potential of the economy. As a result, overinvestment in this sector is weighing on China’s economic growth, relative to more productive, alternative investment elsewhere in the economy. Or at least, this type of economic growth is bound to be unsustainable and lead to significant financial losses.
These factors mean China is increasingly unable to convert part of its savings, which comprise a massive percentage of its GDP, into profitable investments. If this trajectory continues unabated, major medium- and long-term economic and financial risks will follow. To break this pattern, China needs to find alternative, profitable investment opportunities into which it can pour its excess savings. Structural economic reform would help aid this transition.
The risks of rebalancing
Until recently, China’s government reluctantly intervened in the real estate and infrastructure sectors by bailing out debt-burdened developers and local government-related entities when their projects failed to provide sufficient returns. This interventionist policy prevented many investors from incurring too many losses and kept the real estate sector running smoothly. However, this strategy failed to motivate developers and investors to manage associated financial risk more wisely. As a result, they continued to invest money in unproductive projects, which helped prevent a broader macroeconomic adjustment.
To break this cycle, Chinese policymakers introduced the “three red lines” policy in 2020, which forced real estate developers to reduce the amount of borrowed money they use to make investments. This policy exposed developers’ accumulated financial risks, and many large developers defaulted on their debt as a result. This time, the government did not bail them out, forcing developers to deal with the consequences of their poor risk management. These defaults have slowed investment in the real estate sector overall, which was a key goal of Chinese policymakers.
However, reduced investment and growth in the real estate sector (which, by some estimates, accounts for 25% of China’s GDP), is slowing the country’s overall economic growth. While Chinese policymakers view this slowdown as a reasonable price to pay to avoid further financial risks and the continued misallocation of savings, their economic rebalancing strategy has begun to have second-round effects. These include stagnating or falling real estate prices, as well as financial losses incurred by banks, individual investors and local governments.
Regarding the latter issue, a sharp reduction in housing-related income from land sales, on which local governments depend for revenues, will significantly restrict local governments’ budgets. In addition, local governments often raise funds for infrastructure and housing projects through local government financing vehicles (LGFVs). If these investments go bad, local governments may have to bail out their LGFVs, incurring further financial losses. Therefore, economic rebalancing will put significant financial pressure on local governments.
Due to the risks of slowing investment in the real estate sector, Beijing must tread a fine line between rebalancing the economy and limiting the economic slowdown and financial losses. This requires a carefully calibrated policy that accounts for short-term and systemic financial stability, as well as medium- and long-term economic sustainability.
China’s Great Economic Rebalancing, Part 2: Potential Solutions
China’s economic rebalancing is creating a host of issues. Most pressingly, government attempts to discourage overinvestment in the real estate and infrastructure sectors are slowing economic growth. Several short-term strategies are available to ease this transition, most promisingly an expansionary fiscal policy that increases private consumption. However, China will also need to make longer-term strategic changes to support its rebalancing, namely by creating alternative outlets for excess savings. Above all, these outlets will need to include more productive investment opportunities.
Short-term solutions: Consumption-oriented fiscal stimulus
To counteract the short-term slowdown in economic growth caused by reduced investment in the real estate and infrastructure sectors, the Chinese government has three primary policy levers: fiscal policy, monetary policy and exchange rate policy. Until now, Beijing has refrained from deploying these tools forcefully, instead focusing on microeconomic reforms aimed at facilitating private consumption. However, if the outlook for China’s short-term economic growth deteriorates further, signaled by several months of deflation, policymakers would likely opt for a more expansionary fiscal policy to stimulate household consumption.
An expansionary fiscal policy would raise government spending and transfers and/or cut taxes, making it the most direct way to stimulate domestic demand, especially private consumption. Additionally, as private consumption rises, savings rates will decline, which will decrease overinvestment. In this way, an expansionary fiscal policy would help solve China’s short-term issue of an economic slump while also supporting the government’s longer-term goals of shifting away from overinvestment. The central government would need to fund this stimulus, as local government finances are already weak due to their reliance on falling real estate-related revenues and their prospective financial losses.
