China faces an economic perfect storm – with potentially catastrophic consequences

Xi Jinping
Chinese president Xi Jinping faces a challenging economic situation with China teetering on the edge of deflation - FLORENCE LO/POOL/EPA-EFE/Shutterstock

It may seem odd to those of us having to contend with sustained inflation, or what has been dubbed the cost of living crisis, but in China households and firms are experiencing precisely the opposite. Some may consider falling prices a positive development for the Chinese economy. This would be a mistake.

The immediate story is nuanced. In July, consumer prices were 0.3pc lower than in the same month last year, but the negative dip is mainly because there was no repetition of last year’s 25pc surge in pork prices.

In fact, if you look at “core inflation”, which strips out volatile prices such as food and energy, China’s inflation increased from 0.4 to 0.8pc. Overall, the prices of goods were about 0.5pc higher than last year, and services were 1.7pc higher.

Factory gate prices have been much weaker, falling for many months. These mainly reflect the behaviour of commodity prices.

The broadest measure of inflation, which is available only each quarter, is the “GDP deflator”. This has only ever been negative five times: for almost two years in 1998-99, briefly in each of 2009, 2015 and 2020, and again in the April-June quarter 2023, when it was 1.5pc lower than a year ago.

The important questions now are: will a protracted deflation plant roots, and would it matter?

To the latter point, it matters a lot. When prices are weak or falling because of a chronic shortage of demand in the economy, and not because of vibrant competition and buoyant income and productivity, they reflect unequivocally bad conditions.

There is little question that China’s economy is not in a good place. It grew at a frail pace in the second quarter of 2023, well below the forecast. This doesn’t negate its leadership in clean technologies, electric vehicles and other science and tech accomplishments of course. Both are real.

But it is pressingly urgent for the Chinese Communist Party (CCP) to diagnose and correct these conditions before deflation becomes more deeply embedded.

Deflation punishes debtors, of which China has many, and is often a companion of economic stagnation. In China, this could have catastrophic geopolitical consequences.

The pandemic and the CCP’s zero-Covid policies, which were abandoned late last year, undoubtedly weakened its economy, placing additional stress on the real estate market, on households and private firms. But Covid was not the cause of China’s current woes. It has faced a perfect storm of rapid ageing, declining fertility and a falling working age.

Worse, the deadweight of over-indebtedness and debt service difficulties among local and provincial governments and state enterprises has thrown a spanner into significant parts of the economy, crushing dynamism and growth.

The real estate sector, which accounts for roughly 25pc of China’s economy, a huge proportion, has finally tipped over and faces years of shrinkage. This was the predictable consequence of over-indebtedness and overbuilding combined with worsening demographics which curtails household formation and reduces the number of first time buyers.

Personal income growth is growing at roughly half the rate that prevailed before the pandemic and, in the meantime, households have become less confident about the prices of homes, which comprise about three quarters of their wealth, and about the economy more broadly.

While measured unemployment appears to be relatively low and stable – we don’t really know – youth unemployment has ballooned to over 21pc, as the summer’s graduate throughput of 11-12 million students come on to the job market. By way of contrast, in the UK, youth unemployment is 11.4pc; in the US, around 8pc, albeit measured slightly differently.

Productivity growth in the Chinese economy has slowed to a crawl. And private firms and entrepreneurs, the backbone of China’s rise, are playing second fiddle to a much more state-centric and state-controlled economy and in a much more restrictive governance environment.

Meanwhile, the external environment China faces nowadays, regarding trade, export controls, and foreign investment, is punishing.

This hasn’t deterred China from registering ever larger balance of payments surpluses, as also revealed by recently published data, but mercantilism always has a soft underbelly, which is the fragility and weakness of the domestic economy.

For almost a year now, political leaders have used formal and informal party events to call for stronger domestic demand and stronger consumption. The latter in particular is essential if deflation is to be stymied and reversed.

Yet time and time again, this has proven easier to say than to deliver because the Government needs to embrace deep economic, and often political and institutional, reforms which run contrary to the CCP’s DNA.

In the coming weeks, the Chinese Government will almost certainly lower interest rates and ease financial rules for banks and for housing, sanction additional borrowing for infrastructure projects the country does not need, and offer both words of encouragement to private firms and consumption-looking measures that will do little to boost household income and consumption.

The deflation threat will not dissipate until or unless the Government is prepared to transfer resources and wealth to households, and that may mean both purchasing, and some political power.

China has not yet tumbled into deflation, as Japan did from 1995 until relatively recently. Yet there is little doubt the country is flirting with it. The longer this continues, the more it looks as though the 21st century may not be China’s, after all.

George Magnus is research associate at Oxford University’s China Centre, and author of Red Flags: Why Xi’s China is in Jeopardy

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