Will China’s Economic Slump Be Contagious?
Written by Benjamin Hart, an employee of Intelligencer who became a member of the New York team in the year 2017.
Image Composition: Intelligencer; Photograph: CFOTO/Future Publishing via Getty Images
Following Xi Jinping's sudden removal of numerous restrictive COVID measures in early 2023, it was expected that life in China would go back to normal. However, the country's economy is facing significant challenges. One major issue currently is a longstanding real estate crisis, but there are several other indicators suggesting trouble in a country that has been accustomed to steady growth rather than crisis. Additionally, Xi, being an ideologue who has implemented strict measures on private businesses and pandemic protocols, has contributed to widespread uncertainty. It is questionable whether he is the right leader to tackle this problem. To gain insight into China's current situation and its potential impact on the global stage, I interviewed economist Brad Setser. Setser is a Senior Fellow at the Council on Foreign Relations and previously worked at the Treasury Department, where he frequently writes on this subject.
Each day brings new headlines discussing the decline of China's economy. Consumer spending is decreasing and youth unemployment is on the rise, with the government even ceasing to release statistics on the matter. Is there one specific cause of this gloominess? Or is it more of a domino effect where everything is going wrong simultaneously due to a loss of overall confidence? I believe there is one core reason behind this malaise, and in a way, it is concrete. The slowdown of China's property sector, the decrease in new construction, and the slight decline in housing prices play a significant role. Many housing prices are artificially propped up through various regulations, preventing them from naturally falling. The property sector, which includes property development, building new apartments, associated infrastructur
Was this outcome expected in any way, since the prosperous times had lasted so long and they perhaps weren't sustainable? Or did it come as a shock to you and other individuals who closely monitor this situation? I believe it has been surprising that this decline has continued for as long as it has and that there hasn't been a more decisive action taken thus far. However, it was evident that there would come a point when the construction industry, which was closely linked to a series of financial imbalances, would experience a decline, presenting a challenge to China's economy. Yet, the precise timing of the slowdown was initially a deliberate choice made in policy. The implementation of the "three red lines" policy that initiated the initial property market correction was an intentional effort to deflate a property bubble. The prolonged nature of this decline seems to indicate that the Chinese political system has faced difficulties in formulating a cohesive response. Ultimately, this was a crisis that could be predicted, but the exact timing and endurance have been slightly unexpected.
The implementation of Zero COVID measures heavily impacted the daily lives of regular Chinese families at certain times, effectively disconnecting China from the global community. About half a year ago, there was a general belief that once these restrictions were lifted, there would be a gradual recovery similar to what happened in other countries after the removal of COVID restrictions. However, it has come as a surprise that the adverse effects of the struggling real estate market on consumer faith have outweighed any anticipated increase in consumer spending.
President Xi appears to have a different viewpoint when it comes to providing direct stimulus like the United States did during the COVID-19 pandemic. You have expressed concern about his stance. Is this because you believe it is the most effective solution for the central government to address the crisis, considering the local governments are burdened with debt? I am uncertain if it is the sole solution, but I strongly believe it is the most favorable option. There are two notable aspects about China's economy that stand out to me. Firstly, household consumption plays a significantly smaller role in overall economic activity compared to other countries. In China, property investment, infrastructure investment, and manufacturing investment have a much larger impact. Typically, it is the opposite in other regions such as the United States and Europe, where household consumption drives the economic cycle. Secondly, the central government in China has practically no debt. When considering various definitions of central government debt, including the railway ministry, it accounts for only 25 percent of GDP. This is substantially lower than the debt of the United States federal government, France, and even Germany, which is known for its fiscal prudence among major advanced economies.
By combining these two factors, when faced with an economic downturn, the most logical response is for the central government to utilize its financial resources to directly assist households. This could be done through methods such as distributing monetary aid or providing rebates on the Chinese equivalent of payroll taxes. Another option could be to find a way to alleviate the burden of healthcare costs, similar to how the U.S. government covered the expenses of COVID vaccinations. There are various ways to directly support households and their income, such as expanding unemployment insurance. It is notable that China has chosen not to implement these measures. Even during the initial shock of the COVID pandemic, China refrained from implementing such measures, but its recovery was aided by strong global demand, which the U.S. and Europe supplemented with household stimulus.
However, this task is becoming more challenging as there is a decrease in demand for Chinese products in countries like the United States, correct? They cannot rely on exporting as a way to resolve this issue, as they did in the past. In my opinion, the situation in the United States is stabilizing. A similar trend can also be observed in Europe, although China's exports to Europe are still significantly higher than in 2019. They are just no longer experiencing growth. Therefore, it can be viewed as more of a correction rather than a sharp decline. The export level will still remain relatively strong. However, China had become accustomed to achieving growth by selling to the rest of the world. Net exports played a crucial role in China's growth in 2020, 2021, and even 2022. Unfortunately, this will not be the case in the current year.
