China Economy: Has the export-investment-state-driven growth model reached its limits?

The Chinese economic slowdown is a result of a weakening trade with the US and EU, ballooning real estate debt, a consumption slump and the private sector’s inability to create jobs.

The Chinese economy appears to be undergoing a historic churn. This is a product of several factors, such as the structural challenges of the investment and exports-driven growth model, government intervention in order to reshape economic structure and incentives and a turbulent external environment.

The scrapping of the zero-COVID policy in late 2022 had created expectations for a rapid economic recovery in China. This was reflected in the rise in growth expectations in the first quarter of 2023. There was anticipation that pent-up consumer demand, increased fiscal spending, and efforts to boost market confidence and signal openness and policy predictability would result in growth rebounding. This, however, has not come to pass.

GDP Growth Slumps

The first signs of systemic weakness were evident in April. By June, most investment banks had slashed the optimistic annual GDP growth forecasts for the Chinese economy from around 6 percent to just over 5 percent. This would still be in line with the official target of around 5 percent fixed by the government. Over the past week, these forecasts have further been downgraded to well below 5 percent.

Official data for the year makes for a sobering read. China’s GDP grew at 5.5 percent year on year in the first half of the year. That might sound strong, but the figure is inflated owing to the base effect of the weakness of 2022. More importantly, quarter-on-quarter growth from Q1 to Q2 in 2023 was merely 0.8 percent.

Foreign trade, which had been key to China’s economic growth through the pandemic, has weakened significantly. In dollar terms, China’s foreign trade volume during the first half of the year was $2.92 trillion, down 4.7 percent year-on-year. This weakness has persisted since.

Despite enhanced diversification of trade, exports to two of China’s biggest markets, the US and EU, have slumped significantly. Foreign trade accounts for over one-third of China’s GDP. So the continued weakness in external demand will weigh heavily on future growth.

Real Estate Vulnerability

Likewise is the case with the real estate sector, which is believed to account for around 25 percent to 30 percent of GDP. The sector’s woes can be traced back to Beijing’s massive stimulus in response to the global financial crisis of 2008 and the obsession with GDP numbers in the Chinese political economy.

Easier capital flows led to the real estate sector’s expansion. This developmental model fuelled speculation, wasteful investment and ballooning local government debt. Since as far back as 2016, the Chinese leadership has sought to curtail speculation, bring in market discipline and tackle local debt risks, with limited success.

In August 2020, the government outlined new “red lines” for property developers, limiting their credit-raising ability. It also placed strict buying restrictions to stem speculation. However, faced with a worsening growth outlook, in November 2022, the regulators blinked, announcing a 16-point relief plan entailing credit and financial support and easing home-buying requirements.

A Bailout Dilemma

This hasn’t had the desired effect. In the first half of 2023, developers have spent 10 percent less on land year-on-year, and sales by value of top 100 developers rose only 0.1 percent year-on-year. Officially, from January to July, property investment fell 8.5 percent. Fragility continues to plague the sector.

This is deeply problematic for local governments in China. They earn around 30 percent of their revenue from land sales. This income has been shrinking. At the same time, their expenditure and debt burdens, estimated to be over $12.8 trillion, pose systemic risks. The top leadership in China is aware of these challenges.

Central officials are reportedly scrutinising the books of China’s weakest provinces to find ways to cut debt, while an emergency liquidity support tool is being mulled. In addition, the Politburo meeting in late July argued that “major changes have taken place in the relationship between supply and demand in China’s real estate market.”

While it avoided harsh phrases such as houses are for living and not for speculation, there was no indication of the state stepping in to offer a bailout.

Consumption Falters

This feeds into the consumption challenge that Beijing is struggling to address. The real estate sector accounts for around 70 percent of household wealth. Falling prices are eroding this wealth.

In addition, China’s household debt is now at 63.5 percent of GDP, getting close to the 65 percent red line previously used by the IMF as a marker warning of financial risks. All of this, along with weak employment prospects, particularly for the key 16-24 year-old demographic, is weighing down consumption, and feeding into a deflationary economic trajectory.

Based on the July Politburo meeting’s readout, it is evident that the government recognises these demand side challenges. But its policies so far have focussed on supply-side incentives to boost sales of automobiles, household goods, electronic products and service consumption across sports, leisure, culture, and tourism.

Private Sector Struggling

Additional supply side impetus is coming through investment demand. From January to July, China’s fixed-asset investment rose by 3.4 percent, but the private investment component of this fell by 0.5 percent, weakening through the months. This indicates that the Party-state’s outreach to the private sector has failed to revive confidence.

Part of the challenge in this context is that the Party-state remains deeply engaged in directing private capital towards what it views as national and strategic priorities. In that regard, data does show progress being made, particularly around long-term agenda items like industrial upgradation, development of core and emerging technologies, export market diversification, green technology and low-carbon development.

However, it is the state that is the key actor in this regard, while the private sector remains weak. A consequence of the private sector’s woes is poor employment growth, since it accounts for over 80 percent of urban jobs. This further feeds into the consumption challenge.

It’s a vicious cycle, breaking which calls for policy innovation. However, so far, Beijing has offered only incremental adjustments and cash infusion through rate cuts. What’s unclear is whether this is a product of policy contestation in Zhongnanhai or a decision to bear short-term pain for long-term reform.

Manoj Kewalramani is the Chairperson of the Indo-Pacific Studies Programme and Research Fellow-China Studies at the Takshashila Institution. Views are personal, and do not represent the stand of this publication.