China is Facing its Worst Economic Crisis since the Cultural Revolution. What does a Weaker China Mean for the Rest of the World?

The vast program of economic reforms launched in 1978 by Deng Xiaoping has enabled China to achieve spectacular economic growth: China's GDP grew at an annual rate of 10% since the introduction of the reforms. In 2010, China became the world's second-largest economy after the United States.

One of the hallmarks of the economic reform era was boundless optimism: “Tomorrow will always be better than today”. With the economy in hyperdrive, future prospects seemed limitless, while the emergence of new technologies and better education provided a sense of freedom, even under an oppressive communist state. Capitalizing on these good feelings, the Communist Party was able to consolidate its grip on the country and build some local support.

China faces an economic downturn

The Chinese economy, the world’s second-largest economy kept growing during the Covid-19 pandemic, while all the rich economies of the Group of Seven (G7) contracted. It seemed only a matter of time before China would overtake the United States as the world’s leading economy.

However, the Chinese government has made a number of errors, such as persisting for too long with zero-covid lockdowns and imposing intrusive regulations on private companies, thereby clipping the wings of China’s biggest growth engine. The result: China's private sector is in retreat. Whereas in 2021, private companies accounted for 55% of the collective value of China's 100 largest listed companies, by mid-2023, this share had fallen to 39%, according to estimates by the Peterson Institute for International Economics.

This explains the high youth unemployment rate among 16-24-year-olds, estimated at almost 50% by Professor Zhang Dandan of Beijing University (more than double the official figure).

1.     Bad debts

One of China's biggest problems is that it has relied on a borrowing binge to sustain growth since the global financial crisis of 2008. Ever since, the combined debt of the private and public sectors has doubled to 3 times the country's GDP. On average, debt has risen by 10% of GDP per year.

The engine of the Chinese model is investment, massive investment – in factories, highways, airports, shopping malls, high-rise apartment buildings and so on. When China embarked on its reforms, it was destitute and much of the new infrastructure was needed. Improved transport systems boosted economic efficiency; new housing accommodated families migrating from farms to cities in search of opportunity. These investments transformed China into a global manufacturing powerhouse, posting spectacular growth rates.

The current economic slowdown is, in many ways, typical of any credit-driven boom-and-bust cycle. China’s real estate market, which accounts for around 30% of GDP, is the main culprit. Despite a shrinking population, property developers have taken on more debt to build more new homes every year than the US and Europe combined. Today, China has between 23 and 26 million unsold apartments – enough to house the entire population of Italy.

When Xi decided to tighten real estate regulations, he unleashed a series of events that have become a considerable drag on growth and a major challenge for his government. Home prices began to fall, developers began to default and people became angry.

2.     The economy is decelerating

China's $18 trillion economy is decelerating. The much-vaunted Chinese model – the mix of liberalization and state control that generated the country's hypersonic growth – is crumbling.

The news of this economic crisis comes as no surprise. For years, economists and Chinese policy makers have been warning that the Chinese model was fundamentally flawed and inevitably doomed to failure. Early in his tenure, in 2013, Xi signed off on a Communist Party reform bill that pledged to give the market a "decisive" role in the economy. But these reforms never saw the light of day. Xi was not prepared to relinquish political control for the sake of economic growth.

Politics have further exacerbated the debt problem. The Communist Party has trumpeted high growth rates as proof of its legitimacy and competence, so that when rates fell below target, the government unleashed credit to bring them back up.

There is no magic solution. Debt restructuring will hurt economic growth. The government will have to write off bad debts and close down zombie companies. Economists call on China to "rebalance", meaning that it must scale back its dependence on investments and foster new engines of growth, especially domestic consumption, which is abysmally low compared to that of other major economies. Finally, it must introduce far-reaching market reforms, which policymakers have so far avoided.

“If China were to implement the right reforms", explains Daniel Rosen, co-founder of Rhodium, "growth would certainly be very low during a period of adjustment, but it would then emerge with an annual growth rate of 3 to 4% – not bad for an economy its size".

