10 March 2024

In a blog six years ago, I suggested China’s growth slowdown had just begun. I indicated the headwinds emanating from the property crisis, shrinking population, weak productivity growth, debt deleveraging, and the rebalancing towards consumer-led activity would slow China’s long-term GDP growth potential towards 3.5% to 4%. In the interim, most investors and pundits have accepted this diagnosis. Indeed, commentators now are competing to be the most bearish on China’s prospects.

Nevertheless, China’s government has projected the economy will again expand 5% in 2024. However, confronted with these structural impediments, achieving this above-trend GDP result will require either an easing of these underlying headwinds or a large-scale macro-policy stimulus. To be sure, I am hopeful China will overcome its economic problems eventually, especially as it enjoys impressive capabilities in key sectors, e.g. renewable energy, high tech, electric vehicles, etc.

However, I believe China’s 2024 GDP forecast is unachievable. Indeed, economic growth will struggle to expand 3-3.5% not only in 2024, but in the next few years as well. In order to become more bullish, Chinese fiscal policy must become more assertive; prioritising support of household spending, not State-Owned Enterprises (SOEs) investment. And, China’s central bank (PBOC) will need to cut interest rates another 150bp: sooner rather than later.

Structural Headwinds: Still Formidable

Debt Deleveraging and Property Sector Adjustment

In order to achieve their above-trend GDP forecast, underlying growth impediments must be easing. But, are they? To be sure, there’s nothing that can be done about the adverse impact of the nation’s declining population. However, China confronts also the challenge of reversing the enormous debt burden accumulated during it’s rapid growth phase. Some progress was made prior to Covid, especially in the corporate sector (Chart above). Since the pandemic, however, business sector liabilities have again soared. And, overall debt is at record levels.

In an international context, China’s post-Covid debt increase exceeds other major countries (Chart above). Indeed, private sector debt in Europe and the USA is lower than before the pandemic. It’s worth noting, no nation has experienced a large-scale deleveraging without recession or protracted below-trend GDP growth.

Economic Rebalancing: Progress Has Slowed

A key Chinese policy objective is to rebalance the economy away from business investment and exports and towards consumer and domestic service sectors. Meaningful gains were achieved prior to the pandemic. Once again, however, progressed has slowed post-Covid (Chart above). To be sure, pent-up consumer spending surged in 2023 following the end of lockdown; advancing over 8%, and accounting for nearly 80% of China’s GDP growth last year. However, consumer confidence remains weak (next Chart). And, I expect household spending will cool substantially in 2024, unless authourities overcome their reluctance to provide fiscal support to consumers.

Property Crisis: Investment and Productivity Stagnation

Slowing productivity growth has played a central role in China’s secular growth slowdown (Chart above). Previously, excessive capital spending, especially in inefficient SOE activities, led to a huge misallocation of resources. Not surprisingly, therefore, the government’s long-term aim is to cut the investment/GDP ratio, and shift capex towards private sector firms. During Covid, however, the government’s fiscal stimulus focused again on plowing resources into SOE investment (Chart below). Consequently, there’s little reason to expect overall productivity growth has improved.

Meanwhile, private capex has stagnated since the pandemic (Chart above). On the one hand, manufacturing investment has remained relatively healthy. However, service sector capital spending, supposedly a priority area, has stagnated. Most important, of course, has been the crisis in the property sector. International experience suggests China’s real estate adjustment will remain a drag on economic growth for several years yet (Chart below). Indeed, the IMF estimates property construction may decline 50% compared to 2022 levels before stabilising.

Overall, I expect capital spending growth will lag GDP in coming years, and the investment ratio will decline.

International Risks: Vulnerable to De-globalisation

China’s policy aim is to reduce its reliance on exports, while boosting the domestic economy. During four of the past six years, however, the external sector has continued to contribute positively to GDP growth. In 2023, however, strong consumer spending did result in the foreign sector becoming an economic drag. With global growth remaining tepid in 2024, I expect this trend to continue this year and beyond.

In addition, China appears potentially vulnerable to rising global geo-political and trade tensions. Indeed, the IMF estimates China’s economy is one of the world’s most at risk to friend-shoring (relocating supply chains to politically allied partners) and reshoring (returning overseas production to the domestic economy) — Chart above. Indeed, China’s trade patterns are beginning already to reflect these shifts. The share of trade with the USA, Europe, Korea, and Taiwan is declining. Meanwhile, links with Russia and other nearby Asian nations are expanding (next Chart).

Macro-Stimulus: Fewer Options than Expected

Can macro-policy stimulus offset the likely slowdown in overall economic activity? The options are probably more limited than is widely believed. In addition to ballooning private sector debt, government liabilities have also soared in recent years. Moreover, according to the IMF’s definition, “augmented” government debt (including local government liabilities) will exceed 120% of GDP this year: higher than any other G20 nation except Japan (Chart below).

Therefore, despite all the talk of policy stimulus, China’s fiscal boost was been pretty limited last year, and is projected remain conservative in 2024 (subject to change, of course) — next Chart. Actually, in order to stabilise the public sector debt/GDP ratio, fiscal belt-tighening amounting to 5-7% of GDP will be required over the medium term. This is likely to involve boosting the tax burden with the aim of raising revenues and reducing income inequality, while still supporting household spending overall. Fortunately, China is unlikely to repeat Japan’s post-bubble mistake of tackling the debt/deficit problem before the economic recovery gains sustainable momentum.

The burden, therefore, will lie with the PBOC’s monetary program. And, despite recent interest rate reductions, monetary conditions remain far tighter than in countries previously experiencing real estate or other economic crises (Chart below). Therefore, I expect the PBOC to cut rates another 150bp. Future reductions, however, are likely to be coordinated with other government measures to address the real estate crisis. Unfortunately, therefore, these adjustments will come later, rather than sooner.

Strategic Implications

• China’s 2024 5% GDP growth forecast is unachievable. The economy is likely to expand only 3-3.5% in both 2024 and for the next few years.
• Macro-policy stimulus is required. As fiscal room to maneuver is more limited than expected, the burden lies with the PBOC. Interest rates will decline 150bp in the next 12-18 months. As a result the Yuan will depreciate another 5% or more.
• Chinese equities reflect many of these risks, and valuations are very cheap (next Chart). And, China dominates many key growth industries, e.g. tech, EVs, renewable energy, and critical natural resources. Nevertheless, as I suspect additional stimulus may be slow to emerge, I’ll wait till fiscal policy provides more support for consumers and interest rates head towards 2% before getting more bullish.