China’s decade-long economic slowdown is accelerating. The pace has picked up since former U.S. President Donald Trump launched his trade war against China in early 2018, and even more so since the COVID-19 pandemic started in early 2020. This year has been particularly difficult as stubborn zero-COVID policies have ground the economy to a halt, further pushed by the bursting of the real estate bubble that had been China’s most important engine of growth for decades.
Many ask themselves how much of China’s deceleration is cyclical and how much is structural, but also how much can be reverted. On the first issue, the cyclical element of the ongoing deceleration of the Chinese economy is clearly important and adds additional downward pressure to the well-known structural factors, such as aging and decreasing labor productivity.
Zero-COVID Policy and Property Bubble Combine to Dim Growth Prospects
Cyclical factors have been made more acute by zero-COVID policies, which are estimated to have cost the economy two percentage points of growth in 2022 by reducing mobility and, thereby, consumption. In addition, the demise of the real estate sector is another important factor adding downward pressure on growth, whose effects will be more enduring. Against this backdrop, Chinese policy-makers have been announcing successive rounds of fiscal and monetary stimulus for months, as a way to achieve the official 5.5 percent growth (People’s Republic of China [PRC] Ministry of Finance [MOF], August 25). By now, it is apparent that the target will not be achieved notwithstanding these efforts to support the economy on both the fiscal and monetary fronts.
The question, thus, is whether President Xi Jinping’s third term may change this reality, and if so, how? While the economic situation is clearly difficult both for structural and cyclical reasons, the fact that Xi has continued to push for zero-COVID policies casts light on the direction that he is seeking to move in with his economic agenda. Hitherto, there are no clear signs that Xi will change his zero-COVID policies at the outset of his third term. On the contrary, stringent zero-COVID epidemic restriction measures, including mass lockdowns, have remained in place, even in extreme circumstances such as the recent 6.8 magnitude earthquake that struck the mega-city of Chengdu in Sichuan province earlier this month (South China Morning Post, September 6). If there was a time to lift mobility restrictions, it would be now in the run-up to the 20th Party Congress so as to avoid discontent among the population given the massively negative impact of such restrictions on population movement, consumption and economic activity, more generally.
The other big shock affecting the Chinese economy today is the bursting of the real estate bubble. Based on other countries’ experience struggling to absorb the excesses of a burst real estate bubble, the first years of Xi’s third term will be defined by a painful economic adjustment process. Undoing such overcapacity in the property sector will imply lower investment in the real estate sector for years, with obvious negative consequences on growth (Caixin Global, September 1).
As the zero-COVID policies and the consequences of the bursting of the real estate bubble are bound to continue to exert a negative impact on the economy after Xi Jinping’s re-appointment, one could imagine that policymakers will be asked to step up their efforts to jump start growth coming out of the Party Congress. The problem is that extensive efforts have already been made to use both fiscal and monetary policies to support growth this year in an attempt to meet the official 5.5 percent target, but to no avail. In fact, while fiscal and monetary policies are already laxer than last year, these measures have clearly not been enough to bring the growth rate back to the desirable path.
Back to Beijing’s Old Playbook?
The reason for this, which is not bound to change during Xi’s third term, is the lack of workable options on fiscal and, even, monetary policy. Starting with fiscal policy, the government has often announced the use of infrastructure investment as a stimulus tool since the second half of 2021 and, especially, the second quarter of 2022, but these injections have not generated enough growth to get close to the official target. Indeed, infrastructure investment increased at a decent 7.4 percent year-over-year rate from January to July, but at least 18 percent would have been required to achieve the official growth target (Xinhua, August 31). Furthermore, the stagnant growth so far has weighed on China’s tax revenues, making it harder for local governments to engage in infrastructure spending, especially as their COVID-19 epidemic prevention expenditures remain high (Caixin Global, July 5). By July, the narrowly defined general government deficit was 65 percent of the annual budget deficit, which is significantly higher than previous years (Barron’s, September 12; Gov.cn, August 17).
The fiscal situation appears even more concerning when another critical component of the government deficit in considered, namely the government fund, which is supported by government land auctions (PRC MOF, July 14). Due to the slump in property sales, the year-to-date government fund deficit has already reached 94 percent of the annual budget deficit (Bloomberg, July 29). Therefore, while the government needs to continue its expansionary fiscal policy to keep the current growth momentum, the room left in the budget to support further expenditures is very limited. As such, Xi might need to reform the economic relations between the central and local governments to increase the efficiency of fiscal policy. This, however, will probably bring to light much more debt, which will be regarded as public, thereby undermining part of the regained fiscal space.
On the monetary policy side, the People’s Bank of China (PBOC) has taken an accommodative stance since the beginning of the year. In fact, the central bank cut the one-year and five-year loan prime rate twice and three times, respectively, to lower funding costs for the corporate sector and mortgages (Sohu, August 22). The PBOC also reduced the required reserve ratio in April to unleash more liquidity (Xinhua, April 20). As inflation is still comparatively low in China, there is in principle some room for further rate cuts, but again this is very limited and it is hard to argue that Xi Jinping’s in his third term will be able to change course. Moreover, a move to push rates too low could have a number of detrimental effects. First, Chinese banks’ financial health has been weakening for years, especially for smaller banks. With additional cuts, banks may find their net interest margin reduced at a time when their asset quality, and therefore profitability, is worsening. In addition, given the hawkish stance of the Federal Reserve and the increasingly less appealing yield differential between China and the U.S., capital outflows may increase and further weigh down the renminbi. In other words, the PBOC is in a bind and will remain in a bind for quite some time. In principle, it needs to cut rates to support the economy but faces too many constraints in doing so.
All in all, there will be strong incentives for President Xi, after receiving a mandate for a third term at the Party Congress, to keep expansionary fiscal and monetary policies in place in order to show a better growth picture. However, the room for maneuver is much more limited than in the past. The fall in fiscal revenue will continue to constrain the government’s ability to invest in infrastructure, even as the return on assets of such projects has declined. The PBOC will also find it hard to push interest rates too low given the concerns about financial health and the rising yield differential between China and the U.S. Because of these policy constraints, in addition to the likely continuation of zero-COVID policies in one form or another, as well as the swallowing of the excess related to the demise of the real estate sector, growth prospects for China under President Xi’s new term should be underwhelming and possibly not go above three percent in 2023 and beyond.
Alicia García-Herrero is a Senior Research Fellow at Bruegel and Adjunct Professor at Hong Kong University of Science and Technology. She is also Chief Economist for Asia Pacific at NATIXIS and a non-resident fellow at the East Asia Institute of the National University of Singapore.