This article first appeared in Forum, The Edge Malaysia Weekly on September 16, 2024 - September 22, 2024

The past few months have not produced the hoped-for rebound in China’s economy. Economic activity has been lacklustre, and demand is weak because consumer and business confidence remains at multi-year lows. Moreover, the real estate sector shows no signs of bottoming out and inflation is so low that there are fears that China will get stuck in a Japan-like deflationary trap. All this has sparked off a flurry of downgrades of economic forecasts by financial institutions and dark commentaries about China entering a dangerous phase of its economic adjustment.

There is, of course, another side to the picture. Recent times have also seen China notch up some impressive gains. It is a world champion in creating new areas of competitive advantage — not just in electric vehicles, batteries and solar panels as already known but in many other areas such as component manufacturing, bio-medical industries and equipment manufacturing as well. Its economy has also reduced its unhealthy reliance on property development and there are signs that reforms may finally be coming in critical areas such as the treatment of migrant workers, the distribution of tax revenues between central, provincial and local governments, and in opening up the economy.

So, where does that leave us? Anyone who wants to comment on China must first accept that China remains a tough call to make. Its economy is in uncharted territory after having undergone a dramatic restructuring in the past 20 years. That means that studying historical trends sheds little light on future prospects. The composition of the economy has changed, the way it interacts with the rest of the world is different, and new psycho-social trends have emerged in the mindsets of Chinese people, especially the young, which none of us fully understand.

With that caveat in mind and based on what we do know, our view is that the risks in China have grown in the past few months. This should not impede a continued rebound in activity in the next few months but the tepid rate of growth makes the economy vulnerable to unexpected shocks. There are also challenges beyond the short term that could become serious. Policy adjustments are keenly required in many areas for the economy to regain its proper footing.

The improvement in economic activity we saw in the early part of this year has not been sustained. Recent economic data has not been encouraging:

• Domestic demand is the major weakness. Consumers continue to prefer to save rather than spend on goods or services, according to the central bank’s survey of urban folk released a few weeks ago. Growth in retail sales in the first seven months of the year remained subdued at around 2.7% compared to a year ago — and that was despite a bump in tourism spending during the summer months. Surveys of purchasing managers show the firms are downbeat with comments like, “Surveyed companies adopted a cautious approach to hiring to save costs, leaving the labour market under pressure.” Fixed asset investment has decelerated significantly, with capital spending by private sector companies essentially stagnating. There are credible reports of capital flight, of large numbers of businessmen seeking to take money out of China.

•    Industrial production growth has been better, running at around 5% in recent months. But there are doubts whether production can continue growing at a faster pace than demand. In particular, demand for goods remains low, with the same central bank survey showing that where consumers are willing to raise spending it is typically in services such as entertainment or tourism, not durable goods.

•     The real estate sector continues to exert a drag: The value of new-home sales by the top 100 property development companies fell 26.8% in the year to August, worse than the 19.7% decline in July.

•     Low inflation risks creating a deflationary mindset as Japan suffers: Producer prices continue to fall — down 1.8% year on year (y-o-y) in August, much worse than the 0.8% fall in July. Consumer prices rose just 0.6% y-o-y in August — and that was mainly because bad weather had disrupted supplies of fruit and vegetables. Non-food prices are barely growing.

Another feature of the economy is that efforts by policymakers to stimulate the economy have not worked well, at least not yet. Bloomberg reports that more than three months after the central government directive to more than 200 cities to buy unsold homes to ease oversupply, just 29 had followed up with substantive measures. Despite the central government’s urging, local governments have not stepped up infrastructure spending — infrastructure-related capital spending has instead slowed, to only 4.9% y-o-y in Jan-July 2024, down from 5.4% y-o-y in the first six months of the year.

Finally, it is striking that well-informed and normally cautious observers are now feeling compelled to speak out in favour of a sharper policy response. The former governor of the central bank, Yi Gang, called on policymakers to move more quickly to address deflationary pressures. He wants the authorities to aim for the gross domestic product (GDP) deflator (a measure of underlying inflation) to return to growth. Last month, Huang Yiping, once a member of the central bank’s monetary policy committee and still its economic adviser, was more direct. He criticised the apparent belief in policy circles that only structural reform can lift productivity, while also decrying what he termed an aversion to adopting the more aggressive policies taken by Western countries. These critiques from regime insiders tell us that the economy’s direction is now considered so worrying that such personalities feel the need to risk their own positions by speaking out.

