China’s economic troubles will have global consequences

In the years leading up to and especially after the financial crisis, international relations experts would often predict that China was on course to dominate the global system. Since Xi Jinping came to power more than a decade ago, he has propagated just such a narrative. He has articulated China’s pursuit of modernity, power and global status as purposeful and strategic, and embedded that pursuit in what he calls the “Chinese dream of national rejuvenation”. He wants to transform China into a powerful, respected and socialist country and to re-frame the global system of governance and values in China’s interests, to create a China-centric world order by 2049, the centenary of the founding of the People’s Republic. 

Yet, here we are, almost 11 years after Xi came to power, and it is not uncommon to hear some of those same people talking about Peak China (even if the term Plateau China may be a better, if less catchy, description for the trajectory of the country’s economic power). A malaise has become a feature of the young, the middle class and of private firms and entrepreneurs. Such low levels of confidence or even pessimism are typical of an economy going through an important transition to slower growth, and in which accumulated problems of over-investment, misallocation of capital and economic imbalances have been allowed to accumulate.

The mood was captured briefly, in October, by the untimely death of former premier Li Keqiang, who was mourned not only in the customary fashion for a departed leader, but also as the symbolic end of an era that began with the promise of extensive liberalising reform and delivered almost nothing. Li, who was associated with reform, was side-lined by his boss Xi Jinping for much of his decade in office. Meanwhile Xi, who is certainly no reformer, became the architect of a more state- and party-centric governance system in which control, stability and repression have prevailed, reflecting China’s faltering development model. This week, Moody’s, the international ratings agency, downgraded its outlook for China’s credit rating from “stable” to “negative”, while maintaining the country’s A1 credit rating for now. The agency expressed concern about the weakening economic outlook and rising debt capacity problems. 

Economic growth started to slow well before Xi took charge in 2012

The governance of Xi may have exacerbated China’s economic problems, as did Covid, but neither was the cause. Economic growth started to slow well before Xi took charge in 2012. China’s economic development model began to show weaknesses before the financial crisis which have only been exacerbated since. Think about them as the six Ds. Excessive debt that has now exposed low debt servicing capacity; the demographics of rapid ageing; loss of dynamism, or productivity growth; the return of decree-type governance in which, for example, private firms and entrepreneurs are stigmatised or coerced; distributional issues of who will pay, and how, for the real estate bust and for the public goods and services provided by local government; and decoupling, as China confronts the harshest external environment it has faced—partly self-made—since the Mao era. 

In the summer of 2023, as China’s disappointing recovery from Covid was revealed, some excited commentators wrote headlines predicting the country’s imminent economic “collapse”. That proved to be hyperbole. Even so, whatever is going on in the Chinese economy merits close scrutiny. Whether the economy has peaked or is plateauing, the implications are not trivial inside China or for the rest of the world.  

How then is it even possible that China may have peaked or plateaued? Well, in the words of a leading academic, referring to the economic gameplan of America’s principal adversary: “It would be foolish to doubt that this strategy will result in spectacular advances and growing supremacy in a variety of fields such as industrial ceramics, lasers, semiconductors, biotechnology, solar energy, robotics, superconductors and possibly in space exploration. These advances, in turn, will be largely used in consumer products and will lead to increasing exports, rising techno-nationalism, and deepening fears among Americans that we can no longer compete.” 

These words, penned in 1987 by the dean of the School for Advanced International Studies at Johns Hopkins University were made about Japan, not China. They might, though, just as well have been written about China now.

Within three years, Japan, whose leading companies such as Sony, Hitachi, Toyota, Honda, Matsushita and Sumitomo were household names, would succumb to an economic shock and relative decline that was to last the best part of two decades.

What Japan teaches us is that two things can be simultaneously true. A country with world-class companies and high levels of achievement in science and technology can also have an economy of deep economic and political contradictions, with asset bubbles and imbalances which, if unaddressed, can end really badly. Having great firms doesn’t protect an economy against bad macroeconomic outcomes. You can have technological islands of excellence, but only properly wired tech ecosystems that diffuse benefits throughout the economy and society underpin resilience and sustainable growth.

Two things can be simultaneously true. A country with world-class companies and high levels of achievement in science and technology can also have an economy of deep economic and political contradictions

China’s problems aren’t quite the same as Japan’s. China’s significant debt is more fragmented than Japan’s was, and is concentrated in property, local governments and state enterprises. Its banks will not be allowed to go bust, as some banks did in Japan. Land prices have not soared to the same extent. China’s party-state has more direct control and policy levers it can pull than Japan’s ruling Liberal Democratic party did 30 years ago. 

On the other hand, 1980s Japan and contemporary China have similar economic development models, based on high levels of both savings and investment. They are both mercantilist, with an intense focus on exports and industry, while wages and consumption play second or third fiddle. They both created too much debt and allowed real estate asset bubbles, over-investment and misallocation of capital to become problematic. Japan’s ossified government would not start appropriate economic reform for 20 years, China’s Leninists will probably not try it at all. 

Now we have a framework for being able to imagine how China may be peaking, it is important to address why it has arrived at this juncture. Consider, for example, three of the significant factors that hang over China’s economic prospects—population, real estate and governance.

