China is sneezing, world may catch a cold

Deflation has been primarily driven by falling food prices. Food and tobacco prices in July contracted by 0.5%, primarily on account of a fall in the price of pork—China’s favourite meat—by 26%.

Now, a single month of falling retail prices doesn’t exactly mean that China is entering an environment of short or medium term deflation. Nonetheless, it is worth mentioning that the producers price index for industrial products in China has fallen for 10 months in a row. In July, the fall was 4.4%, implying that wholesale prices at the factory level have been falling for 10 months now.

This means that there is a slowdown in demand, both domestically as well as internationally. In July, China’s goods exports in US dollar terms fell by 14.5% from July 2022. At the same time, goods imports fell by 12.4%. Non-oil goods imports are always a good indication of domestic consumer demand, and thus a slowdown in overall imports suggests a slowdown in domestic demand.

In fact, data from the National Bureau of Statistics of China shows that the total retail sales of consumer goods rose by just 3.1% in June, after rising by 18.4% in April and 12.7% in May.

So, clearly, there is a problem. And this is likely to have a global impact, given the huge size of the Chinese economy.

Youth unemployment

One of the main symptoms of the problem with the Chinese economy is high youth unemployment rate (chart 1). In June, the unemployment rate in the 16-24 age group stood at a very high 21.3%.

Further, a couple of days back, the National Bureau of Statistics, which publishes the youth unemployment data, decided to temporarily suspend publishing it from July onwards.

What this clearly implies is that the Chinese economy is not seeing enough new economic activity to be able to create jobs for the youth entering the workforce. In fact, in November, the news agency Bloomberg had reported that the Chinese ministry of education expected around 11.58 million students to graduate from universities and colleges in 2023. These students are putting further pressure on the youth unemployment rate.

Real estate

The other big symptom of all not being well in the Chinese economy is the state of residential Real Estate. According to the China Real Estate Information Corp., a leading industry data provider, new home sales made by China’s hundred biggest real estate developers fell by a third in July this year in comparison to July 2022. Further, data from the National Bureau of Statistics shows that investment in real estate development for the period from January to July fell by 8.5% to 6.77 trillion yuan in comparison to the same period in 2022. This was primarily on account of a 7.6% fall in investment in residential housing which makes up for nearly three-fourth of overall investment in real estate. A report in Nikkei Asia points this out.

This implies multiple things. First, the demand for homes is falling. Second, as a consequence of this, the supply of new homes is also declining, with investment that goes into making new homes sliding. Third, the Chinese started lapping up on residential estate from 2014 onwards. As per CEIC data, in 2014, the total Chinese household debt stood at around 33% of the gross domestic product (GDP). The GDP is the measure of the size of an economy during a particular year. As of March 2023, it stood at a little over 63% of the GDP, having been flat for close to two years now. Home loans account for nearly two-thirds of the housing debt. So, clearly, the demand for home loans, and thus homes, has been subdued over the last two years.

Fourth, over the years, residential housing has become a major part of the assets owned by the urban Chinese. A survey carried out by the People’s Bank of China (the Chinese central bank) in 2019 on the assets and liabilities of urban households estimated that residential housing assets accounted for 59.1% of the household assets. This data is slightly old but there is no material reason to assume that things in 2023 would be any different.

Fifth, the demand for residential real estate has been a major driver of economic growth, especially in the smaller cities. In fact, as Stanford’s Center of China’s Economy and Institutions put it in a December 2022 report, the estimated size of China’s real estate sector has remained at around 26% of the GDP since 2018, which is exceptionally high. They further estimated that more than three-fourths of construction in 2021 was in hundreds of smaller tier-III cities where population is expected to shrink, leading to a huge demand-supply mismatch.

What all this tells us is that residential real estate is a very important part of the Chinese economy. Any fall in demand hurts developers who are already struggling to repay their loans. A fall in demand impacts prices. In fact, data from the National Bureau of Statistics points out that in June, home prices across 70 major cities fell by 0.4% in comparison to May. As a news report in Nikkei Asia points out: “The figure has been falling steadily since summer 2021, other than a post-lockdown break that began in February but lasted only until May.”

A fall in price also hurts those who already own real estate, given that it forms a significant portion of their overall assets.

How did it get to this?

It is a perilous moment,” Eswar Prasad, an economist at Cornell University, told The New Yorker, regarding China’s current economic state. So, how did the Chinese economy end up in this state? The answer is not so straightforward. We need to look back at the heart of the Chinese growth model and how things have played out post the financial crisis of 2008.

Economist and long-time China watcher Michael Pettis has explained this in his writing. Pettis introduced the idea of ‘social capital’, which he defined in a 2014 article published by Carnegie Endowment, as “the set of institutions – including the legal framework, the financial system, the nature of corporate governance, political practices and traditions, educational and health levels, the structure of taxes, etc.,” in a country.