3.     The threat of deflation : the effects of a sluggish economy

In contrast to the United States and Europe, where inflation was rampant, China’s inflation was low, coupled with weak domestic and foreign demand.

Just as China was in desperate need of a domestic consumption boost, Xi's draconian policy of shutting down markets during the pandemic delivered a devastating blow to household incomes, particularly those of the middle class [the lifeblood of a prosperous society]. This led to a very weak domestic demand. At the same time, Chinese exports were hit by a global economic slowdown and the introduction of sanctions. These sanctions reflect the determination of Western countries to disengage their economies from China, fearing the consequences of Taiwan coming under mainland control by force, or that Chinese claims to the waters of the South China Sea could lead to confrontation.

4.     The end of optimism

The go-go years of China’s economic growth have come to a halt, and with them, welfare benefits and job creation galore.

In the absence of a free press and freedom of expression, it's virtually impossible to know how the Chinese people really feel about Xi and his policies. However, some statistics provide clues. Take entrepreneurship, for example. Just a few years ago, incubators were popping up all over the country in response to a wave of business start-ups. That enthusiasm has since faded. According to reports from Global Entrepreneurship Monitor, which tracks start-up trends worldwide, the number of entrepreneurs in China has fallen dramatically, from 15.5% in 2014 to just 6% last year.

The Chinese aren't starting families either. The number of babies born in China fell by almost half between 2016 and 2022, to 9.6 million for a population of over 1.4 billion. According to Nicholas Eberstadt, a demographics specialist at the American Enterprise Institute, this decline in the birth rate "reflects a deep disaffection with the bleak future the regime is preparing for its subjects" and "can be interpreted as a landslide vote of no confidence in President Xi Jinping's rule".

Rising pessimism may also account for the number of Chinese fleeing their country. According to the UN Refugee Agency, by the end of 2022, more than 116,000 Chinese nationals were seeking asylum worldwide, 10 times more than in the previous decade.

What are the implications of a weakened China for the rest of the world?

The slowdown of China's economy may undercut Xi's ideological assault on the world order.

China’s economic difficulties suggest that authoritarian regimes cannot both tighten control and sustain economic progress - that, ultimately, political reform must accompany economic reform.

It's unlikely that Xi will accept this inconvenient reality. If anything, he will pursue his anti-West agenda with even greater urgency. Xi's economic philosophy does not seek integration with the rest of the world, but rather prioritizes the domestic front, by mobilizing Chinese resources for domestic purposes and competition with the United States. His mantra is "self-sufficiency", which means eliminating China's dependence on the outside world, especially the West. Thus, by focusing on self-sufficiency in areas such as artificial intelligence and semiconductors, he seeks to protect China from US sanctions by substituting imports with local alternatives.

While China's detachment from the West is in itself a major shift, it is not the only one China has undertaken. The country's companies and banks are also, in many ways, scaling back their engagement with the world.

This is why economic weakness could make China's leaders all the more dangerous, more inclined to champion nationalist causes and embark on foreign ventures, such as the military conquest of Taiwan. Expansion appears to offer a solution for seizing economic resources and markets, making nationalism a crutch for a wounded regime. If he cannot deliver rapid growth, he will have to find another way to justify the repression of his people. Xi may not be able to make China rich, but he can certainly make it great!

Final thoughts

The Chinese economy is by no means beyond repair, but the road to recovery will be both costly and painful. The economic landscape varies considerably from region to region and from sector to sector. What's more, China retains many advantages: unrivalled manufacturing supply chains, innovation centers, plus a gigantic domestic market.

By prioritizing political power and control over economic efficiency, Xi is alienating valuable trading partners such as the US and its allies, the G7 members, who are jointly moving to “de-risk' their exposure to the Chinese economy. Yet these countries can provide China with what it needs most for its growth, such as cutting-edge technologies and an influx of foreign capital.

A weaker economy will hold back China’s ability to project its power abroad. It won’t be able to ramp up its military spending so rapidly. And it won’t be keen to run up more bad debts abroad to gain influence in the Global South.

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