Alicia García Herrero (Natixis) | The years of China’s high growth are past, as the world learned painfully in 2023. Notwithstanding the enormous tailwinds stemming from having exited Zero-Covid policies during 2022, the Chinese economy barely reached the underwhelming 5% GDP growth target cautiously set by Premier Li Qiang back in March 2022.
The reasons for the very slow recovery of the Chinese economy in 2023 are both cyclical and structural. On the cyclical front, China’s financial conditions have remained very tight in 2023 with very high real interest rates due to deflation. Such high real interest rates and the government crackdowns on a number of sectors have hurt those in need of funding, especially the private sector which remains more productive than state-owned enterprises.
On the structural front, the main factor dragging down China’s growth is the plummeting return on investment. One of the key reasons for this is the slow and painful process of absorbing the real estate bubble accumulated during the past couple of decades. Low returns, however, have also reached infrastructure investment and even manufacturing. For the latter, Chinese authorities stubbornly pile up additional investment through different industrial policy plans to move up the ladder. The result, given the stagnant domestic investment and a more reluctant external demand, is increasing overcapacity with an immediate and important negative consequence for China, persistent deflationary pressure.
China’s overcapacity is a double-edge sword for the world. For countries competing on the industrial space with China, such as South Korea or Germany, China’s overcapacity and deflationary pressures translate into formidable competition in third markets. On the positive side, China’s deflation has also helped central banks globally in their fight against inflation, given China’s 20% share in global manufacturing exports.
What To Expect For 2024?
All in all, both cyclical and structural headwinds are behind the very poor confidence in the Chinese economy both domestically as well as by foreign investors, which is well reflected in the extremely low stock market valuations. In fact, China’s stock market is practically back to the levels of 2005, which is shockingly poor for an economy that has multiplied its GDP size nearly eight times since then.
The question then is what to expect for 2024 and the most optimistic answer I can offer is that the Chinese economy will “muddle through”, with growth decelerating only slightly compared to 2023, which means remaining in the 4.5-5% range. This goal, which in the past would have been underwhelming, will not be reached without support but even that is no longer easy. Monetary policy would need to be laxer to bring down the very high real interest rates that are hurting companies’ and households’ access to credit.
This is easier said than done as the People’s Bank of China (PBoC) also needs to stem capital outflows and a further depreciation of the RMB. The Federal Reserve’s hawkish stance clearly does not help as it leaves the PBoC with very little room to cut interest rates given the already very wide negative interest rate differential between China and the US, pushing even more capital out.
The RMB lost nearly 9% in 2023 until the Fed changed its message towards easing in the third quarter of 2023 leading to the easing of the US dollar and, thus supporting the RMB. This support has only been temporary as the FED’s recent hesitation to cut rates too early in 2024, is supporting the US dollar and re-igniting capital outflows from China as well as a deepening stock market rout to which the PBoC has responded quite mildly. In fact, no interest rate cut has been announced yet but also a further easing of liquidity with a 50 basis point cut in reserve requirements, to which the market has responded with an even bigger sell-off.
Given the PBoC’s conflicting objectives, (growth versus financial stability), it seems natural to turn to fiscal given the crucial role it played in stimulating the Chinese economy in the past, especially in 2008 after the global financial crisis, and also in early 2016 after the stock market collapse in the second half of 2015. The reality is that China no longer has fiscal space as public debt is four times larger than in 2008 (100% of GDP compared to 25% then). This huge increase has mostly been generated by local governments’ wild infrastructure and real estate investment but also massive industrial policy to create manufacturing champions.
Before the real estate cycle burst in mid-2021, local governments could still count on land sales to finance their expenditure, which also increased substantially during the Covid pandemic, especially for testing and quarantine. As if this were not enough, the growing interest rate burden of such a ballooning debt further limits local governments’ space to support the economy. In other words, China’s local governments are starting to grapple with the problem of fiscal sustainability as growth decelerates and real interest rates reach record high levels, pushed up by deflation. As a consequence, it seems difficult to imagine that local governments will be able to stimulate the economy as was the case in the past without a fiscal reform which allows them to generate new sources of fiscal revenue. The hope that the central government is considering this major reform is vanishing as no direction has yet been offered by Premier Li Qiang or the new economic leadership since they took over nearly a year ago.
Risks Are Only Growing
Against such a backdrop, reviewing our expectations on the Chinese economy is more important than ever, with “muddling through” being now placed as the most positive outcome to be expected. For this new normal of structural – but slow – deceleration to be achieved, major risks need to be averted. A very obvious one stems from the poor financial health of local governments. This risk has become more likely given that banks have been asked to support real estate developers, leaving very little room for them to continue to lend to local governments, some of which are finding it increasingly costly to place their debt.
Another key risk comes from China’s obsession with continuing to invest in manufacturing upgrade without the country’s own consumption being able to absorb it. The never ending need for foreign demand to absorb China’s manufacturing, giving growing overcapacity, is creating entrenched deflationary pleasures for China but also massive competition for other industrial nations, leading to protectionism.
Beyond economics, the widely expected geopolitical risk in 2024 was surely the Taiwan elections on January 13. While the Democratic and Progressive Party (DDP) clinched to the Presidency for the third time in a row, very much against Beijing’s preferences, it lost the control of Taiwan’s legislative body (“the yuan”) in favour of the most China-friendly party, the long-ruling Kuomintang (KMT). This is possibly the best news, in terms of easing China-related risks, that we may have for the rest of 2024, and the DPP will be very much constrained as regards its relations with the mainland and the mainland will also be keen to wait and see how the DPP’s complicated presidency will evolve. The wild card, of course, will come in November with the US elections.
All in all, it seems hard to argue that geopolitical risks are being contained but only transformed. China’s structural deceleration is creating cracks in the economy, which could push the leadership to play harder with nationalist card.
In sum, we should be grateful if the Chinese economy is able to offer a boring 2024, with muddling through, since risks are only growing except for a nice New Year gift from Taiwan’s elections which has lowered the biggest geopolitical risk, at least temporarily.
