[Dong-hyun Ahn’s Economics] China’s ‘growth engine’ stalled, state-led model no longer works

[Financial News, September 5, 2023] Dong-hyun Ahn (PERI Research Fellow/ Macroeconomy·Finance)

[Dong-hyun Ahn’s Economics] China’s ‘growth engine’ stalled, state-led model no longer works

 

China’s economy at a crossroads

There’s been a lot of talk on Wall Street lately that the world’s second-largest economy could be on the brink of collapse. The reality is that China’s economy has seen red flags on most economic indicators, including growth, unemployment, domestic demand, investment, and exports. After the pandemic, China’s growth rate was 2.24% in 2020, 8.45% in 2021, and 2.99% last year. Even this year, when the reopening is in full swing, growth forecasts are hovering around 5%, falling short of the 6% target that is considered the limit.

While the rest of the world is struggling with inflation, China’s consumer and producer price indexes have regressed to -0.3% and -4.4% respectively, indicating a deflationary trend. This means that domestic demand is frozen. Youth unemployment is over 20%, investment is only up 3.4%, and exports are down 14.5% year-on-year as of July. It’s a total disaster.

 

China’s economy in total disarray

China’s economy has experienced growth since 1978, when Deng Xiaoping came to power. Through a state-led development model of reform and opening up, China’s growth rate began to parallel that of the U.S. as a result of a formula in which the U.S. consumed goods produced by China using cheap labor in exchange for China’s growth.

This trend continued after Deng Xiaoping’s death in 1997, with sustained growth through 2010. Since then, however, China’s growth rate has been in a distinct downward spiral, as it entered the early stages of middle-income development with a gross domestic product (GDP) per capita of nearly $8,000.

The outlook depends on whether you view the recent slowdown in the Chinese economy as a short-term phenomenon caused by the aftermath of the coronavirus outbreak or a more structural problem. Recent theories of China’s economic crisis lean more towards the latter. There are two main schools of thought, one pointing to economic problems and the other to political ones.

 

Only strong domestic demand can save the day

The first view, or economic factors, is advocated by mainstream economists such as Michael Pettis and Paul Krugman, who argue that China’s state-led, investment-driven growth strategy has reached its limits and needs to shift to stronger domestic demand, especially consumption-driven growth.

However, when the growth rate declines and the rate of return on investment falls below the cost of capital, there is a problem of overinvestment, which is counterproductive to growth. South Korea experienced this overinvestment in 1997, and China is in a similar situation.

Coincidentally, our GDP per capita was $13,400 in 1996 when we had our crisis, and China’s GDP per capita is now $12,700, which is a similar level. In this case, the center of growth needs to shift from investment to consumption. China, with its large population, is well positioned to do so, and the recent announcement by the Chinese government to shift to a domestic demand-driven economy is timely in this regard.

 

Side Effects of Artificially Lowering Rates

The problem is that this policy shift hasn’t really happened yet. This is evident in the level of interest rates. China has been using a policy of “financial repression” – artificially lowering market interest rates – to boost government spending and spur corporate investment. In fact, according to an analysis by Zhiwu Chen, a professor at the University of Hong Kong, China has artificially lowered interest rates by more than 5 percentage points from the equilibrium rate and is still doing so. When investment returns fall, investment should be curtailed, but by artificially lowering the borrowing rate as investment returns fall, the problem of overinvestment is not solved.

The biggest beneficiaries of this low interest rate policy are local governments and state-owned enterprises. The reckless overinvestment of local governments in China has reached a critical mass. The demolition of a massive bronze statue of Guan Yu in Hubei’s Hengzhou city is a symbolic example of the extent to which local governments have squandered their budgets. State-owned enterprises(SOEs) are also the biggest beneficiaries of the low interest rate policy. According to Professor Chen’s analysis, the wealth transfer from the low interest rate policy reached 1.2 trillion yuan for SOEs in 2016 alone, compared to only 800 billion yuan for private companies. SOEs, which are relatively less productive than their private counterparts, have benefited from the funding, further distorting the allocation of resources.

 

Xi Jinping’s crackdown on business

While the Chinese government has recently been advocating a domestic demand-driven growth strategy, the move actually began in 2015 when Xi Jinping took power. Since 2015, mortgage loans to households have surged. According to Professor Chen’s analysis, in 2014, mortgage borrowers benefited from low interest rates by only RMB 200 billion, but this surged to RMB 500 billion in 2015 and then soared to RMB 1.3 trillion in 2021.

In other words, low-interest household loans were increased to stimulate domestic demand, but most of them were diverted to real estate speculation. As a result, private consumption growth has been negligible. China’s strategy to overtake the U.S. by boosting consumption to drive growth is doomed from the start.

The second view comes from political economists like Adam Posen of the Peterson Institute for International Economics. The instability of Chinese politics makes it difficult to guarantee further growth. The collective leadership system that was maintained after Deng Xiaoping’s death ended with the rise of Xi Jinping. Coming from the Taizai Party, whose father was a revolutionary member of the Communist Party, Xi Jinping, unlike Deng Xiaoping, advocates a more dogmatic and principled form of communism. This rise to absolute power has led to increased authoritarianism and increased corporate surveillance through anti-espionage laws. There has also been a regulatory backslide, with increased control over new industries, including the information and communications technology (ICT) sector.

 

Unable to escape the ‘middle-income trap’

In this sense, Pozen argues that China is now in an “economic long COVID”. Increased government control and interference has exacerbated private sector confidence, which was already weakened before the pandemic, by city lockdowns during the pandemic, causing businesses to cut back on investment and households to increase savings, all of which is playing it safe and preventing stimulus measures from having any effect.

In fact, these two views, overinvestment and political unrest, seem to be two different things, but in the end, they are both aspects of China falling into the trap of a middle-income country. To solve the problem of overinvestment, the axis of growth must be shifted to consumption. Political stability is more important than ever, as high uncertainty about the future leads to a precautionary demand for money, which depresses consumption.

However, the timing of the authoritarian regime has increased uncertainty, raising concerns about the Chinese economy. When both the economy and politics are unstable, a regime’s legitimacy is undermined, and the best way to avoid this is to create external enemies. This is the reasoning behind China’s “hard line” toward the United States. Coincidentally, the United States, which is not immune to criticism for nurturing the tiger that is China over the past 40 years, is also in a position to keep China in check.

In the end, the strong-versus-strong confrontation between the US and China is unlikely to be resolved anytime soon. In sum, the future of China’s economy depends on how it manages to deal with the overinvestment and political retreat that occurred at the inflection point of the transition from a state-led growth model to a market economy.

 

September 5, 2023

<Dong-hyun Ahn, Research Fellow> Professor of Economics, Seoul National University