What’s happening with the Chinese economy and what are the spill over effects?

The reason for China's centrality is mostly explained by the underperformance of its economy. The reopening of the Chinese economy, after two years of stringent mobility restrictions, was awaited with great expectation. It would provide a healthy boost to the global economy at a time when both Europe and the US were expected to fall into recession. 

The reality was quite different: both the US and Europe performed better than expected, while Chinese economic growth has been lacklustre. Concretely, all drivers of growth (C+I+G+X-M) a showing signs of deceleration: consumer confidence and retail sales are weak (C), the real estate property crisis is weighing on fixed investment (I), the fiscal policy stance of the government is contractionary (G) and exports (X) and imports (M) are declining at a double-digit rate due to lower international demand for goods. As a result, growth forecasts have been consistently revised down since March.

What explains China's lacklustre reopening?

Analysts point to five elements that explain the poor performance:

1. Lack of stimulus during the pandemic. While the US and Europe implemented strong stimulus packages during the lockdowns (equivalent to 13% of GDP in the US and 10% of GDP in the euro area), China's fiscal support was much weaker (3.8% of GDP). As a result, both families and firms had to draw on their savings to survive during the pandemic. Since the reopening, they have been rebuilding their savings, consuming, and investing less. This is usually referred to as a balance sheet recession because households and firms try to improve their balance sheet by saving more and that depress aggregate demand. Japan suffered this after the 1990 financial crisis.
2. China’s fiscal policy stance has been contractionary. As in most modern economies, government spending accounts for a significant share of GDP (33% of GDP in China's case). Therefore, its contraction has a significant impact on growth figures. For most of 2023, China's fiscal impulse - the change in government revenue minus expenditure - is in austerity mode (revenues are rising more than spending). This means that around 33% of the economy will make a negative contribution in that year.
3. Global manufacturing recession.  In 2020, the pandemic forced consumers around the world to cut back spending on services, leading to a boom in purchases of goods and a backlog of orders. Since the reopening of the US and Europe, consumer demand has shifted from goods to services, and the production and demand of goods has declined globally. China as the workshop of the world is suffering greatly.
4. Overextended Real Estate Sector. China is a country of homeowners, with more than 90% of households owning a home (87% in urban and 96% in rural China). To understand the enormity of this figure, consider that the homeownership rate in the UK is 65% and in Germany 51.6%. China's property sector has been showing signs of oversupply since 2006 when the first ghost cities started to appear,  but the bubble has been continually fuelled by the CCP economic policies of low-interest rates and excess capacity of construction materials.

The housing sector crisis is the main driver of the current economic slowdown. China's construction and property-related activities account for 25% of GDP (the US peaked at 17.6% during the 2008 GFC). So a major slowdown in this sector will have a severe impact on overall growth.  Year-to-date, housing starts are down 24.7%. Although we expect the CCP to intervene to prevent larger developers from defaulting, Chinese GDP growth will be severely impaired.

1. Friendshoring: supply chains are moving away from China to reduce geopolitical risk. FDI flows have turned negative for the first time in decades, meaning that the economic model that worked between 1995 and 2015 is no longer viable. China will have to look inward and develop its domestic markets if it wants to continue growing at a fast pace.

Spillover effects from the Chinese economic slowdown

The spillover effects to other economies are transmitted through three channels: the trade channel, the commodity prices/ inflation channel and the financial channel. 

• Trade channel: The most affected regions would be South East Asian (SEA) countries such as Indonesia, Malaysia, Singapore and Thailand, which are heavily dependent on the Chinese market for their goods exports. An IMF working paper estimates that a 1% negative shock to China's GDP would have a 0.3% impact on the SEA economies.

The euro area, although to a lesser extent than SEA, will also be negatively affected by lower Chinese demand (a 1% negative shock leads to a contraction of -0.12% in the EA). From EA countries, Germany will be the most affected.

Finally, Japan, the UK and the US have even milder spillover effects from a weaker China. This is because China is not a major destination for their exports.

• Commodity Prices Channel: China is by far the biggest commodity importer of energy, metals and food. Thus, slower growth should have a significant impact on these commodity prices (barring other measures such as the OPEC supply cuts).  We flag Australia, Brazil and Chile as the countries potentially more exposed to a material slowdown in the Asian economy.
• Financial channel: Spillovers through financial channels are limited - given the restrictions on cross-border financial flows, investment and banking activities in China - but a stronger-than-expected slowdown in China could affect market sentiment and increase global risk aversion. As a result, US yields should fall and the dollar should strengthen.

China is far from doomed

I do not want this article to give the impression that China is collapsing. Although the 7% growth rates that we saw a few years ago seem to be gone, it is likely that 3% - 4% will be the new normal, which, given the size of China, will still account for around 20% of global economic growth each year. 

China has managed to transform itself from a low-income, low-skill, low-economic complexity exporter to a middle-income, high-skill, high-complexity exporter. China is at the forefront of XXI-century industries such as AI, electric vehicles and solar panels (see charts). The transformation of China's economic structure will not be painless, but a prosperous future remains on the horizon.

Santiago Rossi, Senior Economist