• China’s economic trajectory is highly uncertain given the multitude of economic problems facing the country.
• Real estate, local government debt, weak consumption, and a tough environment for private business are all weighing on the economy.
• China has the capacity to address these problems, but political decisions in Beijing are putting China on track for structurally lower growth.

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

In the wake of disappointing GDP numbers and muddled signals from the Third Plenum in Beijing, the long-term trajectory of the Chinese economy remains an open question. After China abruptly abandoned its draconian “Zero Covid” policy at the end of 2022, many analysts projected a rapid economic rebound. However, the much-anticipated reopening boom failed to materialize. Instead, the Chinese economy has limped along, with growth falling well short of the pre-pandemic trend. The Third Plenum and other recent announcements by the Chinese government have not yet indicated that major changes to managing the economy are underway. As a result, many are beginning to worry that China’s economic recovery will slow further as reforms stagnate.

Even with the slowdown, the Chinese economy is still too important to ignore. China boasts the world’s second-largest economy, one that is roughly equivalent in size to the European Union. According to a Bloomberg estimate, even after its slowdown, China will add as much to global growth as the G-7 over the next five years.¹ Moreover, despite facing significant tariffs from the United States and Europe, China remains the world’s largest exporter by a considerable margin.

Four major factors are currently weighing on China’s growth: first, the real estate market is in a protracted downturn; second, Chinese consumers have held back their spending after the economy reopened; third, deteriorating local government finances threaten a sharp slowdown in investment; finally, China’s private sector “animal spirits” remain weak after the policy crackdowns of the past several years.

The critical question is whether each of these factors is cyclical or structural. Cyclical factors tend to revert to their prior levels, while structural factors are long-term changes to the economy.² If these challenges are cyclical, their negative impact on the economy will diminish, and China will return to more rapid growth. If these challenges are structural in nature, they will become long-term drags on growth and put China on a permanently lower growth trajectory.

Real Estate

China’s real estate market is undergoing a wrenching correction. In the 2010s, rapid and unsustainable growth in housing prices had led many economists to warn about a growing bubble. It was clear that action needed to be taken. Decades of excessive investment and property developers with balance sheets stretched to the point of breaking meant that the real estate market was headed for a painful adjustment irrespective of government policy. However, rather than trying to orchestrate a gradual rebalancing, the Chinese government abruptly pushed the housing market into a sharp correction through Covid lockdowns and poorly designed policies like the Three Red Lines. The housing market’s problems are immense, including millions of unsold apartments, bankrupt real estate developers, and homebuyers losing confidence that pre-sold units will be delivered and that prices will not fall further. Government rescue plans for the housing market, such as buying up vacant apartments, have been too small, given the scale of the problem.

The slowdown in the housing market is likely to be more structural than cyclical. While housing demand may stabilize this year, it is likely to do so at a much lower rate compared to the past few years. As shown in Figure 1, housing sold in 2023 was below 2017 levels. Moreover, 2024 sales are on an even lower trajectory. The sheer volume of housing built over the past decade, combined with a shrinking population, means that new housing demand in China may never return to its previous highs. The housing market will eventually stabilize and when it does it will stop detracting from growth. But real estate is unlikely ever to be the same driver of the economy that it was in the past.

Source: National Bureau of Statistics of China.

Consumption

After China reopened, private consumption has recovered much more slowly than economists anticipated. Consumption has not always been weak in China. During the prior decade, consumption grew rapidly. In the ten years before the pandemic, consumption was responsible for nearly 60% of China’s economic growth. However, as shown in Figure 2, China’s retail sales, a high-frequency proxy for household consumption, remain substantially below their pre-pandemic trend.

Source: National Bureau of Statistics of China.

There are numerous factors that weigh on Chinese consumption. Chinese homeowners are facing a negative wealth effect, with their net worth declining as property prices are adjusted downwards. Households may also be cutting back due to concerns about the direction of the economy and the high level of unemployment for some sections of society, particularly young people. Finally, weak consumption is linked to the government’s reluctance to provide significant stimulus directly to households.

