Let Sleeping Giants Lie
Let China Sleep, for when she wakes, she will shake the world
Quote comonly attributed to Napoleon Bonaparte
I’m not really sure to what extent people are aware of this, because I’m not seeing too much discourse, but China is going through some stuff - and it’s not the “dye your hair blue after a grueling breakup” kind of stuff. It’s more “all the major economic indicators are coming up very weak” kind of stuff. So what’s going on?
I’ve been going through something - be afraid
China has been seeing a lot of bad news in its main economic indicators in June and July and August. First, unemployment ticked up slightly to 5.3%, and youth unemployment reached an all-time high of 21.3%. This figure is already facially staggering, but it gets worse when you consider it’s closer to, say, Spain (28%) or Greece (24%) than the US (8%) or Japan (4%) or even the EU (14%). The indicator was suspended due to “methodological reasons”1, following a trend of declining transparency in Chinese economic statistics (some of which are probably just outright fraudulent)2.
Plus a lot of minor quibbles here and there:
Q2 GDP growth was half a point below projections, standing at 6.3% vs 2022
Inflation has been at or near 0% for several months, and even turned into deflation in July (!!!!)
Industrial production grew 3.7% vs the past year, compared to proyections of 4.4%
Retail sales were also below target, at 2.5% (vs expected 4.5%)
Imports fell 12.4%, the biggest drop since February 2020, while exports dropped 14.5%, their biggest decrease ever.
June, July, and August PMIs (an indicator of how businesses perceive the economy) have been surprisingly weak
Is the Chinese economy in a recession? No. Is it going to enter a recession? Also no. The IMF, World Bank, OECD, and most private analysts peg Chinese growth at roughly 4.5% this year, which is around twice the normal US/Europe rate of expansion, but half the growth seen in the pre-COVID era. This would be a negative sign for the Asian giant’s trade partners (as in, every other country on Earth) but, once again, there will be no recession. (so far I have a solid track record of calling non-recessions).
A lot of problems seem to be concentrated in the financial markets: the stock market declined by 6% in August, and a number of major trusts and companies are going bankrupt and being sold at clearance, everything-must-go rates. Most of these are tied to the real estate sector in some way or another: developer Country Garden narrowly avoided defaulting, while Xinhua Trust, a shadow lender; is literally being sold on an e-commerce site; Zhongrong (part of the Zhonghzi group of holdings) might be about to go belly up; and of course, the ongoing saga involving Evergrande for the past three years.
What’s the government doing? The Bank of China has slashed interest rates by around 150 basis points (i.e. 1.5%, not 150% - there’s a difference between basis and percentage points!), and the government has announced a stimulus package mostly composed of infrastructure spending and relief for the real estate sector.
4-D chess
Long-term prospects for the Chinese economy seem overall pretty negative: China’s investment-led, urbanization-led growth model might be sputtering out. There appear to be, roughly speaking, four D related headwinds on China’s economy: debt, demographics, demand, and decoupling.
In terms of debt, the Chinese authorities are indebted up to their eyeballs: non-financial credit has reached 300% of GDP, of which roughly 20 points of output corresponds to the central govenrment, and 70% of GDP to local autorities - which are, alongisde property developers, very close from having cash flow issues to pay off their liabilities. There won’t be any sort of default incident, mainly because almost all debt is domestic and the government can control the banking system to prevent any sort of systemic incident. However, this is a two-edged sword: the government will also need to flex its muscles to keep itself funded, a state of affairs known as financial repression which has some pretty unpleasant side effects (ask Latin America).
Secondly, demographics: China’s population is growing at slower and slower rates due to its fertility rate crashing, as a result of government campaigns, while the share of the population at 60+ is steadiy growing. In fact, it’s estimated that its population has already started shrinking, having peaked in 2018. A smaller, older population also has a lower share of working-age adults, resulting in a slew of unpleasant consequences in terms of growth: there won’t be much demand in the economy.
Thirdly, and relatedly, demand. as will be developed a bit more later, the Chinese consumer has fared quite badly over the last three years, resulting in a lower starting (or finishing) point for consumer finances. Income growth and spending have decelerated while household balance sheets have deteriorated, due to the aforementioned decline in China’s property market. The CCP has a longstanding, hardline opposition to direct stimulus that sounds straight out of the strangest 90s fiscal conservative fever dreams, resulting in a weaker post-COVID recovery and in a weaker prospect for future demand. This isn’t a Vulgar Keynesian point about spending trickling up or something. Instead, China needs more consumption to pay for its astronomical pile of investments, and the government proposes more investment instead.