Where China’s economy will head in the coming year or more will depend on the answers to a few key questions:

Will painful adjustment processes in the economy finally work themselves out?

The critical variable is when the drag from the property sector starts to ease. We had previously expected the support measures offered by the government to be effective, thereby allowing the real estate sector to cease being a negative influence on the economy by early next year. However, the hesitation of local governments to follow up on central government edicts does not lend confidence to this view. Estimates by various independent economists suggest that the central government would need to spend trillions of renminbi to stabilise the real estate sector rather than the RMB900 billion (RM547 billion) on offer.

Can we expect more forthright policy measures to restore confidence?

Thus, the next important question is whether there will be a shift in policy,  away from calibrated incremental measures to more aggressive ones that overcome the malaise in confidence across consumers, businesses and local officials. It does not seem likely right now. Just two weeks ago, even in the face of disappointing economic data, Finance Minister Lan Fo’an insisted that the economy was still growing at a good enough clip and that its performance in the first half was “generally stable and progressing steadily”.

There is a good reason for this. In our view, it is not that China’s leaders are unaware of the problems in the economy because economic information is being suppressed, as some in the international media have suggested. There are indeed problems with Chinese data but our sense is that China’s leaders have multiple ways of securing a good enough feel for the economy.

Rather, the obstacle to policy change is more likely that the authorities are focused on the long-term aim of rebalancing the economy away from its previous excessive reliance on debt and real estate. They are also determined to dispel the notion that the government would always step in to bail out investors who indulged in over-investment and speculative excesses. When they introduced measures in 2021 to overcome these issues, policymakers knew that the economy would take a hit but felt that that slowdown was necessary for the longer-term health of the economy. If it appeared that the economy might slow a lot more than expected, they were confident that they had the tools to prevent a downward spiral.

Looking at it from their perspective, they were not wrong in this view since the dependence on debt and property could not go on forever. Moreover, they have done just enough to keep the economy growing while it restructured toward a more balanced and sustainable economy. So, what might cause policymakers to accept the need for a shift? This will hinge on two further questions:

•    Is deflation a real risk?

Weak inflation or outright deflation is a greater risk the higher the economy’s exposure to debt. China’s macro leverage ratio — the total debt of households, firms and governments in relation to the size of the economy — has continued to rise, reaching a fearsome level of 294.8% in the first quarter of this year. If prices begin to fall, the real value of this debt will grow and defaults and bankruptcies will threaten financial stability as well as economic growth. Thus, one factor that could encourage more aggressive stimulus measures would be clear signs that weak inflation was giving way to outright deflation. That does seem to us to be a real possibility.

•     Can export growth be sustained?

Improving export performance has helped to keep the economy on a track of reasonably good growth. In fact, the August data show export growth actually accelerating, reaching 8.7% from 7% in July. However, we do not believe that export growth can continue to lead the economy. China is so competitive in some areas and the scale of its export surge so vast that the damage done to its trade partners from such export surges becomes politically unacceptable to the latter. Whole industries are hollowed out — Chile’s sole surviving steel company has gone into distress as a result of Chinese competition and European automobile manufacturers are also teetering. In addition, China’s growing trade surplus (and the concomitant deficits elsewhere) are also becoming a political sore point. That is why it is not just a hostile America or its allies in Europe that are hitting back at Chinese exports. It is also countries that are otherwise friendly to China such as Thailand, South Africa, Indonesia and Brazil that are imposing trade restrictions on China. China’s current boom in manufacturing investment will create so much production capacity that much of the new production coming on stream in the next year will have to be exported. The simmering trade tensions will almost certainly come to the boil, resulting in a major pushback against Chinese exports.

China could be approaching a similar moment as in late 2022. Then the government was forced to make a U-turn on its extreme Covid-19 prevention measures when the Omicron variety of the Covid virus made its previous measures embarrassingly ineffective and even the normally compliant populace resorted to public protests. Growing deflationary risks and the risk to exports as a source of growth are likely to persuade the authorities to make a vigorous and decisive shift in policy. If that happens, then China’s economy will turn around. If policy does not respond in time, though, there is a risk that slower growth and deepening deflationary pressures could create major stresses in the financial sector and perhaps even trigger a crisis.

Manu Bhaskaran is CEO of Centennial Asia Advisors

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