China’s mistakes could cost Australia dearly

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China’s economic authorities have a problem. They are confronted with the threat of deflation and the prospect of “Japanification,” or the decades of economic stagnation from which Japan is only just emerging.

This week’s inflation data showed consumer price inflation at zero last month and factory gate prices falling 5.4 per cent (year-on-year), their ninth successive monthly decline.

Chinese President Xi Jinping’s ambition of toppling the US as the dominant global power is on shaky ground.Credit: AP

Apart from a brief moment of deflation in early 2021, when pork prices were tumbling, it’s the first time since the 2008 financial crisis that China has experienced deflation.

This time, the challenges the economy is confronting owe more to domestic developments and structural issues than they do to external settings, although the weakening global growth environment isn’t helping.

The core of the problem, and a factor that complicates efforts to respond to it, is debt. China has too much of it.

The central government isn’t the culprit, rather it is local governments, businesses and households that have driven China’s debt-to-GDP ratio up to about 280 per cent of GDP. The world’s developed economies have an average debt-to-GDP ratio of about 256 per cent.

Local governments account for about 30 per cent of China’s GDP and their financing vehicles another 40 to 50 per cent, according to Fitch Ratings. They’re massively overleveraged and short of income because they are reliant on property sales to developers for much of their revenue.

Xi Jinping’s crackdown on property developers in 2020 – the “three red lines” policy that restricts their leverage – not only decimated the sector but shut down the local governments’ main source of income. Their response, often using their financing vehicles to replace the developers as buyers of the land, has compounded the problem.

Despite efforts by Beijing to relieve the stresses on both local governments and the better-managed developers with concessional funding and, for both groups, loan repayment holidays, the construction sector that has accounted for about 30 per cent of China’s growth in the past remains depressed and local government finances increasingly stressed.

Households and businesses, after the pandemic lockdowns and two years of the draconian “zero COVID” policies that were only lifted late last year have, after a modest and short-lived bounce that created expectations of a big, consumer-led rebound in China’s growth, retreated to the sidelines.

China’s economy has struggled to sustain a strong recovery after the end of harsh COVID policies. Credit: AP

Household wealth is concentrated in property, so the trauma in the property sector and the experience of households which invested in deposits for uncompleted or yet-to-be-built apartments has had a chilling effect on spending. In a system with little in the way of social safety nets, consumers are more focused on debt reduction than on consumption.

Urban youth unemployment of more than 20 per cent and a slowing of the rural-to-urban drift that has been a major influence on China’s economic growth in recent decades might also be contributing factors.

Business, particularly those in the private sector, are scarred by their pandemic experiences and confronted with weak demand. There appears to be significant over-capacity within China’s economy. Price-cutting by retailers to try to stimulate demand is also squeezing margins.

The authorities will be very mindful of the Japanese experience, where the interaction between a property boom and debt, when the bubble finally burst, led to three decades of economic winter.

The crackdown by Beijing on private businesses – the torrid couple of years experienced by the tech entrepreneurs in particular but, more broadly, the rebalancing of policy away from the private sector towards state-owned enterprises under the banner of “common prosperity” under Xi – has injected significant uncertainty into the private sector, which provides the overwhelming majority of urban jobs.

The slowing of the global economy and the restructuring of global supply chains in the wake of the pandemic, the war in Ukraine and the continuing increases in tensions between China and the US is impacting external demand for China’s manufactured goods, which is showing up in weaker exports.

Foreign investment has also been weakening, with the massive losses experienced by foreign lenders to the property sector, the weakening of China’s growth rate, the restrictions imposed by the US and its allies on high-tech exports to China, China’s raids on foreign consultancies and its shutting down of access to economic and business data possible strands to the explanation.

The authorities have made some cautious and half-hearted efforts to ignite some growth.

The People’s Bank of China has been edging down its policy rates and encouraging banks to lend more at lower cost to mortgage borrowers. There have been other measures directed at the property sector and related areas like home decor and whitegoods. There’s been talk about incentives for purchases of electric vehicles and other very targeted measures.

What we’re not seeing is any signs of the kind of major stimulus program Beijing executed in response to the 2008 financial crisis, when it countered the global economic recession with a $US586 billion ($890 billion at the time) infrastructure-centred spending spree.

That’s because, while the stimulus did result in double-digit economic growth rates, it left a legacy of ghost cities and other waste on a grand scale.

That experience and the uncomfortable levels of unproductive debt within the economy, have deterred the authorities from large-scale stimulus programs ever since.

There is an expectation that there will be some stimulus, probably after the next quarterly meeting of the Politburo late this month, where the country’s first-half economic performance will be reviewed.

China is facing the prospect of “Japanification,” or the decades of economic stagnation from which Japan is only just emerging.Credit: AP

More efforts to generate some growth in the property sector and measures to stimulate consumer demand are expected, although large-scale cash handouts or tax cuts for households and businesses are unlikely, given that the recipients would be more likely to save the extra cash or use it to pay down debt than spend it.

Nevertheless, the authorities will be very mindful of the Japanese experience, where the interaction between a property boom and debt, when the bubble finally burst, led to three decades of economic winter.

With a population that is now shrinking and ageing, their considerations won’t just be about short-term relief – structural changes will be needed if China is to avoid being trapped in a low-growth, middle-income economic trap, dashing Xi’s ambitions of toppling the US as the dominant global power and raising the risk of civil unrest.

It is, of course, in everyone’s interests, but particularly Australia’s, that our largest trading partner is able to devise a response that enables it to avoid a downward spiral into persistent deflation and can achieve its modest (by China’s standards) targeted GDP growth rate of five per cent this year and help the rest of the world avoid, or at least moderate, a global recession.

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