China’s economy is slowing down. What gives?

By now you’ve probably heard, China’s economy is not doing so well.

The country’s once-booming real estate sector is stalled. China has slipped into deflation. Foreign direct investment is down. So are exports. Youth unemployment reached a record high of more than 20 percent in June. And this is just what we know. After all, China has slowly stopped releasing lots of public economic data, making it hard to get a complete picture.

What we do know is that the story of China’s unimpeded economic rise is turning out to be a bit more complicated — and it may have been a long time coming, with or without China’s very strict Covid-19 pandemic policies. All of this could have profound economic, political, and social fallout for Beijing, and the rest of the world.

Before getting there, it’s worth trying to figure out the basics on why China’s economy is struggling right now. To do that, Vox called up Stephen Morgan, a professor emeritus of Chinese economic history at the University of Nottingham, who wrote a book on the Chinese economy.

Basically, China’s economy is out of balance and has been for some time. Investments dominate the country’s economy, far more than consumption — that is, what households are spending. It didn’t matter so much when investment juiced China’s GDP in good times, and indeed, kept China’s economy afloat during the Covid-19 pandemic.

But that investment playbook has been losing its potency. A chunk of investments are unproductive — for example, a shiny new airport is great, but if it sits empty and no one travels through it, that’s not a great return on investment. But whether the airport is busy or a ghost town, it required bonds and loans to build. That produced growth, but it also increased China’s debt, so much so that right now, it’s triple — yep, around 300 percent — the amount of China’s economic output. “That doesn’t really matter until the debt has to be settled. More stimulus simply increases debt and delays the reckoning,” Morgan said.

What that reckoning might look like is hard to answer because the Chinese government and its leader, President Xi Jinping, are not exactly known for transparency. As Morgan sees it, China is dealing with a “slow fizzle.” But how Xi and his government manage that fizzle is far from an easy question for anyone to answer.

Our conversation below has been edited for length and clarity.

Jen Kirby

There’s all this talk about China’s economic slowdown. But I wanted to ask first, broadly, what is, or has been, the “China model”?

Stephen Morgan

The best way to think about what the Chinese model of economic development is is to think of it as an investment-led model. When China began to reengage with the world economy, over 40 years ago now, it suffered from chronic underinvestment: housing, infrastructure, education, services, etc., were very poor.

By about the middle of the 2000s — around 2005, or so — China had actually filled up a fair bit of that. It was about that time that Premier Wen Jiabao urged a shift away from investment to consumption.

As soon as we start to talk about investment and consumption, I think we need to also make clear what we mean in terms of that, and of GDP [gross domestic product]. People tend to think of GDP in terms of output of goods and services. The other way economists think of GDP is: What are the inputs to creating those outputs? The most important inputs to creating growth are, firstly, investment. Secondly, household consumption. Plus government services, and a little bit in terms of net inputs. But it’s investment and household consumption that really matters.

From the 1980s right through until the early 2000s, household consumption [in China] was roughly around 48 percent, and so the rest went on investment and government services. But beginning around 2000, just after China joined the World Trade Organization, there was another huge burst of economic growth. Household consumption massively collapsed to reach about only 34 percent in 2010. Investment was nearly 50 percent of GDP. Now, how does that compare to the world average? Well, roughly, the world average for household consumption is about 60 percent. If you’re looking at the United States, it’s around 70 percent.

China is at the other extreme. It got down to 34 percent. At present, it’s still 38 percent. So you’ve got a problem. There’s been an excessive amount of investment, particularly in real estate and infrastructure for the last 15 years. What that has done is massively increased China’s debt level. But it also means the Chinese household just really doesn’t have the share of income to actually spend. So when the Chinese government talks about increasing consumption, in truth, the only way it can increase consumption is to try to transfer assets and cash from companies and the government to the households. That’s the bind that China is in at present.

Jen Kirby

Can you talk a little bit more about this investment?