If an expansionary fiscal policy proves insufficient, policymakers could resort to altering China’s monetary policy by cutting interest rates more forcefully. However, this option is not ideal, as lower interest rates would also increase unprofitable investment in sectors like real estate, slowing the deleveraging of the sector. Lower interest rates would also reduce banks’ net profit margins, undermining bank profitability and their ability to absorb credit losses directly or indirectly related to the real estate crisis. Moreover, this strategy would widen the gap between Chinese and U.S. interest rates, which would put downward pressure on the yuan and lead to increased capital outflows. These constraints mean the government would likely only lower interest rates if the risks of recession and deflation are particularly high.
Lastly, the government could try to stimulate the economy by adjusting its exchange rate policy. In this scenario, a weaker exchange rate would make China’s exports comparably cheaper, thereby increasing foreign demand for Chinese goods. However, this strategy would be unlikely to significantly kickstart economic growth, given that China is far less dependent on external demand than it was in the past (and economic growth in its major export markets is declining). Additionally, this option would require a substantial weakening of the yuan, which might undermine domestic financial confidence. If that were not enough, weakening the exchange rate would require the government to cut interest rates, which, as stated previously, might compound the issue of overinvestment and lead to a host of undesirable knock-on effects. Therefore, Beijing is unlikely to resort to a policy of currency depreciation.
Longer-term solutions: Profitable investment opportunities and consumption
To ensure that China’s short-term economic slowdown does not become a long-term stay in the middle-income trap, policymakers must create new outlets into which the country can pour its excess savings. By putting these savings to work, China’s economic growth potential, which is already considerable, would increase. This is evidenced by the fact that China’s per capita income is less than a third of the United States’, pointing to what economists call catch-up potential, a country’s ability to adopt advanced technology, improve human capital and increase capital stock to support faster economic growth and higher per capita incomes.
To tap into this potential, China needs to create profitable investment opportunities. This would require policymakers to introduce wide-ranging structural reform aimed at ensuring greater competition, a less privileged position of the state sector, and a greater role for markets to improve productivity and economic growth. Beijing’s decision in March to relax controls on the technology sector may reflect early moves in this direction. However, finding or creating financially profitable and economic growth-enhancing investment opportunities will be challenging.
If the government fails to create more productive investment opportunities, China will still need an outlet for its excess savings. Policymakers would likely attempt to solve this issue by continuing to stimulate private consumption. However, this would require much more than a simple, one-off fiscal stimulus. Instead, policies would need to increase consumption structurally by raising the household share of national income, which would be fiscally costly and may be difficult to achieve politically. Even if such a stimulus succeeds, a large share of savings would need to be shifted to consumption, which would be a long-term process. A gradual transfer of income from the government and the corporate sector would be preferable. The government could support this stimulus by providing government-financed health and pension benefits, thereby reducing households’ precautionary savings. If necessary, the government could also try to finance all or some of these measures through deficits or through higher taxes on the corporate sector, thus reducing corporate savings as well.
Chances of success
Chinese policymakers will face many challenges in the next few years, but they also benefit from several advantages. First, China’s state-capitalist economic system enables policymakers to intervene forcefully and quickly to maintain economic growth and preserve financial stability. Second, China learned much from observing the Japanese and U.S. financial crashes in 1991 and 2008, respectively.
As a result, Chinese policymakers will continue to remedy overinvestment in the real estate sector and mitigate its related financial risks. In this scenario, China would gently settle into a lower growth trajectory (underpinned by continued high investment) in the context of more sustainable financial returns on investment. After all, the economy has plenty of catch-up growth potential left.
However, if policymakers fail to act forcefully enough, they could lose control of China’s economic rebalancing. If this happens, China could be forced to implement disruptive large-scale financial restructuring in the real estate and infrastructure sectors, and even costly government bailouts. It might also push the economy into more sustained stagnation that could lead to deflation. As we will see in part three, this failure could impact China’s political stability and have far-reaching implications for trade partners around the world.