The current decline in consumption has the potential to be short-term in nature if the government commits to implementing pro-consumption measures. However, such policies to date have been piecemeal and small scale. Instead of sending checks to households or improving the social safety net, two approaches that would likely spur new spending, the government has instead been pushing rebate programs and nebulous efforts to promote “consumption upgrading.” After decades of prioritizing investment and exports, the Chinese government appears to have an ideological aversion to embracing personal consumption as a major driver of the economy.

Fiscal Problems

China’s economic malaise is also linked to deep-rooted problems in the country’s fiscal system. Local governments are a significant economic engine in China as they spend tremendous amounts on infrastructure and services for their cities, much more than their official budgets can support. To bridge the gap, they use off-balance sheet entities called local government financing vehicles (LGFVs) to issue debt. This method has allowed local governments to invest large amounts in infrastructure they would otherwise be unable to afford. Figure 3 shows that there has been trillions of dollars of infrastructure spending supported by off-balance sheet borrowing over the past several years.

Source: International Monetary Fund.

However, the consequences of this off-balance sheet borrowing are ballooning debt levels and the threat of financial instability. Many local governments are cash-strapped, cutting essential services and delaying salary payments to civil servants. Beijing is pressuring local governments to clean up their finances and reduce off-balance sheet debts.

Without fiscal reforms to give them new and more sustainable revenue sources, local governments will have to sharply cut back on infrastructure investments and other spending. Beijing has struggled to resolve the country’s budgetary issues for over a decade. The policies under discussion currently are decidedly incremental and unlikely to resolve the root causes of local government fiscal problems. Absent a change in course, China is likely to see these debts leading to a structural, rather than cyclical, decline in local government spending.

Private Sector

The business environment is the final major factor impacting China’s growth. Private companies are the source of growth and innovation in China. The country’s economic miracle of the past few decades can largely be attributed to private economic activity displacing poorly run state-owned enterprises.

Yet since 2015, Xi Jinping has pursued policies that have systematically benefited state-owned companies at the expense of the private sector. This has been done to reassert the Communist Party’s control over the economy and combat sources of instability associated with free markets.³ It has created a major drag on growth because more productive private companies are no longer replacing inefficient state-owned enterprises at nearly the same rate as before.

Figure 4 shows the declining private investment as a share of total investment. The fall in private investment began in 2015 and accelerated sharply during the pandemic. While private companies have slowed their investments, state-owned enterprises have used their privileged access to bank loans and capital markets to entrench themselves further.

Source: National Bureau of Statistics of China.

Given the severity of the challenges private companies face and their impact on the economy, Beijing has started to recalibrate its approach. The Chinese government is discussing ways to improve the business environment and create a more level playing field for the private sector. However, a dramatic change in approach towards private companies is hard to reconcile with Xi’s desire for greater control. As long as the Party refuses to relax its grip over large swathes of the economy, private companies are going to face challenges growing. As a result, it is likely that the slowdown in private investment will be structural and not cyclical.

Conclusion

China remains a large and important economy, but it is facing challenges on a variety of fronts. The problems in the housing market appear to be deep-rooted and, therefore, structural. We are witnessing the unwinding of several decades of overinvestment in real estate. The other challenges – weak consumption, strained local government finances, and a diminished private sector – can all potentially be addressed through policy changes. However, there are significant political obstacles to making the required policy changes. Despite some shift in rhetoric, none of the policies offered up so far indicate that Beijing is ready to make a dramatic turn back towards reform. As a result, these challenges are also likely to become structural drags on China’s growth. That may change if economic conditions continue to deteriorate. The Chinese economy is not resigned to structurally lower growth; instead, political decisions are putting it on that path.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

1. Tanzi, Alexandre. “China Outweighs G-7 as Leading Driver of Global Economic Growth.” Bloomberg, April 18, 2024.
2. Swanson, Eric. “Structural and Cyclical Economic Factors.” Federal Reserve Bank of San Francisco, June 11, 2012.
3. Borst, Nicholas. “Security over Growth: China’s New Economic Approach.” Seafarer Capital Partners, October 2022.