Skepticism about the world’s second-largest economy, China, is growing among Wall Street and other sources. Many indicators, such as the growth rate, unemployment rate, domestic demand, investment, and exports, are showing concerning trends. In 2020, the Chinese economy grew by 2.24 percent, followed by 8.45 percent in 2021, and 2.99 percent in the last year. It was anticipated to rebound to around 5 percent after reopening, but it has remained below the government-set threshold of 6 percent. While many parts of the world are grappling with high inflation, China is facing deflation, with the consumer price index and producer price index declining by 0.3 percent and 4.4 percent, respectively. Youth unemployment stands at over 20 percent, and investment has only increased by 3.4 percent. Additionally, exports have plummeted by a staggering 14.5 percent in July compared to the same period last year. China, once a formidable force in global growth, is now in a massive crisis.
The Chinese economy began to grow significantly in 1978 under the leadership of Deng Xiaoping and the state-led growth model. As Americans consumed China’s low-priced factory products, driven by cheap labor, China experienced rapid growth while the United States managed to control inflation. This practical exchange further propelled China’s economic growth. The momentum continued even after Deng’s death in 1997. However, things started to change around 2010 when China entered the middle-income bracket with a per capita GDP of nearly $8,000.
Projections for China’s future differ based on whether the current sluggishness is seen as a temporary outcome of Beijing’s strict Covid-related restrictions or a structural problem within the Chinese economy. The consensus leans towards the latter. There are two views on the causes of China’s crisis: economic factors and political factors. Mainstream economists like Michael Pettis and Paul Krugman argue that China’s growth model, which relies on state-led investment, has reached its limits. They believe that boosting domestic demand is crucial for reinvigorating the economy. In the past, Chinese leaders, including Deng, studied and borrowed from the Korean development model of the Park Chung Hee era, which aimed to drive economic growth through investment funded by accumulated savings and limited consumption. Similarly, Beijing made substantial investments in fixed assets, amounting to 40 percent of GDP. This public investment-driven model can stimulate growth when the economy is booming, as investment returns may exceed the cost of raising funds. However, during an economic downturn, when investment returns fall below the financing cost, over-investment can hinder growth. Korea experienced a similar situation and faced a liquidity crisis in 1997, just a year before the Asian financial crisis. China is now facing a comparable predicament. In 1996, Korea’s per capita GDP was $13,400, which is close to China’s current per capita GDP of $12,700. This situation calls for a shift in the growth engine from investment to consumption. However, China’s policy transition in this regard has stalled. One example is Beijing’s interest rate policy. The Chinese central bank has resorted to “financial repression,” which involves artificially lowering market interest rates to stimulate fiscal spending and corporate investment. According to Chen Zhiwu, a finance professor at the University of Hong Kong, China has been keeping interest rates artificially more than 5 percentage points below the balanced level. This deviation from market rules makes it difficult to resolve the issue of over-investment. Local governments and state-owned enterprises are the main beneficiaries of the low-interest-rate policy. Chinese provincial governments are struggling with the consequences of their reckless spending. For instance, the demolition of a 190-foot-tall statue of the Chinese war god Guan Yu in Jingzhou city of Hubei Province, after spending over 300 million yuan ($46 million) on its construction, represents wasteful expenditure by local governments. State-owned enterprises also enjoy advantages from the low interest rates. Chen stated that the wealth transfer to state-owned enterprises due to cheap rates reached 1.2 trillion yuan in 2016 alone, while the benefit for private companies stopped at 800 billion yuan. This distortion in wealth distribution has exacerbated as public corporations with low productivity received more benefits compared to private companies.
The policy of driving growth through domestic demand is not a new concept; President Xi Jinping initiated it in 2015. Mortgage loans surged during this period, but the benefit was often directed towards real estate speculation rather than stimulating consumption. As a result, private consumption did not increase significantly to meet Beijing’s goal of outpacing the U.S. economy through consumption-driven growth. On the other hand, some economists, like Adam Posen, president of the Peterson Institute for International Economics, believe that China’s potential for additional growth is hampered by political instability. The collective leadership that existed until after Deng’s death gave way to Xi Jinping’s strongman rule. Xi, a member of the Princelings, pursued a more rigid form of communism compared to the accommodative approach led by Deng. Under Xi’s imperialistic rule, there has been an increase in state control and surveillance over companies, as seen through the enactment of anti-spy laws and tightened regulations in new industries like ICT. Prof. Posen argues that China is suffering from “economic long Covid,” where low confidence in the private sector due to government intervention, even prior to the pandemic, is further weakened by draconian government measures during the pandemic. Consequently, stimulus measures are ineffective as companies continue to reduce investment, and households choose to save rather than spend. These two perspectives on the crisis, over-investment and political instability, may seem contradictory but reflect the complexities of a country caught in the middle-income trap. To address over-investment, growth should be driven by consumption. However, in the face of future insecurity, there is an increased demand for precautionary savings, making political stability crucial to prevent a decline in consumption. The authoritarian government’s uncertainty casts a shadow over the Chinese economy. When both the economic and political wings are destabilized, the government often looks for external enemies to divert attention. This explains Beijing’s hard-line stance against the United States. On the other hand, the United States cannot help but contain China, as it has been blamed for nurturing a powerful force over the past four decades. Resolving the rivalry between these two superpowers will take time. China’s economic future depends on how the government addresses over-investment and political instability during the transition from a state-led growth model to a market-driven one.