Lastly, decoupling. The US has been taking Great Power competition with China pretty seriously, resulting in a bunch of policy changes that are going to take economic activity out of China and towards the Western sphere. There’s a whole bunch of stuff going on that’s just too high-minded geopolitics for a simple economist, but it’s not looking good for China on this angle either.
A second 2007
There’s, roughly speaking, two major explanations for why the Chinese economy is doing badly. The first is that, much like the US, China is going through its own Vibecession.
A second sort of explanation is as follows: the Chinese economy is in astronomical levels of debt, while consumer income is stalling and balance sheets are deteriorating thanks to a housing market crash. The financial system is highly exposed to housing due to complicated, intangible investments in the housing market that entangles all the big players with each other in very opaque ways. The closest analogue is the 2008 Great Recession in the US, where a slowing economy, bad financial management, and issues in the housing market resulted in a widespread recession that worsened as the government refused to intervene properly.
The term for this sort of event would be a “balance sheet recession”, where a decline in the value of the assets of some part of the economy pushes it into some sort of insolvency (i..e being unable to pay off its debts), resulting in cutbacks to expenditures that lower investment, consumption, and growth. Another example would be the Great Depression, where higher interest rates crashed the stock market and tanked consumer spending, thus pushing the entire economy into a prolonged recession that was worsened by the gold standard constraining the economy. Looking at the data, there’s not a lot of evidence that this is happening in China, and the evidence for that case is pretty weak and convoluted. This means that this won’t be another 2007, or even a 2001, and it’s gonna be more a 2022/2023 if anything.
But there’s a fundamental issue with China’s economy: the government has pushed down demand systematically in favor of an investment-led economic model, where government infrastructure spending and private capex expansion have been the drivers of a 30-year economic boom, and for which (definitionally) an external sector surplus and a household sector savings surplus must be maintained. The whole decoupling thing risks the external surplus part, which also puts some major constraints on monetary policy - the impossible trinity isn’t impossible for no reason (just ask Liz Truss - remember her?).
At the same time, China’s model of consumer repression isn’t going to work out for much longer if the government makes everyone save and not spend. This would be an old-fashioned Keynesian blunder called the “paradox of thrift”: if nobody spends, then everyone is poorer, because one woman’s spending is another woman’s income. As a corollary, I’m not doing anything objectionable when I spend all my money on fancy coffees and nice clothes every month, I’m just preventing the paradox of thrift.
Overall, we’re getting into pretty neoclassical, 1920s territory: capital has decreasing returns, which means investments begin turning less and less profitable over time. The Chinese Communist Party (CCP) has achieved enormous growth by taking a billion peasants and turning them into decently educated urbanites, but it’s not like there’s a second China to pull out of a magic hat, and at a certain point you start running up against the Production Possibilities Frontier: you just need more productivity and stuff like technology, education, and good vibes, rather than pumping capital into the economy. Pretty standard middle income trap stuff.
China finding new ventures is unlikely, since it has a pretty throbbing pace of investment, and its current troubles might be negative for, say climate change technologies (or positive. Experts remain divided). And foreign investment? Well, for once, it’s drying up because of good ole’ higher interest rates in the US, fears about decoupling, and slowing growth in China. Plus, attracting foreign investment to prop up the economy would require higher rates, which would depress the economy - not a pretty picture if a depressed economy is a reason why foreign money is drying up.
China’s Vibecession
…overall savings haven’t changed that much; it’s that specifically people are abjuring things like durable goods, purchases, investment in small business, stuff that ties up their assets, and they’re preferring things that feel safer and more liquid like bank accounts.
Adam Posen in an interview with Marketplace
The Vibecession narrative, which is best explained by Adam Posen at the Peterson Institute, posits the following: COVID provided a shock to the CCP’s credibility, which cooled investment and resulted in unwillingness to spend and borrow from consumers. This is also coupled with a general slowdown of the economy for three whole years in the COVID era, since the Politburo did not do much stimulus and particularly omitted direct cash transfers to the population.
