The Age of Slow Growth in China

In December 2017, the United States updated its National Security Strategy, making two notable modifications: labeling China and several other illiberal countries as strategic competitors and recognizing economic competition as central to great-power rivalry. Since then, Washington has used economic tools with increasing boldness in its commercial and national security dealings with China—and even more forcefully in response to Russia’s war on Ukraine. This new willingness to contemplate decoupling from other major powers—a reversal in what had seemed an inexorable trend toward deeper connectedness—marked the end of permissive engagement with them as the default U.S. posture, especially in the economic domain. Now, the burden of demonstrating that economic interactions with China are benign has essentially fallen on the private sector.

To rally support for this strategic shift, U.S. officials and security analysts have emphasized the most intimidating aspects of China’s behavior and rhetoric, characterizing Beijing as the “pacing threat” to the United States in all domains. China’s leaders and their factotums have helpfully provided all the evidence needed to substantiate the sense of rivalry. The Chinese Communist Party has committed to maintaining an annual economic growth rate of between six and eight percent, which would allow China to easily pass the United States in GDP by the end of the 2020s. That economic growth, the CCP has made clear, will directly support a major increase in defense spending. Meanwhile, China’s Belt and Road Initiative and other overseas financing programs aim to pull perhaps 100 nations into an orbit with Beijing as the center of economic gravity. And Beijing will continue to compel Chinese companies to master and indigenize all strategically important technologies, with the goal of eliminating reliance on foreign capabilities within a few years.

This portrait of a Chinese juggernaut warrants Washington’s urgent steps to reinvest in competitiveness, ensure the United States can parry China’s spending on defense, and tighten permissive rules for U.S. companies that Beijing has exploited for strategic gains. The United States and other liberal democratic states have made strides over the past decade in recognizing China’s ambitions and their implications for the global economic balance of power. But by not challenging the narrative of the inevitable rise of China and the inevitable decline of the United States, Americans are needlessly doing the CCP’s marketing work.

China’s rise is far from inevitable; in fact, a long-term economic slowdown is unfolding. Rather than willfully disregard this reality, the United States should talk about it. Policymakers across the world have taken Washington’s silence about the risks to China’s economic outlook as evidence that Chinese President Xi Jinping is telling it straight when he says that the CCP is in control and has a 100-year plan to put China on top. Exposing the far less rosy reality would temper China’s appeal to middle powers as a reliable security partner and draw attention to the systemic economic risks of partnering with China on development projects. China’s brand of lending to developing countries risks undermining governance, saddling countries with debt, and obscuring hard-learned lessons about economic liberalization.

China’s rise is far from inevitable.

Washington wants other nations to resist Beijing’s authoritarian allure for geopolitical reasons. But economists worldwide—including in China—are on the same page: the CCP’s turn back to statism is dangerous. There is no basis for the belief that China, or any country, can deliver high, politically determined growth targets in perpetuity without completing basic fiscal, financial, and other market reforms. Pointing out the weakness of China’s economic model and the riskiness of the path the CCP has chosen is a chance for the United States to demonstrate geopolitical leadership that like-minded partners can follow.

WISHFUL THINKING

Consider the headwinds China is facing in 2022. At the annual meeting of the National People’s Congress in March, China’s leaders declared that 2022 GDP growth would be 5.5 percent, a normalization back to 2019, prior to the COVID-19 pandemic, when growth was 5.9 percent. They have stuck to this target despite a host of new economic challenges.

Where could such an expansion come from? There are three possible sources: business investment, household and government consumption, and trade surpluses. The size of China’s economy was $17.7 trillion in 2021, according to official figures, so 5.5 percent growth would mean about $1 trillion more in 2022. Using growth in 2019 as a basis for comparison, business investment in China would need to contribute about 1.5 percentage points toward the 5.5 percent growth Beijing promises this year. Because net exports are likely to be negative and consumption is likely to decrease, investment would need to contribute even more—around 2.5 percent—to growth this year. But nearly half of all growth in business investment in recent years has been related to the property sector. The authorities tolerated this overinvestment despite the risks in order to achieve political growth targets, leaving the largest property developers in debt default crises. There is no logical way investment can add 1.5 points to GDP growth in 2022, let alone 2.5 percent. In “sunrise” higher-tech industries, a series of unanticipated new regulatory moves has frightened away investors. New business starts by entrepreneurs have dried up and are in deeply negative territory.

Household and government consumption combined would need to add about 3.5 percentage points in 2022 toward the 5.5 percent growth target. But with almost 100 million consumers in lockdown from COVID-19 outbreaks, retail activity is frozen. Promising high-tech, job-creating sectors are shedding employees owing to government interventions aimed at control, reducing income growth and hence consumption potential. And local governments have shrinking resource bases to support their spending, since they were ordered to stop selling land to property developers but don’t have permission to replace that lost revenue by raising taxes or imposing new ones. Local officials are now being told to do what was condemned not long ago: quickly issue special revenue bonds without concern for repayment. But even a municipal debt binge cannot offset the fall in the housing bubble and the consumption slowdown that resulted from COVID-19. It looks as if it will be hard to replicate even last year’s base of consumption expenditure, let alone grow it by hundreds of billions of dollars.