Stephen Morgan

Investment is largely going into, as I said, infrastructure, real estate. At present, probably about 40 percent of that is unproductive. One way to think of that is “bridges to nowhere.” The thing about investment is it doesn’t matter whether the bridge goes to nowhere or it actually serves a purpose. It produces GDP growth.

When I was living in China, between 2013 and 2020, in Ningbo, I used to take the bus to work every day. The bus stops between my apartment and the university were rebuilt three times — three times in about six years. The first time they needed rebuilding. The second time, there were some nice improvements, like electronic boards that told you when the bus was going to come. The third time they rebuilt all the bus stops with so much steel you would need a tank to knock them down. Other than that, there was very little welfare benefit. That’s wasted investment.

This increase in investment means that local government has to get the money from somewhere. Basically, it gets that through loans and bonds and so on. Debt levels have gone up. They don’t really matter, unless they have to be settled. And that’s the problem. They haven’t been settled. They just keep on being pushed out.

Jen Kirby

The problem now seems to be that China can’t keep relying on that investment playbook. You have all these bills due, you have so much debt, so if you invest more, you make the problem worse, not better. Is that the best way to look at it?

Stephen Morgan

I think you hit it on the head, Jen. The Chinese investment-led model ran out of steam quite a few years ago but it’s been kept going because there’s been a reluctance to try to shift from investment to consumption.

The reason for that is what it will mean. You’ve got to transfer assets and cash from the corporate sector and the government sector to the household. That means that corporations, like big property developments, local governments, and so on, are not going to have the resources they previously had. These big companies, many of them are state-run, and local government, which is state-run, there are lots of vested interests. They don’t want to see that happen.

Could China do it? Well, yes.

Jen Kirby

So is China trying to shift this balance toward consumption and just can’t? Is that the fundamental issue here?

Stephen Morgan

If we think about what’s been happening over the last couple of months, the Chinese economy seems to be — or is — faltering. Growth has been slowing. The hoped-for post-Covid resurgence has not occurred. How has the Chinese government responded? With only rather small and piecemeal policy measures. Lots of people have become, let’s say, disappointed with these lackluster initiatives.

In particular, they have wondered to themselves: “Why hasn’t the Chinese government gone for the usual playbook — stimulus?” That’s what kept the Chinese economy going from the global financial crisis of 2007 through 2009 to the present. They ramped up investment primarily during that period, and basically, they haven’t been able to take it back.

All of these piecemeal changes seem to be aimed at trying to keep everything together, to let the big corporation slowly unwind, in a sense, to what I call to fizzle.

But there’s no evidence that Xi and the party are listening and engaging in imaginative policies to shift resources from corporations and the government sector to the household sector.

That would include, for example, increasing pensions, increasing health insurance, or the gap in health insurance, so that people know if they got sick, they would be able to get treated much more extensively before they would have to start to pay. If you increase health insurance, then people won’t need to save so much, so they’ll spend. If you increase pensions, which are really tiny, then retired people — and remember, women in urban China have to retire at 55, and most males in urban China have to retire at 60 — will have more money to spend.

The other thing would be policies, like what some of the provincial governments did around 2020 to try to keep their regional economies alive during Covid, which was to give coupons to residents that gave them a discount if they spent more than a certain amount of money in restaurants or on food each month. There’s a report that I saw quoted recently that this had a huge multiplier effect. People went out and spent money in restaurants, and that kept more people employed, who in turn spent money, and so on.

But there’s no evidence that the Chinese government will engage in any imaginative change to policy, either direct cash handouts, increased pensions, or increased health benefits. If you get the gist from what Xi says, Xi is very much against it, he reckons people should put up with hardship, it makes them strong.

Jen Kirby

If the current trajectory is unsustainable, though, why is there resistance from corporations and local governments?

Stephen Morgan

For corporates, it is going to reduce their profits. For local government, what it primarily means is they will not be able to grow the local economy in ways that will [show up] in GDP data. If the local officials cannot meet targets for local economic growth, those local officials are not going to get promoted.