As in many other countries, China’s population is starting a long decline thanks to a slump in fertility. In 2022, it fell to just below 1.1 children, about half the rate required to stabilise the total population. In 2023, fewer than eight million children may be born in China, much less than half the number recorded in 2016 when the one-child policy was abandoned formally. According to the United Nations Population Division, by the end of the century, China’s population might have fallen below 800m, to about half that projected for India. Long before that, by 2040 or 2050, China will be a significantly older country than the United States.

Rapid ageing and a shrinking population could damage China’s economic potential and performance. The state will be less able to finance the provision of goods and services, and individuals, who have nowhere near the kind of pension and healthcare benefits or residential care resources that we find meagre in developed countries, will be unable to pay for them. Despite the country’s wealth, China is in danger of “getting old before getting rich”. 

In a society where extended families care traditionally for one another, fewer children, fewer marriages and more multi-generational “beanpole” families could have meaningful effects on the ways citizens think about communities, work, society and even military service. These are issues that can affect social displacement in high growth and wealthier settings, and so imagine their impact in middle-income and occasionally still quite poor China. 

Moreover, according to valuable research conducted by Scott Rozelle and Natalie Hell, China is not well educated. Using the 2010 population census, they estimated that just 30 per cent of the workforce had secondary school qualifications, and 15 per cent had anything further. These proportions have edged up since, but remain appreciably lower than in developed market economies and China’s peer group countries such as Mexico and Turkey, and also lower than the levels in South Korea and Taiwan when they had China’s current income per head. 

Low levels of educational attainment not only mean workers are poorly equipped for more complex, digital and tech-orientated work, but are associated broadly with a failure by nations to spring the so-called middle-income trap. In this framing, leaving poverty behind is one thing, but becoming a developed economy becomes an elusive goal. 

The Chinese government has been paying attention to this problem. In recent years, educational attainment levels have been increasing. Over time, as young people age, they will be better qualified than their retired parents. The stock of human capital, as it is called, should improve. Yet, this will also require addressing childhood diseases and learning problems that Rozelle found in rural areas, still accounting for almost half the population, and school and university curriculums in which the study of Xi Jinping often takes precedence over academic content.

In terms of population and ageing, then, Peak China has already arrived. But can the same be said of China’s economy? 

China’s power in the world rests not on its reliability as a champion of human freedoms and values, but on its credibility as an economic power and its status as the richer partner to states whose support it is trying to win for a new model of global governance. 

That position once seemed assured. When Xi came to power, Justin Yifu Lin, a well-known Chinese economist who is now close to the government and who had then just finished his term as chief economist for the World Bank, predicted that China could keep growing at 8 per cent for another 20 years if policymakers implemented the right economic reforms—as he was sure they would. Many economists in the west, resigned to the sour post-Lehman legacy of the time, agreed.

It is extraordinary how rapidly things have changed. Putting to one side doubts about the integrity of China’s GDP statistics—they are carefully manicured and treated more as a political message than an economic measure—such optimism has been well and truly punctured. China’s economy is now about $5 trillion or 20 per cent smaller than under those rosy forecasts. In fact, during the 2010s, China’s economic growth almost halved. Now, it is halving again, to around 2 to 3 per cent. 

In a way, such declines in growth matter less for a $19 trillion economy than a smaller one, and, in any case, Xi emphasises that national security, self-reliance and the “new productive forces” of technology and science are more important nowadays than high GDP growth. Unfortunately, the party’s problem is that these new sectors are not nearly big enough to compensate for those that are stagnating or in decline. And the diffusion of benefits from them into the wider economy is low. 

But the proximate reason for China’s current debt troubles is the real estate market. As we in the United Kingdom know from our own experiences in the early 1980s and after the financial crisis in 2008, real estate busts are normally big and painful, and can be protracted. China’s is no different, following more than a decade in which real estate was used by the government as a tool to counter unwelcome economic downturns. In so doing, China’s leaders inflated a bubble that was then sustained by a financial system in which everyone “knew” that prices would only rise, no one would default and no firms would fail. Well, we know how this ends, and in China it has. 

Several real estate developers—notably Evergrande, the world’s largest real estate debtor, and Country Garden, poster firm for the boom—are now on life support. The real estate sector accounts for between a fifth and a quarter of the economy—much more than in the UK—and faces chronic oversupply, falling prices and years of shrinkage. While large Chinese banks have little direct exposure to the big developers that are in trouble, the financial system as a whole is at risk. Households hold most of their wealth in housing. Businesses in construction materials, home appliances and furniture all face a bleaker future, as do those already financially pressed local governments. 

Chinese officials have been trying to stabilise the market or even lift it over the winter, but there is little question that the sector will shrink under pressure from oversupply. With fewer households being formed, due to a decline in the population of first-time buyers and a sharp fall in the number of marriages, that pressure seems unlikely to ease.

