Xi’s Credibility Gap

China’s economy began running into tougher times in 2023. Some of the country’s problems were new: slowing global demand could not but impact China’s exports, which nevertheless remain well above their 2019 level. But other problems reflect the continuation of trends that were long underestimated or considered temporary. Covid and rigid confinement policies were thought to be an exceptional episode. Investors and analysts expected not only a strong rebound but also – at last – the turn to a consumer, service-oriented society. This would solve the imbalance in China’s external accounts and provide a new lease on economic growth. The tree of the covid pandemic, however, hid the massive forest that is Xi Jinping’s basic approach: security before growth, self-sufficiency sthrough innovation, heavy investments over household consumption, sweat and tears.

Overall, China’s leader thinks laziness is predominant in democracies, and that his people’s “struggle” over “lying flat” will set the economy back on course. To the Chinese people, it has become apparent that Xi’s politics have overridden previous policies. He has resisted calls for redistribution and for financial stimulus and hit the entrepreneur and middle classes hard, by doing things such as banning private tutoring, taking down star entrepreneurs, and pushing in an overbearing and intrusive way for political education and Chinese Communist Party (CCP) ideology. China’s geopolitical drive abroad, incidents with neighbors and threats over Taiwan have doubled the perceptions of risk in China’s middle classes, not to mention in foreign entrepreneurs.

Internationally, media amplification and a new consensus around deflation, stagnation, youth unemployment, flagging demography and “peak China” have reversed much of the previous consensus. There is significant backlash from the era of the “China miracle”, which dominated the scene for decades. The truth is that the confidence crisis of the summer of 2023 and the persisting failure to kickstart the economy beyond small sectoral gains has long-term underlying causes,which many of China’s economists and reformers had foreseen. The new consensus itself therefore needs to be unpacked.

CAUGHT BETWEEN DEGLOBALIZATION AND THE REAL ESTATE CRISIS

The facts: growth has slowed down, but not disappeared. This has been a trend since 2010. For several years – arguably since 2015, and certainly since 2019 – the actual breakdown inside China’s growth has contradicted the previous consensus. China’s export performance has consistently outstripped that of the domestic economy – before the covid pandemic and after it. The corollary to that fact, however, is that China’s transition to a more mature consumption and service economy – expected by foreign observers to balance trade and financial relations – never materialized.

China’s trade surplus, at $1 trillion in 2022 and 2023, is now 2% of global GDP. At some point, China’s exports were always going to hit a brick wall – that of global demand, with a dash of geopolitical reluctance, leading to decoupling/derisking and deglobalization talks in the West. Since Trump set tariffs – kept in place by the Biden administration – the United States has diminished its relative dependency on Chinese imports; the European recession in 2022-2023 also put a limit on China’s export drive into the EU. This is not so much an issue of competitiveness for Chinese goods as an outside demand constraint. A 398 billion euro trade deficit with China is hardly sustainable, in economic or political terms. Of course this has implications for China too, where exports have been the main engine of growth.

Then comes the real estate and construction crash, gathering force since 2021. In this sector, again, growth had been phenomenal. The sector represents 30% of China’s GDP and the key source of finance for local governments; it plays an outsize role for the urban population’s prudential savings and retirement planning. The crash has harmed confidence, and therefore household consumption and investment. As it happens, infrastructure investment faces a glut of existing capacities in areas such as transport, and a rate of return in alternative energies that can hardly match that of King Coal. For years, it was exports, and a leading edge in digital hardware that propelled China’s growth.

Even with the losses from real estate, the crisis has still been a slow motion one: Xi Jinping and the country’s leadership have been left with choices.

After all, in absolute terms, China’s economy still grows faster than most, including Europe and the United States.

One is reminded of Japan’s “lost decade” talk in the 1990s: while there was then a very real debt trap and deflationary spiral, Japan’s key industries never lost ground to their Western competitors, and the growth of Japan’s GDP still surpassed that of the EU in that decade.

SECURITY OVER GROWTH

Of course, one can doubt the quality – and veracity – of this growth. Indeed, there has been a drive to rein in false statistics coming from local governments. Infrastructure investment has not accelerated, but it is still high. In fact, much of the investment aimed at self-sufficiency actually hinders productivity growth, which is better served with foreign technology and cutting-edge machinery. Post-lockdown entertainment and travel consumption has indeed rebounded, as opposed to consumption in durable goods. Even as youth unemployment has soared, such figures do not take into account what happens in rural areas – where, one must say, underemployment has been rampant for years, leading to a youth exodus.

The so-called “zombification” of the economy, with transfer of local and state-owned enterprise (SOE) debts to ghost companies backed by implicit (not explicit) state guarantees, has been going on for years.

Expedients that have worked in the past – that have saved the leadership from going through politically risky and painful reforms with short-term costs and long-term results – call for a vision that is different from Xi Jinping’s. After all, his former associate, Wang Qishan, had cited Alexis de Tocqueville in observing that reform processes are most dangerous in their first phase. After Mao died, there was no other choice but profound change. Today, such difficult choices appear less evident to the CCP and especially to Xi. For example, postponing debt repayment and kick-starting an economic rebound has been a successful strategy that has helped to solve the issue of hidden debt in the recent past.