China’s Great Economic Rebalancing, Part 3: Considering Failure
Despite policymakers’ best efforts, worst-case scenarios sometimes come to pass. In the case of China’s economic rebalancing, this scenario would involve a deep economic crisis and/or severe financial instability that sets the country’s economic growth back for years. While these outcomes remain unlikely, they could occur if Chinese policymakers do not intervene forcefully enough in the face of excess savings and insufficient investment opportunities.
The consequences of such a failure could vary widely, potentially leading to a controlled recession or an all-out economic spiral. In either case, the effects would extend beyond China, significantly impacting China’s trade partners, particularly in Asia.
The path to policy failure
Chinese policymakers are discouraging investment in the country’s real estate and infrastructure sectors, which is slowing economic growth. For this slowdown to remain only a short-term speed bump, China must support domestic demand, especially household consumption, and create new investment opportunities in the real estate sector’s place to absorb the excess savings due to lower investment in the sector. However, in a low-probability, high-risk scenario, policymakers would fail to ensure that these alternative opportunities materialize.
A lack of productive investment opportunities would lead to an excess of savings with few profitable outlets. This would cause interest rates to fall, lowering financial returns. Decreased returns would weigh on financial institutions’ earnings, hurting their capitalization levels and even long-term financial health, as happened in Japan in the 1990s and 2000s. Moreover, decreased investment would slow economic growth even further and could depress prices.
China’s government has many powerful policy levers that could help prevent this scenario from spinning out of control. For example, the central government has enough fiscal space and financial firepower to implement a large-scale debt restructuring, leading to a period of “controlled bankruptcy.” However, this option could lead to a significant fire sale of assets, which could depress prices and weigh on economic and financial confidence and growth. Additionally, tighter government control over the economy would likely lower economic confidence even more, which would make any stimulus policies less effective. For these reasons, the government may respond too slowly or not forcefully enough, thus increasing the risk of a financial crisis.
In a worst-case scenario, Chinese policymakers would lose control of the economic rebalancing and even the process of controlled bankruptcy. In the face of this uncertain economic future, Chinese households would increase their precautionary savings and companies would reduce investment, which could bring about economic stagnation. If this leads to price deflation, including of assets, the value of debt will rise in real terms, further compounding financial stress. This stress could lead both companies and households to save even more in order to pay off their debts or maintain their targeted net worth, exacerbating the above issues and leading to what economist Richard Koo has called a balance sheet recession.
Additionally, slow economic growth would make it difficult for debtors to repay their debts, raising the specter of a vicious debt-deflation cycle. It is worth noting, however, that China does not have an external debt problem. As a result, the government could forcefully intervene to stabilize the financial situation and impose a wide-ranging, if messy, restructuring of domestic debts.
Most importantly, a debt-deflation scenario could lead investors, including banks, to incur substantial financial losses in the context of low profitability due to lower interest rates. Additionally, if asset prices decline sharply, the nominal value of household savings would erode, and a slowing economy could also cause unemployment to rise. As Chinese citizens increasingly feel the pinch of this economic stagnation, the risk of social and political discontent will rise, possibly leading to protests.
If China enters a debt-deflation spiral of falling prices and depressed growth, even if it manages to avoid a financial crisis, the global impact will be serious. For instance, economic stagnation would lead to reduced consumption, including for foreign goods and services. China is the largest trading partner of around 120 countries, so reduced demand would negatively impact their economic growth.
Additionally, deflation would make Chinese goods cheaper in global markets, leading to higher Chinese exports and larger trade surpluses. This could quickly become a major source of international tension, possibly raising the specter of another U.S.-China trade war following the 2024 U.S. presidential elections. Protectionist tariffs, retaliation and counter-retaliation between the world’s two largest economies would negatively impact global economic and investor confidence.
These potential domestic and international consequences of slow economic growth show how important it is for Chinese policymakers to create profitable investment opportunities and increase consumption. However, the complicated nature of forward-looking structural reform means nothing is guaranteed. Therefore, even if Beijing successfully rebalances the economy away from real estate sector investment, Chinese policymakers will have to muster all their skills to keep China’s economic growth from declining further over the medium to long term.
Source: Stratfor September 2023 | By Markus Jaeger