Doubts about China’s numbers are already frightening investors.

As for China’s trade surplus, there are clear reasons to be cautious about growth. First, with exports already at historic highs thanks to the once-in-a-century conditions produced by the pandemic, there is no likely direction but down. Second, China’s terms of trade (the ratio of export prices to import prices) has gotten worse owing to Russia’s invasion of Ukraine and other geopolitical tensions affecting prices, which is driving up China’s import bills. Third, elsewhere in the world, COVID-19 is receding and factories that were temporarily shuttered are coming back online, whereas export regions of China such as Shenzhen and Shanghai are facing the most acute COVID-19 crises China has experienced since the pandemic began.

Taking all this into consideration, it will be challenging for China to maintain two percent growth this year. As Beijing continues to report results that appear much stronger than that, as it did for the first quarter of 2022, the CCP’s credibility will take a hit. Doubts about China’s numbers are already frightening domestic and foreign investors alike away from China’s markets. Accurately measured, zero growth or even economic contraction should not be ruled out this year.

NO QUICK FIX

Unlike Japan in the 1990s, which was one of the wealthiest nations in the world on a per capita basis when it downshifted to low growth, China is relatively poor. Per capita income in China is about one-fifth of that in the United States, at around $12,000 a year. Nine hundred million Chinese citizens are not yet living comfortable urban lives and are waiting for their turn. Given that unmet potential, one would expect China to return to a faster growth rate after a bad year such as 2022. But the problems contributing to the current malaise will weigh on China’s economy for years.

Most striking is the country’s demographic challenge. China has seen declining population growth for years, a trend that is not unusual as nations become wealthier. But since 2015, China’s population growth has fallen from around ten million a year to around zero, and the trend points further down. There are as many as 130 men for every 100 women in their prime, so naturally not everyone can marry. Many people who are married are deciding not to have children or to wait much longer to do so than earlier generations did, for a variety of reasons. In simple terms, they are anxious about their economic burdens. Although there are hundreds of millions of people who have not yet migrated into the modern urban economy, education and health levels for people in rural China are poor, and some researchers have cast doubt on their ability to fill even labor-intensive factory jobs. Fewer workers, fewer future buyers for unbuilt apartments, fewer consumers: these demographic fundamentals are impossible to hide or change in just a few years.

Likewise, it is no longer possible for the CCP to allow a property bubble to act as a supercharger of growth: construction investment will necessarily be subdued for years relative to the past. There is room to shift investment to new, unmet needs such as green energy, schools, hospitals, retention walls to hold back rising sea levels, and a myriad of other priorities. But China’s financial sector is not yet incentivized or organized to push investment toward those areas. A “big bang” of financial reform is first required to achieve that; that would necessarily be followed by a period of slow-growth structural adjustment. Only then could next-generation business investment approach the levels seen in past years. And there is no evidence that such a transformation is on the horizon.

Further, the most important driver of economic growth in the very long term is technological innovation. China has absorbed more technology from abroad, and benefited from it, than perhaps any country in history. But foreign firms and other countries are now taking a far less permissive stance. It is unclear if truly indigenous Chinese innovation can take the baton and drive future growth. Firms that have innovated have frequently been the target of reasserted state control, for fear of independent actors. Other firms are building out a massive technology base, but only with support and subsidies from the state, which calls into question how efficient they are at research and development and how much longer the state can afford to support them. No doubt, given the effort the CCP has put into industrial policy, there will be successes. But as a system, Chinese innovation funding is underperforming.

These are structural problems; they are embedded in the system. They could be remedied. From 1978 to 2012, structure impediments were more often than not remedied, unleashing the growth and development of the past 35 years. But such problems are not being remedied today, and at best it will take years to make a credible dent.

SECOND THOUGHTS

A great deal of global economic sentiment hinges on the widespread belief that, like diamonds, Chinese growth is forever. Once confidence in that narrative slips, the implications will be significant. Some companies have high stock prices because investors assume they will generate future profits from China-related businesses. As China’s growth slows, their valuations are likely to fall. The stock prices of other companies may be depressed because of concerns about Chinese competition, and their valuations could rise. The same goes for long-term valuations of commodities and other assets that are based on expectations of another decade of relatively fast Chinese growth.

Other implications of China’s economic reckoning are clear as well. Foreign investors—both those buying bonds and those building factories—have appreciated China for its political predictability and associated growth: if the CCP said growth would be eight percent, then growth was usually eight percent. If there is uncertainty about that outlook, then investors will require higher profit premiums to justify the risks they are taking. In recent years, strategists in democratic countries have looked for ways to discourage their firms from going to China or to put pressure on those already there to leave. Ironically it is the market itself, in the form of hedging against the prospect of lower economic growth, that is starting to compel those decisions. Western authorities don’t need to command firms to curtail their China ambitions: transparency about the extent of China’s macroeconomic stress will do that job naturally. An elective decoupling is taking place, even without maximum arm-twisting.

