Europe and Germany have to shift perspective: not the strength but the weakness of the Chinese economy will be a central challenge going forward.
The current discourse in Europe is rife with unease about China's growing economic clout and strategies to deal with it. Yet the mood in Beijing is very different. On the ground, the atmosphere is tinged with uncertainty and disillusionment: “We don’t have an idea what this country is going to look like in 10, 15 years,” is a sentence I heard more than once from young Chinese on a recent trip to Beijing. Seen from the inside, China has never felt weaker and its development trajectory never more uncertain than today.
A much-debated new cultural phenomenon has taken hold in China: “lying flat.” In contrast to the entrepreneurial get rich and get glorious spirit of previous generations, young Chinese graduates today face high unemployment and uncertain career prospects. In large numbers, they now choose to stay at home and take life easy. They lie flat.
Since Deng Xiaoping's reforms, the Chinese social compact consisted in the promise of economic prosperity and competent leadership in exchange for political acquiescence. After the apparent mismanagement of Covid and the burst of the property bubble, this compact appears to be fraying.
The current leadership, with its indefinite tenure, distrust of the private sector and aversion to liberal reforms, has left many Chinese thinking that lying flat or leaving the country altogether is the best response to a gloomy outlook. The most telling sign of the sea change that has taken place is that more people are trying to get their money out of the country.
Once a magnet for global investors chasing Chinese labor and entrepreneurialism, foreign direct investment (FDI) into China has turned negative recently. In September alone, foreign exchange outflows reached 75 billion dollars. Seeking safety for their wealth abroad, Chinese families are pouring money into presumable safe havens. Faced with a glut of incoming Chinese flight money, Singapore introduced a 60 percent tax on foreign purchases of real estate earlier this year.
Betting the house no more
On the economic side, China has to come to terms with the after-effects of an enormous credit-fueled property bust. The country’s two largest real estate developers, Evergrande and Country Garden, are financially in dire straits. Many (if not most) of the shadow banks that have financed the construction boom are insolvent. Ken Rogoff estimated in a recent paper for Economic Policy that the real estate sector in China accounted for 20–30 percent of GDP in the past decade. The property bust thus leaves a large hole not only in the balance sheets of banks, but also in the Chinese growth model.
“Credit bites back” was the title of a paper that I wrote a while ago with Alan Taylor and Òscar Jordà. The paper showed how excessive debt accumulation weighs on growth after the end of big credit booms. It typically takes many years to rebuild wealth after housing slumps. The reason is that households strive to pay down debt and increase their saving rates while new construction comes to a halt.
The insights apply to China today: housing busts are a phenomenon that demand the full attention of policymakers. Time is of the essence. Bad loans need to be recognized and banks recapitalized where needed. Maintaining high nominal GDP growth is crucial to ease deleveraging, avoid further declines in asset prices, and fight deflationary pressures.
But even then, it does take time for economies to adjust, as the 2010s in the U.S. and Europe have taught us. Yet China is already flirting with deflation. Consumer prices dropped by 0.2 percent relative to the year before while producer prices have been falling for months. A coordinated policy response to these big challenges is not in sight.
Instead of tackling the property bust heads on, Beijing is even likely to repeat a European mistake: badly timed austerity on the provincial level. Local governments in China account for about half of all public spending, which itself is about one third of GDP. A substantial part of the revenue of local governments consisted in land sales to real estate developers. Depending on the province, this could be 30 percent or more of total revenues.
With the property bust, the land sales have now dried up, leaving a big hole in local budgets. So far, the central government has refused the ease the adjustment and thereby forced procyclical spending cuts on the local level. “Everyone looks after their own child,” is the policy directive from the center: local governments have to make ends meet without help from Beijing.
As a result, China’s macro policies today have a lot in common with Greece post-2008: simultaneous public and private deleveraging after a credit bubble. This policy mix will put pressure on growth and increase deflationary pressures. Moreover, as a recent excellent paper by Ricardo Gabriel, a former Ph.D. student of mine shows, austerity policy and the reduction of public services on the local level tends to trigger political discontent. We are about to find out if China is different.
Can China catch up with Greece?
Staying with the Greek comparison, a recent blog post by my former colleagues at the Federal Reserve Bank of New York asked whether China can catch up with Greece in terms of average per capita income by 2035. Most likely, they argue, the answer is no. The reasons are not only cyclical but also structural.
Economies can grow because they add more labor or capital, or combine them more effectively. The capital-output ratio in China is already among the highest in the world, and capital accumulation inevitably runs into diminishing returns and rising depreciation. The New York Fed estimates that investment can only contribute around 1.5 percentage points to Chinese GDP growth going forward. On the labor side, China will have to cope with a 6 percent decline in the working-age population by 2035.
This means that productivity growth will have to be the main source of growth from here. But in an economy faced with joint private sector deleveraging and public sector austerity, as well as capital outflows and a government skeptical of private initiative, an acceleration of productivity growth seems like a distant hope.
All in all, it would be a success if China managed a growth rate of 3 percent over the next decade. The risks are clearly to the downside. In any case, growth in this range will not be enough to catch up with Greece in per capita income, let alone with the U.S. in overall economic size.
Exporting its way out
With domestic challenges looming, China will, similar to Germany in the 2000s, turn to foreign demand and try to export its way out of the economic slowdown. During the pandemic, China has built, often with subsidized public credit, enormous capacities in the automotive sector, both for electric vehicles and internal combustion engine cars. China’s car production capacity is far larger than what the domestic market can absorb.
The world and especially Europe should prepare for an even larger flood of Chinese cars that will come to global markets in the coming years, once the necessary shipping capacities will come onstream. Profitability will likely be a minor concern for subsidized Chinese car manufacturers, quantities and growing market share are the main objectives.
The flip side and the good news are that China will once again export overcapacity and become a source for global disinflation in the coming decade. Interest rates may come down faster than many think. But the low-cost competition will aggravate the problems of the German car industry. China’s trade surplus, already running at 900 billion dollars, looks set to grow further. Calls for protectionism in the EU will get louder and louder.
The final chapter of Chimerica
In the 2000s, Niall Ferguson and I termed the word Chimerica to describe the combination of the Chinese and American economies that had become the key drivers of the global economy. Chimerica accounted for a third of global economic output and two-fifths of worldwide growth from 1998 until the global financial crisis. Chimerica catapulted China out of poverty and helped sustain the many contradictions of the Chinese growth model.
Now the end of the Chinese economic miracle is in sight, as Adam Posen of the Peterson Institute pointedly called it in a recent Foreign Affairsarticle. Burdened by high debt, past overinvestment, impeding austerity, as well as political uncertainty, the Chinese economy will have to adjust to a substantial scaling back of growth expectations.
But at least in one dimension lackluster Chinese growth could be good news for the world. If China grows too fast, adding to Chinese economic power, the confrontation with the U.S. would inevitably heat up. If China grows too slow, political instability and scapegoating the West would become a real risk. From this perspective, a lukewarm Chinese growth rate of 2–3 percent over the next decade might well be the best outcome for global peace and prosperity.
Europe and especially Germany must adjust to this new environment. In the coming years, China will be a much less dynamic market for German capital goods exports, let alone cars. The fat years are (long) over. Instead, China will increasingly turn to exports to compensate for domestic weakness. In key sectors, this will bring China’s industries in direct competition with European producers. It is high time for Europe and Germany to shift perspective from Chinese economic strength to the effects of Chinese economic weakness.
Cover image: © stock.adobe.com | Cedar