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Is the Chinese Economy Drifting, Tanking or Changing?

Is the Chinese Economy Drifting, Tanking or Changing?
 François Godement
Special Advisor and Resident Senior Fellow - U.S. and Asia

2019 is a year full of ambiguities for the Chinese economy, mainly due to two reasons. The first is the important psychological pressures caused by the US-China trade war, which could potentially reverse the global trade trends that were largely dominated by China in the last decades. The second is the unclear messages conveyed by the Chinese government regarding its economic policy. In response to pressures coming from abroad, the government has alluded to possible reforms. Yet it has also taken defensive measures in order to resist these pressures. It has intensified its efforts to restrain domestic debts and liabilities. Yet at the same time, it has also adopted new stimulus measures, including new credit lines, to revive the economy. Adapt and resist, stop and go... No wonder that, after a phase of seeming invulnerability to US pressures, Chinese economists are showing signs of anxiety. Indeed, not only is the economy drifting, but it might also be tanking.
Such observations could however end up being the mere expression of unfounded pessimism after a phase of unbridled optimism.
The trade conflict has already had two significant consequences.

  • The first was the reboost of China’s exports to the United States, up until October 2018. A drop in the RMB to dollar exchange rate, and a rush to get exports past the gate before the late September tariff increases resulted in China’s highest ever trade surplus with the United States. China’s global imports also accelerated. This was likely caused by consumers’ and companies’ anticipation of tariffs and other upcoming import restrictions.
  • Meanwhile, the government has been consolidating a familiar policy: reining in speculation and bursting the economic "bubbles". It is the very policy that had been implemented, on the eve of the Great Financial Crisis of 2007-2009. At the time, China’s credit and budget discipline was perhaps purely coincidental, but it significantly helped to avoid widespread panic when the global crisis hit. Now, given that China is one of the trade war’s two main players, it is easier for authorities to foresee trouble and thus to tighten their control over runaway credit and finance. Official statements in the spring of 2018 started praising state enterprises and the state economy again. Shadow banking, which, in China, really is the "shadow of banks" and plays a significant role in structured funds with higher returns for savers, was brutally curtailed. So was, consequently, credit to private companies: no doubt the one-party state is in a good position to protect itself from the forecasted storm. However, local authorities have been hit both by anti-corruption campaigns and by a major curtailing of infrastructure projects. This also explains state companies' frenzy to get involved in the international Belt & Road projects. In 2018, investment dropped like never before in China.

These consequences may have been underestimated by China’s government. The Chinese stock market was the one that performed worst in 2018. The decline in manufacturing jobs, which began in 2015, accelerated sharply in the second half of 2018, and even more so in the year’s last quarter. This trend no longer only concerns Northeast China’s rust belt, as it is now also impacting all the coastal regions where consumer export industries are located.

These trade conflict consequences may have been underestimated by China’s government.

There is also more and more talk of relocating international companies outside of China, which might signal a potential break of global supply chains. American and possibly European restrictions on Chinese investment in high tech will also spark retaliatory measures. So will new export controls. Even if tariff issues are somewhat settled by ongoing China-US trade negotiations, this long-term tendency to curb technology transfers of all types will certainly have an impact on the economy.

As per usual, these downward trends are coupled with doubts about China’s real growth rate. This suspicion is both recurring and irrelevant. Not only are many statistics skewed, especially at a local level, but much of China’s GDP is in any case a result of constant stimulus fostered by all levels of government: augmented net government borrowing has been nearing 11% per year since 2016. Indeed, what matters most is the leeway the central government has to support the economy – especially if the latter does indeed go from drifting to tanking. China has key assets and advantages that it can mobilize: foreign currency reserves (with a small rebound since 2017 due to the fight against hot money outflow), a still slightly positive current account balance, huge household savings that are still largely captured by a state financial system practicing financial repression at the expense of savers, and a central government budget policy, which is under control (unlike local finances). These should be sufficient to dispel the recurring doomsday predictions of a crash.