The repercussions from China’s slowdown will stress market-based democracies unevenly, and that will cause tensions among like-minded friends. Beijing will induce some firms to stick it out in China and punish others. This will sow discord and mistrust. But at the same time, less Chinese growth means less to fight over and fewer reasons to risk reputations and compromise on values. If China accounts for 30 percent of marginal growth in global demand for luxury vehicles, for example, U.S.-EU alignment on trade policy is harder than if the Chinese share is only five percent.

Global economic sentiment hinges on the belief that, like diamonds, Chinese growth is forever.

For countries that see China not just as an economic rival but also as an engine of their own growth, a diminished Chinese outlook means a weaker outlook for them, too. This applies to the 55 or so nations that have a trade surplus with China, the 139 countries that have signed up for the Belt and Road Initiative, and others that depend on Chinese tourists (France), corporate services demand (Hong Kong, Singapore, the United Kingdom), or other China-dependent growth drivers. The weakest of these countries may catch pneumonia if China catches a cold, meaning that they may have trouble servicing debt burdens they took on in anticipation of sustained Chinese demand growth or encounter political upheavals if it turns out they erred by deciding to align themselves with Beijing.

Last but not least, a slower Chinese economy means the CCP will have less room to maneuver at home. With less spending power, Chinese leaders will have to worry more about social stability. Less fiscal capacity means fewer resources for outbound investment and official development assistance. Choices about public expenditure priorities will become more difficult. Officially, in 2019, China’s $261 billion in military spending represented 1.4 percent of GDP and was growing at around six percent annually, but many observers think that spending is higher and growing faster. Support for industrial policy, especially for technology deepening, runs to hundreds of billions of dollars a year. These numbers pale in comparison to the growing perennial expenditures on education, health care, infrastructure, government salaries, government debt service, and other obligations. Fiscal promises made assuming five percent or higher GDP growth will have to be scaled back. Beijing can’t do everything it hoped. The party has built authoritarian tools to suppress discontent, but these have been tested only during the long period of high growth.

Presented with these headwinds, will Beijing concede its mistakes and reorient policy back toward the marketization that delivered decades of double-digit growth? Or will the CCP take the opposite course, deeper into command-and-control statism? The past century has seen China go both ways. One cannot be sure, even with Xi at the helm. But China cannot have both today’s statism and yesterday’s strong growth rates: it will have to choose. This reality is stoking debate and disagreement about the way forward. In recent weeks, one camp of officials rolled out promises to attend to investors while another insisted that growth was fine, targets would be met, and no corrections would be taken. Slowing growth will bring that fight to the fore.

HONESTY IS THE BEST POLICY

Washington should draw attention to the realities of economic problems in a responsible manner. There are three rules to observe in doing so. First, be objective. That means empowering U.S. officials by providing them with accurate analyses of the nature of China’s economic challenges and the spillovers that will ensue. U.S. leaders were too often playing catch-up to understand the significance of China’s high-growth period; the downshift to slower growth will be similarly profound, and it is crucial that officials in the executive branch and Congress are prepared to interpret and respond to it effectively.

Second, be intelligently self-interested. Some would leverage China’s economic troubles to pursue maximum decoupling, closing down all trade and investment flows. That would be ill-advised: economic divorce would impose huge costs, worsen inflation, and serve no strategic purpose. The self-interested response to a Chinese economic downturn is to maintain as predictable a trade and investment policy stance as possible, adapting over time to serve the welfare of all Americans and reduce newly arising security concerns. This attitude is crucial because it maximizes American welfare and preserves resources for solving real security dilemmas when they emerge. It would also encourage alignment between Washington and its allies and partners. Such alignment has been the most powerful element of the Western response to Russian aggression, and it would be decisive in the success of a reset with China. The consequences of China’s slowdown should be a regular point of discussion at the G-7, the Organization for Economic Cooperation and Development, the U.S.-EU Trade and Technology Council, the Quadrilateral Security Dialogue, and other multilateral forums.

Finally, Washington should take a sober and constructive tone in discussing China’s economic problems: gloating would be counterproductive. Slowing growth impairs the welfare of 1.4 billion Chinese people and countless others around the world. It could lead China further down illiberal social and political paths just as easily as it could lead it toward reform. Officials in Washington and other Western capitals have a legitimate interest in the fortunes of the world’s most populous nation, and they have a responsibility to address the global economic risks that could result from a Chinese downturn. The proper messages are admiration for the Chinese people and the four decades of exceptional, sustained development their leaders oversaw; humility that advanced industrial democracies all went through periods of painful adjustment in their development journeys, too; readiness to restore channels of cooperation if requested by Beijing; and assurance that the West does not seek to exploit China’s economic challenges but rather wants to see them sustainably resolved. China does not have to lose in order for the United States to win.