China’s forecast GDP for 2023 is 5 percent. When the Chinese government announced that, the local governments knew they had to do something that would generate economic activity in the local area that would get that 5 percent level. The Chinese central government would help to make funds available, either through state banks, through the various credit controls. In turn, those local governments go out and, let’s say, release more land to corporate real estate developers, who then build more houses that aren’t really needed, but still grow the economy and grow the debt level.

Jen Kirby

I’m no economist here, but I’m thinking of what the US did during the pandemic: just give people cash. Why can’t China do the same — say here’s some money, go out and spend it — to help boost consumption, if that’s what it needs to do?

Stephen Morgan

Going back to what I said before, it’s about the imagination of the Chinese government and the party. In a sense, it’s about the psyche of Xi. Xi is of the view that the problem is young people and others don’t want to work hard enough. It’s very much like a strong right-wing aversion, that we find in Western economies, to giving handouts to the poor: If they worked harder they wouldn’t be that in that situation. That’s the sort of view that informs Xi.

Then Xi also has the sort of leftist view of not trusting entrepreneurs and innovators. Both of these tensions are coming together to strangle the capabilities of the Chinese economy to grow.

Jen Kirby

So how does China unravel this, especially if it seems somewhat linked to Xi himself?

Stephen Morgan

One of the things that the [Chinese Communist] Party and government needs to try to do is to effect some sort of change in shifting from an investment-led model to a consumption model, without blowing up the economy and blowing up the party.

The political dynamic here is about enabling households to obtain a bigger share of the overall economic pie while also permitting corporations not to collapse, and also ensure that local government does not collapse. Because either of those would generate social unrest.

If local government starts to fall apart, then local services will fall apart. If all these real estate companies start collapsing — and particularly people who have paid for their apartment but have not yet received it — they are going to be very unhappy. If the real estate companies go into a fire sale, property prices will fall even further. Lots of people who own property aren’t going to be very happy. That’s a huge risk for the party and the state at all levels from local government, through provincial government, to the central government. Managing that is extremely difficult, and I really have no sense, to put it bluntly, what might actually transpire.

We might think because they’ve got a lot of security services that they are very solid. But one of the things about authoritarian regimes — even ones that have huge security structures, such as China — is that these end up being quite fragile, and you very quickly get stuff unraveling.

Jen Kirby

All of this makes it seem like fixing this could have unpredictable consequences, but so could just letting things stay as they are.

Stephen Morgan

The thing for us is that the Chinese economy now is really big. It’s the second largest in the world. If it completely unravels, it’s going to have huge consequences, not just for China, but for the rest of the world. There are many, many big corporations in the US, Western Europe, and elsewhere, that are heavily committed and tied to China. Chinese consumers and Chinese companies will stop buying services and products. You’re going to have this global contraction that will occur.

On top of that is the potential for disturbances. A China that becomes chaotic internally could end up being a much more dangerous China for the rest of the world than one that’s just fizzling along like it is now.

Jen Kirby

Well, I guess that’s the question then: Will it stay on a fizzle? How do you see the path the Chinese economy is on right now?

Stephen Morgan

My view for almost a decade has been that there’s no way the Chinese economy will overtake the US. I think that’s become much more clear now.

It’s a big economy. It’s used up all its potential to simply keep on doing what it had been doing previously, and growing. It’s going to be an economy that will be growing much, much more slowly, assuming that the Chinese state and party are able to stop a major crisis emerging in terms of a big recession, or financial crisis, with indebted property developers, indebted local government collapsing. I think at the end of the day, Xi and the party will do their utmost to try to stop that.