The private sector in China has played a huge role in the country’s economic development, especially since the 1990s when state-owned enterprises (SOEs) were privatised, formal company law was introduced and corporate practice institutionalised. Exactly 10 years ago, at the Third Plenum of the 18th Party Congress, a political forum often dedicated to the economy, the CCP pledged to give market forces and competition a “decisive role in the economy”. Rather than having a supplementary role, they would be a “pillar”.

Yet, the reality did not live up to the message. The role of private firms and entrepreneurs in China has never really been officially recognised. Xi’s China has underscored the dominance of SOEs and taken private firms and entrepreneurs backwards in time politically and probably economically too. Private firms play a subordinate role to ambitious industrial policy goals that call for strong state guidance, CCP control and the deployment of vastly increased state financial support for state-owned enterprises. Private and “mixed-ownership” firms, which are really private firms in which state enterprises build stakes and management rights, have to align themselves closely with the party. Most must have party committees in or close to operational management. Memories of the so-called “rectification campaign”—introduced in late 2020 against Jack Ma’s Alibaba subsidiary, Ant Financial, but extended to an array of technology, data, educational, and online platforms—are still fresh. 

As China abandoned its zero Covid policy, rhetoric towards private firms softened, but this has not notably changed the political and regulatory environment, and state firms continue to be prioritised. Repeated acts of arbitrary punishment or detention meted out to businesspeople who fall foul of the government’s wishes or narratives leave private firms and entrepreneurs feeling insecure. The government’s use of national security regulations and anti-espionage laws to control access to information that potential investors may require is also something that foreign firms have become increasingly wary about. 

While China’s slowdown will impact the rest of the world, financial contagion is a low probability event—so long as it is able to use its control of the financial system to prevent large banks from going bust. Instead, the likelihood is that the CCP will continue to eschew liberal and market reforms, and so foreign firms and countries will find China a big but more sluggish market. This will be especially true for those supplying commodities to the beleaguered property sector, but also those providing goods for the fabled middle class. Meanwhile, China is decoupling its economy under the banner of national security and in the name of self-reliance; the US and others do the same, under the less threatening name of “de-risking”. All of this means that many businesses, including Chinese firms, will diversify and move supply chains and production away from the Chinese mainland. There will be higher costs all round, but perhaps especially in China. 

We cannot know how all of this will influence the CCP’s behaviour at home, in the face of more instability, or abroad, in the many disputed areas of the South China Sea or with regards to Taiwan. Perversely, domestic challenges might make Xi’s China try harder to exploit the “historical opportunity”, as Xi sees it, to wean countries away from the USA’s alliance systems and security umbrellas, and to draw them into China’s own governance system and values. 

In several ways, China has been trying to do this already through the Belt and Road Initiative (BRI), and the Brics group of countries. The heyday of the BRI ended in about 2017, as countries that had borrowed money from Chinese banks struggled to repay their debts, but the initiative remains a central and personalised part of Xi’s foreign policy. The Brics, meanwhile, expanded in 2023 to include Egypt, Ethiopia, Saudi Arabia, Iran, the UAE and Argentina (although the last of which may decline to take up membership following the election of Javier Milei). It is probably a much more agreeable governance entity for Xi than more established forums such as the G20, because it is devoid of the influence of the US, and although formed by a disparate group of countries, Brics nations share at least a degree of opposition to the US and the US dollar-dominated financial system, with which Washington can weaponise sanctions. 

The governance agenda is important. Since 2021, China has launched three initiatives in Global Security, Global Development, and Global Civilisation. These span sovereign and territorial integrity; globalisation, food security, industrial policy and low carbon; and “human rights”, cultural and learning exchange, and values, respectively. In September, the Ministry of Foreign Affairs issued a lengthy “Proposal of the People’s Republic of China on Reform and Development of Global Governance”, capturing these three initiatives and expanding them to include plans for science and technology, as well as for the UN, its agencies and other global bodies. The language is colourful and ostensibly inclusive but is really designed to encourage nations to align with China’s model of “subsidised capitalism”, adopt its technology and business standards and protocols (rather than the west’s) and bring them into a new China-centric governance system.

Xi’s ambitions may not come to pass. What happens elsewhere—including in Russia, the Middle East and the US following their respective presidential and congressional elections in 2024—will play a crucial part in determining the outcome. The pushback that China is encountering from liberal-leaning democracies on commerce, trade and national security is likely to intensify. Some countries in Asia, such as Japan, South Korea, the Philippines and Vietnam, are showing signs of resistance to what they regard as China’s coercive diplomacy.

Ultimately, though, the challenging economic path China is now on will change the psychology and outcomes of competition between Beijing and the US and other liberal-leaning democracies. China’s position as an economic role model for many countries in the global south, tarnished already by its approach to international debt restructuring negotiations, could also be affected adversely. 

 The UK and its allies—above all the US—have a difficult task ahead in figuring out the appropriate diplomatic and strategic approach to this post-peak China. They should avoid over-complacency, as China’s ambitions and capacities remain strong, but also over-caution, given the array of frailties and problems that Beijing is accumulating. The view that once threatened the west, of the inevitability of the Chinese century, seems to be fading. But the reality that’s emerging is no less worrying: post-peak China is still powerful, just that much more unpredictable.