Broken China

The world’s second-largest economy may have reached its zenith, says Richard Vague.

China failed to deliver anything close to its historically robust growth in the September 2022 quarter, with 3.9% against the 7% average annual rate it reached in the five years before Covid. That 7% is a lofty level it will struggle to ever consistently re-attain. 

Why will China’s growth remain below its historically higher levels? 

First and foremost, it had achieved that high growth rate through rampant construction of housing and other real estate, but it built so many houses and apartments that an estimated 50 to 100 million are empty across the country. 

A prime perpetrator of this insanity was a company called Evergrande, which went through a massive, headline-grabbing debt default in 2021. But overbuilding permeates the entire housebuilding industry in China, so companies including Kaisa, Fantasia, and Shanghai-based Shimao Group soon followed suit. The same fate has now cascaded to hundreds of more developers, raw-material suppliers, and contractors. 

These companies had been able to overbuild because their lenders—mainly China’s banks—used exceedingly lax criteria in making the loans the companies needed. However, in 2020, China’s government began to worry about the housing excess and the overleveraged state of housebuilding sector companies and imposed much stricter lending criteria. These are its now-famous “three red lines” policy that many housebuilders couldn’t meet, so their new construction efforts ground to a halt. 

With its construction boom, China, the second largest economy in the world, racked up a business debt level of 157% of gross domestic product. It is a stultifying level compared with 81% in the US, 117% in Japan (the world’s third largest economy), and 72% in Germany (the world’s fourth largest economy). Not surprisingly, the largest component of China’s business debt is real estate loans. 

Here’s the dilemma: China can’t have it both ways. By restricting lending, both new construction and the country’s overall economic growth quickly slowed. If China’s government were to remove these restrictions, new construction would resume and the country’s growth would benefit (since GDP increases whether or not the home is sold), but it would simply add to the excess of unsold real estate and create yet more loans that would never be repaid. 

On November 13, China’s struggle with this dilemma burst into the press yet again with the Wall Street Journal’s headline, “China Dials Back Property Restrictions in Bid to Reverse Economic Slide.” China had imposed restrictions on how much real estate lending banks could do but saw the resulting adverse impact, flinched, and then unwound many of the previous restrictions and gave lenders permission to extend loans to home builders in financial trouble. Yet there’s only so much increased lending you can do when so much excess already exists. 

China’s problems go deeper still. The most structural and insurmountable constraint on its economic growth is its slowing population growth, a legacy of its notorious one-child policy. The slowdown is now so pronounced that it’s likely to tip into a population decline. 

In 2022, China’s population growth plunged to zero. The United Nations views its current population level of 1.425 billion people as its peak and forecasts that China’s population will decline to 1.415 billion people in 2030 and 1.312 billion in 2050. The UN’s projections may be off a bit, but given its excess of housing and other real estate, the last thing it needs to sustain robust economic growth is a population decline. China’s growth has been further challenged by its draconian zero-covid policy, which required that factories, cities, and even entire regions be shut down if cases are discovered. These shutdowns, even for short periods, further smothered economic growth. 

And there is one more major factor at play in China’s economic slowdown: the decoupling of the economies of China and the US. 

Some US companies that have their manufacturing in China fear their access to China’s manufacturers could be completely cut off.

For the past two generations, China’s focus on manufacturing and low wages has made it the first choice for outsourced manufacturing from the US and other major industrial countries. Almost all of Apple’s iPhones are made in China. But the rapidly deteriorating political relationship between the US and China means that many companies are now either reshoring manufacturing back to the US or moving it to countries with far less political risk, such as Vietnam and Mexico. Some companies that have their manufacturing in China fear their access to China’s manufacturers could be completely cut off, leaving them without products to sell—a risk that’s simply too high, regardless of the cost differential. 

These four factors will mean a continued drift to slower growth for China. It will inevitably seek to offset slowing growth with increased central government spending, and it will succeed to a limited extent, but not enough to restore the consistently robust growth of the past. Since China’s growth has had an outsized impact on global growth, it will also put downward pressure on growth globally. In the years leading to Covid, annual global growth was 3%, but without China it would have been only 2.4%.

With this, the world may have now entered an era of slower growth