China’s development model is unraveling before our eyes

There’s no denying that China’s economy is struggling. After the zero COVID-19 policy was lifted at the start of this year, investors were upbeat about the prospects for a strong rebound. However, China’s economy has fallen well short of expectations. 

Real GDP growth slowed considerably in the second quarter, as exports declined and households accumulated savings to protect against an ongoing slump in property values. Data for July point to ongoing weakness this quarter, including exports that plummeted by 14.5 percent, the steepest decline since the onset of the pandemic, and emerging signs of deflation.

Meanwhile, China’s stock market has fallen far behind markets elsewhere in Asia and the U.S., underperforming them by about 20 percent in the past three months. At the same time, pressures on the Chinese yuan persist as it hovers near a 16-year low versus the U.S. dollar.

China’s leaders acknowledge that the economy is experiencing a “tortuous” recovery from the coronavirus pandemic. They have vowed to bolster consumer spending, tackle high youth unemployment that now exceeds 20 percent in urban areas and provide more support to the ailing property sector. But the response thus far has been light on details.  

One reason: China’s ratio of total debt to GDP reached a record high of 290 percent in the first quarter of this year. This represents a doubling of the ratio since the 2008 global financial crisis, which limits the government’s ability to inject added stimulus.

These developments have given rise to a debate about whether China’s economic problems can be overcome.  

Eswar Prasad of Cornell examines whether China’s growth has gone from “miracle to malady” In an NBER working paper. He concludes that while the underpinnings of China’s growth seem fragile, a more benign future is possible “with growth that is more moderate by its own standards, but that is more sustainable from economic, social, and environmental perspectives.” Consider this the “soft landing” scenario.

My own take is the current environment poses the biggest challenge thus far for China’s model of economic development. It began with market-oriented reforms under Deng Xiaoping that encouraged the formation of rural enterprises and private businesses, liberalized foreign trade and investment and also included public investments in industry and education. They succeeded in transforming China from being a rural, agricultural economy to an urban industrial economy by the end of the 20th century.

The reform process continued into the first decade of this century when China was granted entry into the World Trade Organization. As James Mackintosh reported in the Wall Street Journal, China’s total factor productivity soared after it joined the WTO, but it then peaked in 2010 when the reform process stalled. Thereafter, China’s overall economic efficiency has faltered since 2014, when Xi Jinping tilted policy to favor state-owned enterprises over private enterprises. China’s earnings per share have been relatively flat since then, which is a key reason why its stock market has underperformed global peers over the past decade.

The domestic economy has also been impacted by a drop in prices of residential and commercial property, which accounts for around 25 percent of China’s economy and is the primary mode of saving for the Chinese populace. Evergrande, the country’s largest property developer, recently posted a combined loss of $81 billion in the last two years after falling into default in 2021. Some observers believe China could be headed for a real estate bust similar to what happened in Japan in the 1990s which led to deflation. However, George Magnus of Oxford University’s China Centre, notes that Chinese banks are state-owned and he points out other differences that lessen the risk of a Japan-style bust.

Another key development is the external environment has turned adverse for China. Following the imposition of duties on U.S. imports from China by President Trump in 2018, multinational corporations began to diversify their supply chains away from China in response to the COVID-19 pandemic and heightened tensions between the U.S. and China. According to the Rhodium Group, U.S. firms made $120 billion of foreign direct investment in China and $62 billion of venture capital investments during the past decade. However, the pace has slackened recently, and a U.S. initiative to vet technologies such as advanced semiconductors, artificial intelligence and quantum computing is underway.

China’s Commerce Ministry concedes the country’s foreign trade situation is “extremely severe” and blames geopolitics for the recent slump in exports. In a recent interview. the head of the ministry’s external trade department said, “Some countries’ forceful push for ‘decoupling,’ ‘severing chains’ and so-called ‘de-risking’ are human-made obstacles blocking normal commerce.”

Weighing these developments, it is clear that China’s development model that combined domestic reforms with export-led growth and access to technology from abroad is now threatened. The Chinese government faces two key choices. First, does it wish to pursue policies that favor state-owned enterprises, or does it want to create incentives for the private sector to flourish? Second, does it want to align itself internationally with autocratic states, or is it willing to re-engage with the West? 

These choices will ultimately determine whether China’s economic miracle continues or ends.

Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including “Global Shocks: An Investment Guide for Turbulent Markets.”