SHANGHAI – It was meant to be the year China’s economy, unshackled from the world’s strictest Covid-19 controls, roared back to help power global growth.

Instead, halfway through 2023, it is facing a confluence of problems: Sluggish consumer spending, a crisis-ridden property market, flagging exports, record youth unemployment and towering local government debt. The impact of these strains is starting to reverberate around the globe, affecting everything from commodity prices to equity markets. The risk of US Federal Reserve rate hikes tipping the United States into recession has also heightened the prospect of a simultaneous slump in the world’s two economic powerhouses.

What is worse, President Xi Jinping’s government does not have great options to fix things. Beijing’s typical playbook of using large-scale stimulus to boost demand has led to massive oversupply in property and industry, and surging debt levels among local governments. That has sparked a discussion about whether China is headed for a Japan-style malaise after 30 years of unprecedented economic growth.

Exacerbating this is Mr Xi’s more assertive approach to dealing with the US, which has added fuel to American efforts to cut China off from supplies of advanced semiconductors and other technologies set to drive economic growth in the future.

“A few years ago, it was difficult to imagine China not rapidly overtaking the US as the world’s biggest economy,” said Bloomberg Economics chief economist Tom Orlik. “Now, that geopolitical moment will almost certainly be delayed, and it’s possible to imagine scenarios where it doesn’t happen at all.”

In a downside scenario – with a sharper property slump, slow pace of reforms and more dramatic US-China decoupling – Bloomberg Economics sees China’s growth decelerating to 3 per cent by 2030.

Base effect

China’s official growth target of around 5 per cent, which was deemed unambitious when it was announced in March, now looks more realistic. Goldman Sachs in June cut its forecast for China’s growth this year to 5.4 per cent from 6 per cent.

At first sight, in a world economy expected to grow a meagre 2.8 per cent, that does not look too shabby. The reality, though, is that with China still under strict Covid-19 rules in 2022, a low base for comparison is flattering the headline. Netting out the base effect, growth for 2023 will look closer to 3 per cent – less than half the pre-pandemic average, Bloomberg Economics said.

If the government continues to sit on its hands, things could get worse. In a scenario where property construction crumbles, reduced land sales hit government spending, a US recession weakens global demand and China’s markets shift to risk-off mode, Bloomberg’s economic forecast model Shok shows another 1.2 percentage points shaved off growth.

“We’re caught in a kind of vicious circle in the sense that you need a massive stimulus to create a little moderate impact,” said London School of Economics and Political Science economics professor Jin Keyu.

“We have to be prepared for slower growth in the future because China is really in transition right now from industrialisation to innovation-based growth,” she said. “Innovation-based growth is just not that fast.”

To be sure, China’s policymakers have defied the doomsayers before and could do so again. A bigger-than-expected stimulus, proactive moves to resolve bad debts, a commitment to support entrepreneurs and extending an olive branch to the US could dispel some of the pessimism.

But for now, the lack of substantial stimulus or real reform is frustrating investors. The 12 per cent rally enjoyed by the MSCI China Index in January proved a false dawn as the gauge steadily gave back all the year’s gains. It is now down about 6 per cent in 2023 and Wall Street’s biggest banks are cutting forecasts to levels that suggest it will struggle to reclaim the levels seen earlier in 2023.

Confidence trap

At the start of 2023, optimism was high that China would see a rapid recovery in consumer spending, fuelled by revenge shopping, eating out and travel. But anxiety about what weaker growth means for unemployment and incomes, combined with the negative wealth effect from a slumping property sector, has prompted people to save rather than spend.

Ms Xiao Jin was one of the people hoping the abrupt end in December of three years of zero-Covid would mean shoppers would flock back to her toy shop in Zunyi, a city in the south-western province of Guizhou. 

“We barely made any money in the last three years,” Ms Xiao, a mother of two children, said outside her shop in mid-June.

But “business is even worse than last year”, she said.

At the heart of wilting consumer sentiment is the property market. The slump followed the government’s attempt to crack down on heavily indebted real estate developers in 2020 to reduce risk. That pushed housing prices down and a number of the weaker companies defaulted. Many developers stopped building houses they had already sold but had not yet delivered, prompting some home owners to stop paying their mortgages. 

There is no indication the fall in property prices is attracting the new buyers needed to kickstart a rebound. Banks advanced the smallest amount of longer-term loans to households in 2022 in almost a decade and borrowing was down another 13 per cent in the first five months of 2023, indicating fewer people are taking out new mortgages.

Another worrying sign is youth unemployment. At 20.8 per cent, the jobless rate for those aged 16 to 24 is the highest since China began publishing the data in 2018 and is four times the national urban rate. A big reason is the slump in services industries as a result of strict Covid-19 rules and the decline in the property market. The tech crackdown also took away a lucrative career path for many young, ambitious graduates.

Exports weaken

It is not only domestic demand that has disappointed. Foreign trade had been a consistent support during the pandemic as Chinese factories rushed to fill US and European orders, but it has dwindled in recent months. Since peaking at a record US$340 billion (S$461 billion) in December 2021, exports in May were down almost US$60 billion and are set to continue dropping as rising interest rates weigh on growth in the US and Europe. 

In Yiwu, in eastern Zhejiang province, Ms Huang Meijuan has been selling artificial Christmas trees all over the world for more than 20 years. This year, she expects sales to drop 30 per cent from 2022’s record. 

Fading growth momentum is contributing to China’s consumer inflation staying at close to zero. Factory gate prices have already tipped into deflation – leaving businesses with less income to repay their debts.

That economic weakness has forced Beijing to shift gears. The central bank cut interest rates in June and the State Council, China’s Cabinet, said it is discussing new support measures for the economy. Possible options include a further easing in property restrictions, tax breaks for consumers, more infrastructure investment and incentives for manufacturers, especially in the high-tech sector.

Still, property and infrastructure stimulus will probably be “targeted and moderate” given the shrinking population, elevated debt levels and President Xi’s call for curbing property speculation, Goldman Sachs analysts in China wrote in mid-June.

Hidden debts

The reason that large infrastructure-led stimulus is not viable any more is clear if you walk around Zunyi or travel out of the city into the countryside. While the impoverished and mountainous province of Guizhou did need some investment, it is now awash in expensive bridges, tunnels, roads and airports. And it is struggling to pay back the debt it took on to finance all that construction, forcing it to make pleas to Beijing about its severe debt crunch.

Much of the funding for these projects, and others around the country, came from local government financing vehicles – with that debt not appearing on their balance sheets.

It is this “hidden debt” that has become a major risk for China’s local governments and a big worry for investors who have bought bonds sold by the local government financing vehicles. The International Monetary Fund estimated in February that nationwide there was 66 trillion yuan (S$12.35 trillion) of this debt at the end of 2022, up from 40 trillion yuan in 2019, with that quick increase underscoring how local governments ramped up off-book borrowing and spending during the pandemic.

Local governments are themselves under financing pressure. They had come to rely on land sales to property developers to top up their coffers, but that source of revenue is drying up due to the housing downturn.

With the central bank now starting to cut rates, and cities across the country lowering the down payment requirements and removing restrictions on buying multiple properties, the lacklustre state of the property market might gradually change. But massive oversupply means it will take a while for any property stimulus to flow through to actual housing construction, if it does at all. BLOOMBERG