China’s Economy Is Bad, but Not as Bad as Some Think

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The forces that powered China’s growth over the past 20 years have stalled or shifted into reverse. While that hardly qualifies as good news, it’s also not a catastrophe, for China or for the rest of the world.

China’s economy is in the worst shape in decades as financial and geopolitical pressures mount and policy makers struggle to persuade consumers and businesses to spend their way out of a slowdown. At the same time, the world’s second-largest economy isn’t on the brink of a “Lehman moment” that spirals into a global financial meltdown or destined for a Japan-like decadeslong deflationary spiral, China experts say.  

Those ready to write off China underestimate the resources of Chinese policy makers and the power of an $18 trillion economy that is home to 1.4 billion people. And talk of a broad-based breakup, or decoupling, of companies and other nations with China ignores how intertwined it is with the rest of the world. China is the top trading partner for 120 countries.

There’s no doubt that China’s feeble recovery from a three-year period of strict Covid restrictions and crackdowns on property and the private sector has battered business and consumer confidence. And Chinese leader Xi Jinping’s focus on deleveraging, in part to shore up the country’s fiscal health, complicates efforts to stabilize the property market and the broader economy.

Slower growth combined with Xi’s increased intervention in the economy and more aggressive stance globally—including military exercises over Taiwan and raids on foreign businesses—have shined a harsher light on problems that have long worried U.S. executives and investors. Foreign direct investment in China has dropped from $100 billion a quarter about five years ago to $5 billion as companies repatriate profits rather than reinvest, says Nicholas Lardy, a nonresident senior fellow at the Peterson Institute for International Economics and a China economy expert. “That’s a marked change from when companies used to think China was a great place to invest,” he says.

The MSCI China has lost almost $2 trillion in value since its peak in February 2021, with the index down 54% since then. Since 2019, U.S. investment in Chinese private equity and venture capital has fallen by more than 50%. And while the latest survey of members of the American Chamber of Commerce in Shanghai showed a marked increase in the difficulty of doing business in the country, two-thirds said they haven’t changed or considered altering their business strategies or business models in China.

The bad news can lead to good news: The worse the near-term economic situation gets, the more confident money managers and economists are that Beijing will step in with more stimulus to stabilize the economy, and eventually offer a floor for stocks.

Worries about an economic collapse “overlooks that Beijing always intervenes and is willing to kick cans down the road to ensure it is a grinding decline versus a U.S.-style collapse,” says Rory Green, head of China and Asia research for TS Lombard. “There are lots of levers Beijing could pull if they wanted.”

Though some have painted China’s slowdown as an existential crisis, veteran investors point to the breadth and size of the economy. “It’d be one thing if it was a depression, with GDP down 10% and people on the street complaining. But this is not that. It’s going from 8% to 4%,” says Arjun Divecha, who oversees $3.3 billion across GMO’s emerging equity strategies.

Divecha doesn’t think the current economic troubles will spark political instability or that a more nationalist pivot will trigger a conflict over Taiwan. “The Communist Party’s ultimate goal is to stay in power, which means keeping their population happy,” he says.

A further collapse in the property market would go against that goal, eviscerating a large store of household wealth. Property sales are down about 40% from their peak in 2021, and housing starts are down 60%, though Beijing has been able to manage the decline in prices, which are off about 33% from their peak levels.

But two years after
China Evergrande Group
(ticker: 3333.Hong Kong), one of the world’s largest developers, collapsed, Country Gardens is flirting with default as it struggles to find home buyers in smaller cities. The embattled developer’s troubles could add to the burden of indebted local governments that have seen land sales dry up, hurting their ability to finance their debt. 

Policy makers still have options to keep the situation from turning into a systemic problem. They could roll back more of the restrictions they had implemented in recent years, including those on second-home buyers, and even force banks to provide cheaper mortgages, says Shehzad Qazi, managing director at independent research firm China Beige Book. If those efforts fail, that could be enough for Xi to reassess his aversion to household-focused stimulus.

Already, Beijing has introduced a spate of incremental measures including reducing reserve requirements at banks and down payment requirements to spur borrowing and home buying. More clarity on the direction of reform and policy broadly could come at China’s meeting of the Communist Party’s Central Committee, where new economic thinking is often previewed, probably in October.

The property turmoil is overshadowing glimpses of improvement elsewhere. Spending data this summer have been strong, with August retail data better than expected, and per capita consumption in the first half having grown 8.4%, outpacing the 6.5% growth of per capita disposable income. That indicates Chinese households were dipping into the savings built up during the pandemic, and could mark a turning point, says Lardy, who adds that the sentiment in China isn’t as dour as it is on Wall Street.

Repairing confidence among entrepreneurs to revive investment could snap investors out of their funk. Sentiment among privately owned businesses is crucial because they account for about 90% of urban employment. But Beijing’s erratic and sometimes draconian policies with Covid, its crackdown on internet giants like
Alibaba Group Holding
(BABA) and
Tencent Holdings
(700.Hong Kong), and its decision to let Evergrande default on bonds rather than provide it support, have made businesses skittish. 

Policy makers have vowed more clarity on regulatory measures, but it will take time to repair confidence. While it took two quarters for economic activity to stabilize and spending to start recovering in past crises, Green expects that the magnitude of shocks this time means it could take longer to see the turn—and that could mean three quarters of lackluster data ahead.

Beyond that, China’s recovery is unlikely to get it back to its robust past. From 2008 to 2016, China’s banks added almost $27 trillion in assets, roughly a third of global gross domestic product, which was poured into the infrastructure and construction boom that led to the property bubble that policy makers have spent years trying to deflate. This recovery won’t have the same power, with credit growth cut in half to roughly 9% this year, though this still amounts to new credit growth of $4 trillion to $5 trillion—roughly Germany’s GDP, Wright says.

Cautious investors like Divecha favor companies that should benefit as Xi tries to revitalize technology and other companies that will benefit from increased investment as Beijing focuses on extending its global lead in clean energy and reducing reliance on foreign suppliers.

 
J.P. Morgan
economists warn that China could be vulnerable to a systemic default if the troubles at Country Gardens ripple through wealth management products, which lent money to developers and local governments, and then spread to commercial banks.

Yet, a debacle like the global financial crisis is unlikely, since the majority of China’s financial system is controlled by the government. “Provincial authorities, for example, will step in and force banks—or create other financial institutions like asset managers—to take over failing lenders,” Qazi says.

Japan’s “balance sheet” recession took form amid an indebted corporate sector, crashing property prices and tumbling stocks that forced companies to use their earnings to service debt. That curtailed Japan’s economic growth for years, with the corporate sector suffering losses that totaled about 60% of GDP.

China isn’t in as bad a spot yet, in part because policy makers have limited property price declines, and its debt troubles aren’t as severe. China also has a lower urbanization and GDP per capita rate than Japan did, providing room for improvement and a catalyst for growth.

China’s main problem is that consumers don’t feel good enough to spend. To avert a Japan-like deflationary cycle, economists say policy makers need to improve the outlook for the economy, even as it goes through the bumps associated with shrinking its reliance on the property sector.

How much policy makers will have to do to stabilize the economy depends in part on how quickly and effectively they act—and if they can do it before investors, consumers, and businesses give up.

Write to Reshma Kapadia at [email protected]

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