- China faces the risk of a Japanese-style “Lost Decade” due to years of overinvestment and high debt levels.
- Given the likely constraints on investment and exports over the next decade, future growth will have to be driven by consumption.
- China’s central government has sufficient tools and fiscal capacity to bolster household consumption – but it needs to adjust its strategy.
Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.
China’s economic growth miracle has come to an end. The economy is unlikely to return to the rapid growth that characterized the past four decades after reforms began in the late 1970s. The slowdown is due to ideologically-driven policy decisions, which have prioritized economic and political security and stability over growth and dynamism, and the unwinding of years of overinvestment in property and infrastructure.
The end of the growth miracle does not necessarily portend economic disaster. During a recent congressional hearing, I testified that China faced a range of different potential economic futures, including slower but still healthy growth, a lost decade, or even a debt crisis. Which path China ultimately takes depends heavily on how policymakers react to the current economic pressures.
China’s rapid increase in debt over the past decade makes resolving its economic problems more difficult. This is because the significant financial pressures that have built up across the economy will be exacerbated by a further deceleration in growth. The slower China grows, the more stress will be put on the already fragile balance sheets of property developers, state-owned enterprises (SOEs), and local government financing vehicles (LGFVs).
To avoid such an outcome, Beijing needs to do more to support growth and restructuring of the economy. In particular, the Chinese government needs to boost household consumption through cash transfers and social spending.
Japan’s Lost Decades
Japan is frequently cited as a cautionary example of where the Chinese economy may be headed.1 When the real estate bubble in Japan popped at the end of the 1980s, the country entered a period known as the Lost Decade. This period of slow growth, however, extended into the 2000s. As shown in Figure 1, the Japanese economy took two decades to return to robust growth.
High debt levels and low growth created an extremely difficult situation for Japanese corporates. As companies cut spending to focus on repairing their balance sheets, growth throughout the economy slowed. This slowdown, in turn, made it more difficult for companies to pay down their debts. The Japanese government failed to break this self-reinforcing negative cycle and the economy paid a heavy price in decades of slow growth.
The experience for investors in Japan’s stock market was painful. The Nikkei 225, Japan’s analog to the S&P 500, fell sharply over the two lost decades, as shown in Figure 2. By the end of 2010, the index was 57% lower than it was at the beginning of 1991.2 While there were certainly examples of excellent corporate performance during this period, investors with broad exposure to the Japanese market experienced long-term negative returns.
China’s domestic stock market has not yet entered a lost decade, but it’s not far off. As of October 2023, the Shanghai Composite Index is near the same level it was at the beginning of 2015. From an even longer historical perspective, China’s stock market has not yet recovered to its 2007-2008 highs.2
For China, the lessons from Japan are clear. The economy needs to maintain a minimum level of growth to facilitate the deleveraging that needs to occur across multiple sectors. As a rough estimate, the Chinese economy needs to grow by at least 3% a year on average to have a good chance of managing its debt problems. China needs enough growth in other parts of the economy to offset the inevitable losses linked to investment in real estate and infrastructure. Growth below that level is likely to compound the strain on local government finances and bank balance sheets.
Economic forecasting is a difficult, and perhaps foolhardy, endeavor. Rather than make projections, it can be more productive to analyze the components of GDP and the constraints they face. This will help us determine whether China is shifting towards a mode of growth that is likely to be more sustainable over the long run.
China’s GDP, according to the expenditure approach, can be divided into three categories: consumption, investment, and net exports. At the end of 2022, the proportions of GDP were as follows:
There is a broad consensus amongst both economists and the Chinese government itself that future growth needs to be largely driven by consumption.3 This is because both investment and export growth are facing constraints. Over the past decade, investment growth has been driven by local government infrastructure spending, corporate borrowing, and an enormous property bubble. Due to balance sheet pressures, these trends are not likely to be strong drivers of investment going forward. Property investment and private sector investment have experienced year-on-year declines. The government has cushioned the economic impact through an increase in infrastructure spending, but this adds to the pressure on local government balance sheets. Maintaining investment at its current elevated levels over the next decade seems unsustainable.
Despite China being an enormously successful exporter, trade is also unlikely to be a significant driver of future growth. The country exported $3.6 trillion of goods and services in 2022. However, it also imported around $2.7 trillion from the rest of the world. Net exports (exports minus imports) are used to calculate the contribution to GDP.4 Even though China’s trade grew rapidly over the past decade, net exports only contributed an average of 0.3 percentage points to annual GDP growth.2 Faced with growing tariffs and other restrictions on its exports, it is hard to see how trade will be a significant driver of growth in the future. Conversely, a modest slowdown in exports would further weigh on China’s growth.
Consumption Is the Key
It is reasonable to expect that both investment and net exports may add little to China’s GDP growth over the next decade. If that turns out to be the case, it means growth will have to be driven by consumption.