So, given a certain level of social capital, a country can absorb a certain amount of investment and grow at a certain rate of growth.

Over the years, China has followed a high-savings, high-investment growth model. The Chinese state disincentivized consumption and encouraged savings. Through the 1990s and a good part of 2000s, the state identified productive investment projects and used the massive savings to fund these projects. This was a time when the Chinese economy was extremely underinvested for its level of social capital. Hence, the investment drove very high economic growth rates.

The investment to GDP ratio, which was less than 30% in the early 1980s, was at 40% in 2004. So, the Chinese growth model of high savings funding high investments had, as Pettis explained in a recent tweet, “closed the gap between the investment it had and the investment it could productively absorb, given its particular set of business, legal, financial and political institutions”.

Basically, the social capital present in the country was already driving the kind of growth it could.

Then came the financial crisis of 2008. In fact, the Chinese investment to GDP ratio was down to 38% in 2007. The Chinese state decided to drive growth by investing more in the economy. The investment to GDP ratio increased to 44% by 2010 and was at 45% in 2013. This ensured that China grew by close to 9.1% per year between 2007 and 2013, a period during which global growth averaged 2.3% per year.

This investment binge was financed by getting local governments to borrow and build roads, bridges, subways and even housing projects. This led to the debt of the local governments burgeoning by 67% between December 2010 and June 2013 to 17.89 trillion yuan, leading to concerns that the assets built won’t generate enough returns for them to be able to repay the loans taken on.

So, the growth formula required a course correction. The focus moved towards low interest rates financing the purchase of residential real estate and, in turn, boosting economic growth.

When the real sector does well, many other sectors—right from steel and cement to furnishings, paints, etc.—do well. The multiplier effect is huge. Nonetheless, beyond a point, speculation to make a quick buck replaced genuine demand to live in a home. Builders also became over leveraged and this tweak to China’s growth model also ran out of steam.

The way out

China’s investment capital has converged with its social capital and that has led to what Pettis calls ‘investment overshooting’, where an increased investment only creates an illusion of growth because debt rises at a faster pace. And this is unsustainable.

Also, over the years, the investment-led growth model has disproportionately benefited a small elite. (chart 2). In 2021, the average national income of the adult population of China was 88,870 yuan. In comparison, the average income of the bottom 50% was 25,520 yuan. In fact, the top 10% earns, on average, 14 times more than the bottom 50%.

And this has now led to a slowdown in consumption. The typical prescription in such a scenario is for the government to spend more and for the central bank to cut interest rates in order to encourage people to borrow and spend more. The People’s Bank of China cut interest rates on Tuesday for the second time in three months.

There are two problems here. First, any cut in interest rates in a world where interest rates are still going up will lead to money leaving China and thus put pressure on the Chinese yuan. Second, the Chinese have already gone through a borrowing binge, which, from the look of it, is not going to end well.

In this scenario, what the Chinese economy needs in the short-term are direct and indirect transfers of money into the hands of people. As Pettis says: “The problem is that [Beijing] hasn’t figured out how to fund these transfers.” In the long-term, it needs “a new set of policies aimed at driving sharp increases in social capital”.

To conclude, the size of the Chinese economy in 2022 (constant 2015 US dollar) stood at $16.33 trillion or a little over 18.2% of the global economy. In comparison, the size of the US economy stood at $20.95 trillion or around 23.3% of the global economy. The old cliché used to be that if the US sneezes, the world catches a cold. That is now starting to be true about China as well.

Impact on world

So, how will this impact the global economy?

While China is the world’s largest exporter, it’s also the world’s second largest importer behind the US. Hence, a fall in prices will spread across the world through the trade route. This is both good and bad news.

A recent Bloomberg report points out that “Chinese export prices are down nearly 10% this year compared to last year.” This is clearly good news for the rich world—currently struggling with high inflation—and which outsources a good part of its manufacturing to China.

On the flip side, China is also the world’s largest commodity consumer. And a slowing Chinese economy will, as The New York Times puts it, impact everything “from soybeans harvested in Brazil, to beef raised in the US, to luxury goods made in Italy”. Of course, it will lead to oil prices falling, benefitting India.

Further, India’s goods exports to China in 2022-23, were at around 3.4% of overall goods exports. So, the direct impact of the Chinese slowdown on Indian exports will be limited. Nonetheless, Indian exports will be indirectly impacted because of the Chinese slowdown feeding into overall global growth.

The World Bank and the International Monetary Fund forecast China to grow by 5.6% and 5.2%, respectively, in 2023. But these projections are now looking very optimistic. On Tuesday, Barclays cut its forecast for Chinese growth to 4.5% against the earlier 4.9%. Given the size of the Chinese economy, the slowdown in growth will slow down global growth further in 2023.

Vivek Kaul is the author of Bad Money.