Historically, China’s social contract was roughly as follows: if you don’t get political, we’ll make you rich. The one real-life example of go woke, go broke. The middle class didn’t bother with such petty triffles as “free speech” or “democratic elections” because the government promised new cars, new houses, new jobs, and new electronics. But now the government is not fulfilling its end of the bargain, so people and companies are scared and uncertain - and fear is not conducive to good economic outcomes.
There is a large psychological component to this: the CCP and the Bank of China are not boosting the vibes to any meaningful extent, once again due to issues with welfare and transfers, and due to financial constraints on credit creation, resulting in poor expectations for future demand growth. While the US is kind of averting the Vibecession, and consumer spending remains strong, China doesn’t seem very able to.
China is now an autocracy under Xi Jinping, and not an especially friendly one to alternative centers of power in the private sector, which means that there’s always going to be a little bit of doubt over whether or not the government is going to break your company’s back over some petty Politburo squabble you’re not aware of at all.
And overall, the easiest solution to the issues in the previous section are to ttransfer money to households so domestic demand, and not just global and corporate outlays, can prop up the Chinese economy - but this is politically difficult and institutionally hard to manage, despite the autocratic nature of China’s government. Xi might simply not want to give people money, and nobody can make him.
Mother, tell your children / not to do what I have done
Japan has many inefficiencies that limit its productive capacity--too many mom-and-pop stores, not enough computerization in the office, and so on--but inefficiency per se is not the immediate problem. What Japan lacks right now is not supply but demand: Japan's consumers and investors just aren't spending enough to keep the country's shops and factories busy.
The other major point of reference for China’s current woes is 1990s Japan.
What happened in 1990s Japan? After a gigantic property crash, the economy entrered a sharp recession, and the country went through a pretty painful and prolonged downturn afterwards. The economy was, for over a decade, in a state of deflation and stagnation, where neither fiscal nor monetary stimulus was able to get it out of its rut - public investment was high, and interest rates were zero.
The idea here is that of a liquidity trap, and old Keynesian/Monetarist concept. The general principle is the transmission mechanism for a Vibecession: people will expect the economy to underperform in the future, which results in them cutting back, resulting in the economy underperforming in both the present and the future. Amy Adams from Arrival, is that you? Anyways, fiscal policy can’t save you, so the response is purely monetary: the government needs to promise it can be irresponsible with “Rooseveltian Resolve”, bringing forth inflation and higher nominal growth. This was argued back in 2015 for the US economy, as well.
Is China getting Japanified? Yes and no. The similarities are there, but China’s debt problem is qualitatively less severe, its external finances are less complicated, it has a larger domestic market with a still existent untapped peasantry, and it does actually have opportunities for new tech, such as AI or climate solutions. However, the external environment is way more challenging (i.e. decoupling), and the demographic issue is going to be catastrophic. China may simply get too old to get rich, and it probably will never surpass the US as the number one boy of the global economy.
Conclusions
The situation in China is bad, but it’s not recession bad, and not global financial cataclysm bad. Let’s get a hold of ourselves. There’s a weakening economy that can’t be solved without doing things a dictator doesn’t want to do, instead keeping an economic model that isn’t sustainable in any way, shape, or form.
What should China do? NGDP Targeting and Big Fiscal, of course. Eminently 1930s type problem. Abenomics worked, so why can’t Xinomics work as well. And better urbanism, since at this point it seems like bad housing policy is like the cause of everything bad ever. China staking its entire wealth-building model on housing is just as bad an idea as the US doing so, except it’s also much poorer overall so the stakes are higher. Oy gevalt.
TBF this would be facially valid on its own, because the UK is also engaging in some massive data revisions at the moment - case in point: GDP was revised by 2%, which means the British economy actually recovered from the pandemic, contrary to what was previously claimed. Note that this is the level of GDP, not GDP growth - so the UK economy is 2% bigger than previously estimated, rather than having grown by two percentage points more. The general reason would appear to be that they moved the ONS, which computes GDP, from London to the middle of nowhere in Wales, so 90% of staff resigned.
In detail: using night light emissions, Chinese GDP growth was estimated at 65% smaller than reported, while using national accounts wizardry, GDP growth was around 1.7p.p. smaller than reported.
You are excellent.
Enjoyed reading this!