Nevertheless, economic growth will slow to around 2 to 3 percent, at best. In the context of how the American economy most recently has been doing, this is pretty amazing. The gap between China and America is actually widening at present, rather than contracting. What we’re going to see is China going along a path where it does succeed with its investments in education, in some productive areas of technology, in innovating, and continuing to grow, but nowhere near the speed it has previously grown, and nowhere near the speed that will be necessary for it to massively close the gap between China and the US.

Jen Kirby

This is a bit of an oversimplification, but there seemed to be a pact between the Chinese government and the people that, as long the economy was growing, people’s lives were improving and comfortable, then they would accept some of China’s less than democratic policies, like surveillance and censorship, for example. Will China’s slow fizzle alter this and have some political and social consequences?

Stephen Morgan

The short answer is yes. Exactly what would it look like will depend on how that slowdown occurs.

Since about 1989, and the Tiananmen Square protests, there has been a basic social contract between the citizens of China and the party. The party will try to ensure good management of the economy and your and your family’s ability to share in the growth that occurs, as long as you stay off the streets and don’t engage in politics. We will protect you. We will ensure you have your wealth and you can continue to produce wealth.

Xi has changed that. The most clear example of that was the way he turned on tech entrepreneurs in 2020. Sure, there was a lot of excess, there was a lot of monopoly and anti-competitive behavior. But these big private-sector firms had been very innovative and major drivers of economic growth.

Similarly, during Covid, we see increasingly tighter controls and zero-Covid measures, where even a single illness in your neighborhood led to complete shutdown — that hit everyone. That hit your livelihood, that hit your family. We had reports of men and women not able to stand the isolation, jumping off their apartment buildings. That undermined that social contract, and I think that was very much behind the sort of protests that we saw last October and November, which then finally led to the lifting of controls.

There will need to be some sort of refashioning of that social contract. I’m not sure that Xi is the leader who can or is willing to do that because that would involve relinquishing authority. It would involve reopening Chinese society to greater dialogue and diversity of views instead of simply toeing the line.

Jen Kirby

There’s a pretty sturdy bipartisan consensus in Washington that China is a threat, and the Biden administration has pursued “decoupling” — reducing dependence on Chinese technology, for example, and also trying to cut China off from key tech, like semiconductors. The US is getting our allies to go along with it. But if China’s economy implodes, it seems like it would be bad for everyone, so I wonder: how do you think the US and its partners should approach China right now?

Stephen Morgan

It’s a bit like asking, “How long is a piece of string?” I would reply, “How long do you want it?”

But seriously, I think I’d begin by saying that I personally think decoupling is neither feasible nor desirable. That does not mean we should not engage in development of policies and measures that protect economies — and our way of life, for that matter — from some of the potentially adverse outcomes from China. That’s very much about de-risking, about how do you continue to collaborate with China, but yet do it in a way that ensures you don’t endanger your own national security, you don’t endanger your own economy?

The difficulty is, not only is China a much bigger economy now, but in many areas, China now has capabilities that are actually beneficial or useful for America, for the West. In some technologies, or aspects of technologies, it might even be more advanced.

The manufacturing process technology of China is better than just about anywhere else in the world. It’s not like that because China invented it, but because China learned how to do it so well, through all the investment that came with post-WTO introduction of Western supply chains into China.

We in the West — whether the US, UK, Europe, Australia, whatever — we need to engage with China still, so that we can share in that. But also we need to be able to protect ourselves from the Chinese capturing, let’s say, trade secrets or innovations that could be turned back. That’s going to be difficult.

At the end of the day, it doesn’t matter whether the US is collaborating with the UK or Australia. There’s going to be a tension and there’s going to be a risk that one company in one country is going to discover what another has and run off with it. That’s the way the business has always gone. Let’s face it, the United States of America wouldn’t have had its Industrial Revolution if it hadn’t been so successful in stealing lots of British technology and railways and textiles in the 1880s, which it did very successfully.

Jen Kirby

If you’ll indulge me one more: Who do you think gives first, Xi or the Chinese economy?

Stephen Morgan

I’ve got no idea.