The very scale of public or quasi-public indebtedness is key to understanding Xi’s proclaimed reluctance to bail out local governments and real estate companies.

Preference goes to economic security over economic growth. This is a preemptive tactic that works if deflating the real estate bubble takes the form of a long fizzle; it will not work if panic breaks out.

Fear of the latter helps to understand recent censorship of economic statistics, beyond the CCP’s usual preference for opacity. Control is key for the CCP. China’s year-on-year GDP growth is more impressive seen from a low 2022 base year than on a monthly basis. Conversely, the 2023 late spring and summer slowdown in exports followed a huge increase in 2022. China’s “faltering growth” delivered some 25 million autos in 2023, taking global first place for electric vehicle (EV) exports. This performance replicates what happened in the solar panel industry as well.

THE FEAR CYCLE

In macroeconomics and finance, two features stand out that explain the reluctance to change paths. First, the abovementioned trade surplus. Second, a positive current account balance (though exports are wildly undercounted by the official State Administration of Foreign Exchange because, for example, exports from Special Economic Zones are excluded). Foreign reserve holdings, particularly in US dollars, are also undercounted because purchases by state banks and other state-controlled entities are not included. Unofficial estimates place China’s actual reserve holdings at $5 to 7 trillion, by far the world’s first. A third factor, insecurity, also comes into play. Household savings and SOE cashflow increased during and after the pandemic.

This is part of the problem for growth: consumer paralysis and company caution, the reluctance of banks to serve private borrowers, and the fall of the real estate market all worked together to create a doom loop for investment – especially for local government budgets.

The same sentiments also reined in a soaring consumer debt. Any financial stimulus from government is used to pay down debts rather than to create new investment.

Technically, China is in a balance sheet recession, as described by Richard Koo, among others, in the case of Japan in the 1990s. Hyperabundant private savings are not a good sign for growth. But they do provide – at the expense of households – ballast against a massive accumulation of formal and hidden public debt; by most accounts, this exceeds 300% of GDP. Indeed, it is the fear felt by households and companies that provides a savings ballast for rigid government policies. These three factors – current account balance, size of currency holdings, private savings – could even allow monetization of much of China’s bad debt, rather than simply postponing or parking it. It could even go beyond quantitative easing, Fed style, or the purchase of public debt, European Central Bank style.

Monetization was the key to ending Japan’s long crisis after a decade of attempts to restart the economy by more conventional spending means: ultimately, by printing excess currency, Japan’s central bank extinguished bad debt instead of merely holding it. In China’s case, it can happen without devaluation, if capital flight is contained, or with a controlled devaluation that would give an advantage to exports at the expense of international competitors. So far, however, Xi’s global ambitions would seem to preclude that option. At present, he micromanages the renminbi to follow every move of the US dollar. But we have already learned to avoid assuming too much. On covid, after all, Xi finally ate his hat in December 2022 and made a 180° turnaround of his previous lockdown policies.

THE POLITICS OF DECISION-MAKING

We know much less about politics than about policies. The narratives about the present gloomy prospects and the need for a new turn – or a return – to market should not be swallowed whole. China’s economy boomed for decades under CCP and state management. That success was so real that it fueled an international turn towards subsidies, the return of state industrial policies, and ensuing protectionist tendencies. Several major economies have just as much public and company debt as China. India and some European southern countries have even more youth unemployment: China’s demographic fall might be a solution if (and it is a big if) the country is able both to robotize (a real possibility given Xi’s drive to innovation) and to build a healthy capital market (much more problematic). An audacious push for debt monetization – the answer to higher global interest rates – would create much inconvenience on global capital markets, but it is an option to offset financial panic.

Xi’s politics will chart the course. His latest political appointees have less international experience and technocratic savvy than their predecessors. Temporary holdovers have been important as advisers and managers, but do not possess political clout.

One can sense much unease in the public expression of Chinese economists. Actual policy changes are confined to a renewed accent on infrastructure investment, small moves on interest rates, and some support for embattled local governments, which are encouraged to launch new bonds and buy some of the hidden debt. There is a holding pattern for the general economic line. Public encouragement for private companies mostly falls on deaf ears because the intended audience has been shell-shocked by Xi’s authoritarianism and reversals: the first problem of China’s economy today is a credibility gap. Control and censorship are everywhere. When Mao encountered real problems, he moved from left to right, eventually reversing course when he could afford to do so. Xi, even with his personal power, does not live in such a political vacuum, and international constraints are much tighter.

Unimaginative and protective management may turn dire predictions into a lasting reality. Let’s hope for China that we are wrong, and that Xi has the potential to surprise us.

The article is taken from Aspenia magazine, published by Aspen Institute Italia as part of our international partnerships.