Without contributions from investment and net exports, China’s consumption growth will need to exceed 5% for the country to average 3% economic growth over the next decade. If investment or net exports begin to decline, consumption will need to grow even faster to offset the impact. Conversely, if investment or exports recover faster than anticipated, it helps to alleviate the burden on consumption to drive growth.
Consumption can be broken down into two components: household consumption and government consumption. Two data series serve as leading indicators for household consumption: retail sales of consumer goods (Figure 3) and household disposable income growth (Figure 4). Retail sales, which are updated on a monthly basis, are currently growing at a nominal rate of about 6.8% for the year. Household disposable income, which is updated quarterly, is growing at a real (adjusted for inflation) rate of 5.9% for the year. For comparison, in the six years prior to the pandemic (2013-2019), disposable income grew an annual average of 7.1%.2
From these indicators, we can surmise that household consumption is growing, but at a rate that does not create much of a buffer for the economy if there are negative shocks to investment or net exports. Earlier this year, some analysts were projecting a surge of “revenge spending,” with Chinese consumers eagerly spending after the end of Covid lockdowns. However, the recovery has been tepid.
What’s the best way for the government to support household consumption? In the United States, the government often engages in cash transfers to households to stimulate the economy. Historically, the Chinese government has been less eager to send cash to households.5 Moreover, the impact of cash transfers is dampened by the high marginal propensity to save of Chinese households. This is further compounded by the fact that the savings rate of Chinese households increased during the pandemic.6
However, not all cash transfers are created equally. A recent IMF study estimated that targeted transfers to households with liquidity constraints (i.e. low-income households) could be quite effective.7 Transfers to these households are estimated to create a positive multiplier for the economy of 1.5. That is, for every yuan spent on transfers, the output of the economy will grow by 1.5 yuan, driven primarily by an increase in household consumption. The impact of these cash transfers is estimated to be 50% greater than increased investment, which is the historic approach of the Chinese government to stimulating the economy.
The Chinese government can also increase its own consumption to support the economy. What is government consumption? It is government expenditures on goods and services on behalf of its citizens, such as medical services, education, and public safety. As shown in Figure 5, China’s government expenditures are comparatively lower than other emerging markets at a similar level of development (South Africa, Brazil, and Thailand) and substantially below those of South Korea and Japan.
Increased government spending on education and healthcare could offset negative shocks to investment and boost household consumption. One of the major drivers of low consumption in China is precautionary savings, that is saving for uncertain future costs, notably healthcare and education expenses. More government spending to lessen the costs of these items to households should reduce the need for precautionary savings and encourage higher levels of consumption.
Balance Sheet Considerations
Increasing consumption through cash transfers and social spending is fine in theory, but difficult to implement given China’s unbalanced fiscal situation. Local governments currently handle most of the social spending in China, but they are increasingly cash-strapped and indebted. Greater cash transfers and government spending on health and education would therefore need to be shouldered by the central government, either directly or through fiscal transfers back to local governments. While the Chinese central government appears to have sufficient fiscal capacity, it has been historically reluctant to increase taxes or take on increased debt to support greater spending.
In summary, China needs to maintain a healthy growth rate over the next decade to work through its debt problems. Given the constraints on investment and trade, China will need to increasingly rely on consumption to drive growth. The central government has both the tools and the fiscal capacity to bolster consumption. To achieve this, the Chinese government must become more open to cash transfers and social spending and the central government must foot the bill. China’s outspoken former Finance Minister, Lou Jiwei, recently called for the government to dramatically increase social spending. His voice, however, may be in the minority given the apparent reticence of Beijing to commit to greater stimulus, especially consumption-driven stimulus.
China is not preordained to suffer a lost decade, but avoiding one requires the Chinese government to make significant changes to its management of the economy and fiscal system.Nicholas Borst,
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- Koo, Richard. “China’s Balance Sheet Recession and Structural Problems in Light of 1990s Japan.” Nomura Research Institute, July 19, 2023.
- Source: CEIC.
- See “Notice from the National Development and Reform Commission on Measures to Restore and Expand Consumption (发国家发展改革委关于恢复和扩大消费措施的通知).” Central People’s Government of the People’s Republic of China (中华人民共和国中央人民政府), July 28, 2023.
- Imports are sometimes construed as “subtracting” from GDP growth. However, this is only due to the way the GDP accounting identities are constructed. Imports are subtracted to avoid double counting because they are already included in other parts of the GDP equation. See “Do Imports Subtract from GDP?” Federal Reserve Bank of St. Louis, September 13, 2018.
- Batson, Andrew. “Why China Isn’t Sending Money to Everyone.” The Tangled Woof, May 3, 2020.
- Dawson, Jeff. “Why Are China’s Households in the Doldrums?” Federal Reserve Bank of New York, September 27, 2023.
- Nguyen, Anh, John Ralyea, and Fan Zhang. “Short-Term Fiscal Multipliers in China, IMF Country Report.” International Monetary Fund, February 10, 2023.