China’s economy is supposedly doing well. The authorities reported that last year’s real economic growth reached the magic number of 5%, exactly in line with the government’s target. However, if we look under the bonnet of China’s growth engine, we see rather large cracks appearing. Most of those cracks are already long in the making and its causes are not being addressed, making the situation worse by the year. Chalking up 5% real growth sounds great, but inflation is only 0.2% and unemployment numbers, especially amongst the youth (17%), are high. The government’s desperate measures to revive the economy also signals that something must be amiss. China’s official growth number, of course, is a fantasy; we believe the real economic growth number is probably well below 3%.

China is suffering from years of overspending in infrastructure and property assets, which really started in 2008 after the global financial crisis. These investments contribute to GDP growth as and when the investments are made but add little to future growth as most investments proved to be non-productive. This economic development model resembled a kind of Ponzi scheme: more and more investments, largely financed by debt, were required to keep the economic growth rate at the promised level (unsurprisingly being set at 5% for 2025). The government clumsily brought an end to this unsustainable debt growth trajectory by cutting off new loans to property developers under its “three red lines” policy in August 2020. Property prices duly crashed and property developers defaulted en masse. Not only came an end to new property investments, but developers also stopped work on unfinished apartments due to lack of funding. As many (largely pre-funded) apartments were bought as a nest egg for retirement and often were not rented out (i.e. did not generate an income), households lost confidence, reduced spending (aggravated by the covid-19 crisis, which was gravely mishandled by authorities) and accumulated safe financial assets instead, further depressing growth. Local governments lost their main source of income, namely land sales, as new housing starts declined severely. Many local governments struggled to repay debts (often through off-balance sheet vehicles) and had to curtail spending, also because the (state-directed) investments they made generated little income, if at all. As there is no effective centralized function to coordinate investments by local governments, they often ended up competing with each other, contributing to national overcapacity. Weak growth, low inflation, high debt levels (303% of GDP, according to the NBS/PBoC), an ageing and declining population; this could evolve into a 1990s-style Japan crash if China does not properly address the situation that has arisen.

China’s workforce in 2050…  

Acknowledging its high debt levels, the government has been reluctant to address economic decline and (risk of) deflation, but belatedly (in the autumn of 2024) announced measures to revive the economy. Some measures are tried and tested, like reducing policy rates, 1-year and 5-year loan prime rates and mortgage lending rates as well as cutting required reserve ratios for banks. Some have little impact, like the PBoC’s decision to cut rates for existing mortgages, which is nothing more than a subsidy to homeowners paid for by banks and doesn’t do anything for the housing market. Likewise, asking SOE’s and insurers to borrow money from banks to buy stocks to buoy stock markets is likely to be short-lived as valuations are determined by future cash flows, which do not change by buying stocks. “Trade-in” schemes for cars and household appliances (think of rice cookers) seem wasteful and in any case are likely to only affect the timing of purchases (how many rice cookers do you need?). To prop up the property sector, a new lending program was introduced to acquire unsold property inventories whereas the minimum downpayment ratio for purchasing homes is dropped from 25% to 15%. But lowering the downpayment ratio does not address the oversupply of homes and the risk of unfinished new-builds that buyers incur. This certainly will not be a game-changer. The government has issued long-term bonds (0.8% of GDP) to fund “priority” projects, but if not planned properly risks only adding to overcapacity (in semiconductors, for example). Local government special bond quotas were raised, worth 1.5% of GDP, to be issued this and next year, and local governments can swap up to 3% of off-balance sheet debt for explicit local government debt by 2028, addressing refinancing difficulties. However, the main issue is a lack of sufficient new revenue sources for local governments, and this isn’t really addressed.