Returning to the main issue, it appears to be the most logical reason why China has not provided direct assistance to households in response to the impact of COVID and why it has not provided more direct assistance during the current economic decline is because the individuals in power, including President Xi, simply do not support it. This is concerning to me. Other methods for China's recovery pose greater risks, either to China itself or to the rest of the world.
What other alternatives exist? There are alternative choices available. Personally, I find them unattractive, but there are other choices. The favored option being suggested by Chinese officials seems to be to accept a level of growth slightly below the targeted rate. It is argued that those observing from outside China are more anxious than the Chinese policymakers themselves, who have come to terms with the fact that addressing the excessive developments in the real estate market and implementing some of Xi's plans to enhance China's technological self-sufficiency will result in temporary setbacks. Furthermore, they are not overly concerned about an economy that is not expanding as rapidly as it has previously.
An alternative choice would be to ease a set of rules and regulations, exerting immense pressure on the state banking system to provide loans to the real estate industry and aid local governments. This approach would involve overlooking worries about the long-term financial stability and prioritizing infrastructure development to stabilize the property sector. It is worth noting that the banking system in China remains largely controlled by the state, making this option quite feasible. However, China appears hesitant to pursue this route as it would entail taking even greater risks and potentially increasing the long-term deficits faced by the banking system.
And the third option is to allow the currency to depreciate significantly, handle the related impacts on domestic confidence, and attempt to rely on exports to overcome a decline in the property market. Countries worldwide often experience substantial fluctuations in their current account or trade balance during periods of major construction booms and busts. Therefore, despite China currently having a substantial trade surplus, it is conceivable that China may attempt to utilize exports to alleviate this economic decline. Hence, I believe there are alternatives, although these alternatives may not be as advantageous for both the Chinese economy and the global economy.
And naturally, there's no electoral process to contend with. Xi has recently secured a five-year term, and it is assumed that he will secure another five-year term. There is no chosen individual to take over his position in the future.
There seems to be a general agreement that the current crisis will not have a significant impact on the United States at the moment. However, if the situation worsens, there might be more widespread effects. Do you share this view? Unless you own a company that heavily relies on sales in China, the direct consequences of a Chinese economic slowdown on the US economy are relatively limited. Over the past nine months, China's economy has already experienced a decline, while the US economy has managed to keep growing. In terms of its overall size, China only represents a relatively small market for US exports. Manufactured goods account for just a small fraction of US GDP, as China does not import a large number of these products. On the other hand, if you work in industries related to commodities, it is crucial to closely monitor China. This is because China is the largest source of global demand for many commodities and commodity markets. While these markets are influenced by various factors, including supply conditions, a structural slowdown in China will inevitably impact them to some extent.
The connection between finances is not significant, however, the main way I believe China could harm the U.S. economy is if they choose to rely on exporting. This is because the U.S. is the largest market for both consumer and imported goods worldwide. Despite the existence of tariffs, they are not foolproof. One can easily bypass tariffs imposed on Chinese goods by manufacturing products using Chinese components in countries like Malaysia and Vietnam.
In my opinion, if China decides to devalue its currency in order to boost exports, the Yuan would likely drop even further in value. The Yuan is already at its lowest point in 15 years, more or less. If the Yuan returns to the levels it was at when China became a member of the WTO, without implementing significant trade restrictions, certain sectors of the US economy could face significant pressure. Therefore, how China reacts and responds still remains important to me. If China's economic growth simply slows down, the impact on the US would be relatively small because China has never allowed American companies to manufacture goods in the US for sale in China. The only major company that was successful in doing so was Boeing, but China stopped purchasing from Boeing several years ago.
However, American firms do engage in competition with China. Additionally, alternative markets also vie with China in producing specific goods for the American market. Undoubtedly, China possesses the largest manufacturing infrastructure globally. Therefore, sectors of the American economy that directly compete with China could potentially encounter challenges if China fails to explore recovery avenues beyond exports.
Are there any other major economies that have strong connections with China and may experience worse consequences? Absolutely. Germany, for example, has much deeper ties. Germany has achieved greater success in selling capital goods and luxury cars, all manufactured within its borders, to China compared to other major economies selling goods produced in their own countries. Consequently, Germany is significantly more exposed to direct trade with China. The situation is somewhat similar for the rest of Europe, including the United States, where China is not as crucial of a market. Although it is not insignificant, China does not drive economic activity on such a large scale. Most of Southeast Asia and East Asia are closely linked to China, but this connection mainly involves supplying components for China's export-oriented industries.
If China ends up relying on exporting as a solution, it may not directly harm others. However, there will likely be more indirect effects from the Chinese slowdown. The impact will ultimately depend on how the commodity market responds. As of now, there hasn't been a significant correction in the commodity market due to various complex factors. However, there are several other shocks occurring globally, such as Russia and Ukraine's impact on the grain market and the Saudi's control over oil prices. Nevertheless, countries that heavily rely on exporting commodities typically have the highest vulnerability to changes in Chinese demand. Therefore, there is a possibility that these countries may experience more indirect effects from the Chinese slowdown.
This interview has been condensed and made clearer for better understanding.
