China’s economic miracle – is it ending?

Since the introduction of the policy of reform and opening-up in 1978, China’s economy has embarked on an astonishing rise. GDP growth has averaged 9% per annum (Chart 1): real GDP per person has increased from less than US$400 to around US$12,000, while its share of global exports has risen from 0.8% to over 14%. Depending on the methodology used, it is now either the world’s largest or second largest economy, and has accounted for almost one-quarter of global growth since the great financial crisis (GFC).

As a consequence, what happens in China clearly no longer stays in China. Hence, with the western media increasingly full of gloomy headlines about the country’s economy, it is all the more important to try to understand its current difficulties, and what the future may hold.

Many of China’s current problems can be traced back to the GFC. As Western demand for its exports waned, it became increasingly reliant on the real estate sector and investment to maintain rapid growth rates. Construction of new homes surged, as did house prices, and real estate-related activities came to constitute up to 30% of GDP on some estimates (Chart 2). Spending on infrastructure soared, with the length of the country’s high-speed railway network increasing by over twelve times between 2009 and 2019. Investment spending’s share of GDP has averaged around 45% since the GFC, extremely high by international standards.

But stresses began to build in China’s growth model. Credit to the non-financial sector as a share of GDP rose from 139% at the end of 2008 to 266% before the pandemic, and almost 300% at the end of 2022 (Chart 3). Lofty house prices have added to financial stability risks, and exacerbated concerns about rising inequality. Moreover, there was an enormous surge in residential housing under construction that had not been finished, and the share of vacant homes in urban areas has been estimated to be around 20%. There has also been growing concerns about significant diminishing returns from building new bridges, railways and airports.

The authorities have become increasingly aware of the issues with the growth model, and finally enacted major policy measures to rein in the housing market, including ‘The Three Red Lines’ in August 2020, which imposed restrictions on the ability of highly indebted real estate developers to raise new funds. The policy tightening and large hit to sales due to the lockdowns, resulted in the default of a large number of developers, which severely damaged sentiment towards the housing sector, fuelling sharp falls in housing activity (Chart 4) and declines in prices. Falling land sales to developers has also reduced a major source of revenues for local governments, who are responsible for the bulk of public spending in China.

The ongoing housing downturn is occurring at a time when private sector confidence has also been depressed by years of lockdowns that weighed on incomes, and major regulatory measures against certain sectors. The external backdrop is also increasingly challenging given the deteriorating relationship with the US and rapid increases in advanced economy interest rates.

The much weaker than expected recovery this year since the exit from its zero-COVID policy, has increasingly brought fears about China’s economy and growth model to the fore, particularly amongst Western observers. Economists have materially downgraded their forecasts for growth, with the government only just expected to hit its target of ‘around 5%’ for 2023, while the consensus expectation amongst economists is for growth of 4.5% in 2024. Some have even argued that China could be at risk of a ‘Lehman moment’, as problems in the housing sector cause wider contagion across the financial system. Further out, the IMF is forecasting growth of around 4% in 2025 and 2026, and just 3.6% and 3.4% in 2027 and 2028.

The authorities have acknowledged the difficulties the economy is experiencing and have gradually been increasing the level of policy support. But they appear to want to avoid a repeat of past large-scale stimulus. This likely reflects the fact that even though the economy is weak, it is still growing, as well as fears of exacerbating financial stability risks. A more marked downturn would likely lead to more aggressive stimulus. Crucially though, the government’s significant control over the banking system, and the largely closed capital account, likely reduces the risk of a major financial crisis like in 2008-09.

Bottom line, the housing market has switched to being a major drag on the economy, and demographic trends do not bode well for the sector, while investment in infrastructure is increasingly subject to diminishing returns. While current policy easing should lead to some improvement in housing and the wider economy, China ultimately needs to transition to a higher quality growth model with a greater focus on the consumer and innovation. But such a transition is likely to be difficult and could take time. Consequently, we should get used to much lower growth rates than was the case prior to the pandemic.

This has important implications for businesses across the globe. First, slower global growth, assuming another country can’t take its place. Second, Asian economies and commodity suppliers will be particularly exposed. For the UK, China only accounted for 4.6% of total exports in 2022, 6.8% including Hong Kong, although it has a very high banking exposure to them both. Third, lower demand for commodities could ease global inflationary pressures, as could further depreciation of the Renminbi.

But to conclude on a more upbeat note, despite the difficult challenges China faces there is a risk Western observers become excessively pessimistic on its prospects. Rapid advances in electric vehicles and renewables attest to its manufacturing prowess, and it continues to make impressive gains in technology-related areas. Less money going into property should also ultimately mean more investment in productive areas, while the dramatic rise in university graduates over recent decades will contribute to an ongoing upskilling in the labour force. And with GDP per capita around a fifth of the US level, there would still appear to be potential for significant catch-up growth.