China, being based on a Marxist-Leninist footing, effectively is a command economy with a focus on manufacturing (making stuff is deemed worthwhile in communist thinking) and exports. Unfortunately, China’s industrial policy has led to an enormous overcapacity, initially in products like steel and cement, being used to underpin the property bubble. More recently, policymakers accelerated investments in technology-focused sectors (under the common denominator of “new productive forces”). China is supplying the world with cheap EVs, batteries (70% global market share) and solar panels (90% global market share), amongst others with the government subsidizing manufacturing in all kinds of ways. This allowed many countries to accelerate the energy transition at the cost of China’s citizens, who effectively pay for these subsidies. Although the world benefitted from China’s folly industrial policies, dumping overproduction has triggered a backlash in many countries, especially in the U.S., as manufacturing in these countries suffered. China is running a trade surplus in excess of 5% of GDP or more than 1% of the rest of the world’s GDP. This is one reason why Chinese products are subject to tariffs. On February 1st, Donald Trump announced a 10% tariff on all Chinese products on top of existing tariffs (mostly dating from Trump’s first presidency). Although this tariff will not have much impact on China’s economy (highly price-sensitive products are already offshored to plants in South-East Asia), further escalation may follow although the scope for this is limited, in our view, as this will severely hurt the tariff-imposing country (though economic logic might not constrain Mr. Trump to follow through). Main risk of further tariffs is weakening of the yuan, which benefits exports but could trigger capital flight. The fact that foreign direct investments inflows have collapsed on the back of geopolitical tensions doesn’t help.

In implementing its industrial policies, the government has prioritized state-owned enterprises (SOEs) at the expense of the private sector. Indeed, under Mr. Xi “private” became a dirty word as profit-seeking behaviour of the private sector was deemed inconsistent with the Party’s goals. Unclarity about the Party’s goals and the (personal) cost of getting it wrong led to a weakening of animal spirits and reduced innovation (although DeepSeek shows what Chinese entrepreneurs are capable of). Getting rich is perilous these days in China. Similarly, Mr. Xi’s unforgiving crackdown on anything that reeks of corruption has resulted in a culture of fear, where officials at SOEs and local governments are reluctant to take pre-emptive action to address issues for apprehension of being accused of making mistakes or not having followed established procedures. Instead, they invest money in favoured sectors irrespective of the viability of the business case, just to please Beijing. As they all sing from the same song sheet and actions across the country are not coordinated, this adds to overcapacity.

To avoid Japanification of China’s economy, Mr. Xi should de-emphasize broad industrial policies (and, thus, reduce investments) and give the private sector a bigger role in capital allocation. He should embrace entrepreneurship and even profit-making, like his illustrious predecessor Deng Xiaoping did. This would create disruption and innovation instead of duplication and overcapacity. Mr. Xi should also finally follow through on his promise to transform the economy, moving from exports and investments to consumption and from industry to services. Mr. Xi has prioritized investment over consumption, which he refers to as “welfarism” (frugality being a virtue). His ideology is wrong-headed, at least if he wants to foster future economic growth. China’s household consumption as share of GDP is only 37%, compared to an average of 60% for OECD countries. In order to win back consumer confidence, the government should, apart from rapidly and effectively addressing the property crisis by completing unfinished apartments or compensating house buyers, build a strong social safety net (pension system) as many households worry about their old-age living standards. Another step the government could take is to abolish the hukou system of household registration so that migrants from the countryside get equal access to higher-quality housing, healthcare and education in cities. Although here will be resentment amongst city dwellers as they need to share coveted hospitals and schools with more people (some Chinese apparently are more equal than others…), abolishment of the hukou system will be an impulse to the economy. Clearly, the government should also improve education and healthcare services in rural areas.

Although Chinese policymakers have repeatedly stated that they wish to increase the contribution of consumption and services to economic growth, it seems that China doubled down on manufacturing and exports instead. This has led to enormous overcapacity, a deteriorating balance sheet and trade frictions with other countries. If Mr. Xi doesn’t change track, he risks plunging China’s economy into a long-term doom loop of falling prices, increasing debt piles, zombie companies and eventually job losses, maybe not as bad as Japan in the 1990s but certainly not a pleasant experience. The pressure by the U.S. and EU to curtail China’s trade surpluses and supply chain dependencies, will make Mr. Xi’s task to switch to consumption and services even more urgent. “Made in China” should therefore be replaced by a new mantra: “Consumed in China”.