Yet if these resources can be used in the short term to prop up the economy in front of a trade war, how would it play out in the long term for the Chinese economy? Would it result in more unsustainable projects, more financial and real estate speculation, more state-owned enterprises? The Chinese government is probably aware of this risk, as it has so far released only limited stimuli to the economy - essentially bonds, and more targeted credit for private companies.

The cautiousness it has been demonstrating has been criticized by some. The economist Yu Yongding – who also doubts official growth figures – argues for a much more expansionary monetary and budget policy in order to sustain investment. Does he not remember that, during the Global Financial Crisis, he had explained that the huge stimulus delivered by China could happen once, perhaps twice, but that "there weren’t three bullets in the barrel"? Were his suggestion to be implemented, it would be the second time the mass stimulus weapon is used.

Augmented net government borrowing has been nearing 11% per year since 2016.

Others have expressed concerns motivated by economic liberalism, essentially targeting the Party-state’s capture of financial resources and spending. In their view, the divide between public and private consumption, rather than the investment/consumption ratio, is now the main problem. According to another liberal economist, public expenditure has increased from 23% to 46% of GDP. Taxes of all kinds, such as employer-side payroll taxes for social insurance, have shot up. This can partly be explained by the fact that the Xi-Li team is adamant about actually enforcing policies that often used to remain theoretical in the past. Meanwhile, Total Factor Productivity (TFP) is stagnating, after decades of sectoral transfers and technology-based increases. The finance and real estate sectors, which are usually connected to officialdom, are its main beneficiaries. Some critics go as far as discussing the actual cost of a 20 million people workforce for the Chinese Communist Party (CCP), and do so at their own peril.

The overall case for liberal reform can be summed up as follows: China has the same GDP per capita as Brazil, but its household consumption is equivalent to Nigeria’s (according to World Bank statistics). A 32% employer-side payroll tax for social insurance is not so far off from… that of France. Local debt is estimated anywhere between 17 and 40 trillion renminbis – i.e. between 2.5 and 6 trillion dollars, or between 23% and 57% of China’s GDP. The new two-child policy is not sufficient to prevent a striking decline of the birth rate: China’s population will start decreasing before 2030. Cutting public and state enterprises employment, and more generally the public expenses that have a low multiplier effect, is as important in the medium term as a stimulus package is in the short term.

China has the same GDP per capita as Brazil, but its household consumption is equivalent to Nigeria’s.

Some government officials share these views. After the relentless rants about the state economy, Marxism and ideology in the Spring of 2018, a key economic advisor such as Liu He – who is uncoincidentally directly involved in the trade talks with Washington – has been arguing in favor of more support to the private economy, as has Wang Yang, a Standing committee member and known as a reformer before 2012.

Their claim rests on the following 56789 slogan: "the private economy contributes more than 50% of tax revenues, more than 60% of GDP, more than 70% of technological innovation, more than 80% of urban employment, more than 90% of new jobs."In short, some are trying to highlight the fact that private firms are disproportionately penalized in China’s hybrid economy, with its dominant one-party-state and its credit crunch.

It may seem ludicrous to see the Chinese economy as overloaded with public and social expenditures, threatened by an epochal drop in its potential growth rate. China remains – along with Germany – the world’s leading exporter. It enjoys a current account surplus and fascinates other countries with the Belt & Road initiative, its own version of the Marshall Plan. Above all, its size and its strong state seem to protect it against any economic meltdown: China has survived socio-economic downturns in the past. A truce in the China-US trade conflict would immediately spark a psychological uptick and a growth rebound in 2019. Yet the measures advocated by liberal economists and partly condoned by some leaders are both a hedge against a possibly declining international environment, and a longer-term choice to pursue the marketization of the economy.
Could this be sufficient to end the move backwards of China’s economic policy, which has been ongoing in the past five years? This question, which has significant political implications, remains unanswered for now.

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