Month: October 2024

China’s latest aggressive stimulus package has provided hope to financial markets, generating a stock market surge that partially retraces its sustained decline since early 2021, but it is unlikely to turn around China’s disappointing economy. China’s economic growth has been far weaker than its official GDP statistics suggest, as consumption and domestic demand have struggled following the predictable collapse in real estate. China’s economy is expected to continue to struggle. In reports in recent years, I have described the transition of China’s economic structure and its government-generated excesses in real estate, and warned that its adjustments would dampen its economy for years to come. Everything is unfolding as predicted.

The negative wealth effect on consumption is most likely to persist for several more years, as households must save more and spend less to replenish their balance sheets that were hammered by the collapse in housing. Loss of household and business confidence is weighing on economic activity. At the same time, China’s export-related manufacturing sectors are under pressure. Outside of strong demand for EVs and some manufactured goods, overall global demand for China’s goods has diminished and foreign nations and companies have reduced their supply chain exposure to China. China’s exports have been relatively flat in the last two years. Its sizable increase in exports to Russia has been largely offset by lower exports to western nations. Imports have also been relatively flat, reflecting the weaker consumption and domestic demand. These trends in export-related manufacturing sectors have dented employment and wages.

China remains an economic powerhouse and is the second biggest economy in the world and still the largest global hub of manufacturing and trade. However, its longer-run economic prospects will remain decidedly downbeat as long as President Xi’s authoritarian rule persists and clamps down on free enterprise. Such central-control economic systems are prone to misallocating national resources, posing barriers to capital flows and constraining advances in productivity.

China’s boom.

From the 1990s through roughly 2015, economic growth boomed as Chinese leadership allowed U.S. free enterprise alongside its centrally controlled economy. Huge inflows of foreign capital (financial, physical, and human) helped to ramp up the productive output and productivity of China’s enormous pool of low-cost labor to become the world leader in export-related manufacturing. Revenues from exports were wisely allocated into building productivity-enhancing modern infrastructure. Living standards and society advanced dramatically. China grew from a poor third world country to become the driver of global growth and trade, and the world’s second biggest economy. With its successes came higher wages and sharply rising costs of production. This generated a gradually slowing of potential growth, a natural phenomenon among advancing nations.

The shift in economic regime.
President Xi assumed leadership in 2012 (first as Prime Minister), and quickly reverted to his Chinese socialist roots and began clamping down on free enterprise. Economic historians who look back on this major inflection point in China’s modern history debate whether Xi believed the robust growth would continue under his socialist regime, or whether he was willing to trade growth for central control and power. My assessment is he presumed that China’s strong growth would persist and the imposition of his socialist ideals would generate favorable economic performance. His poor assessment failed to learn from the histories of centrally controlled economic regimes.

Excessively high GDP growth targets.
China’s slowdown in potential growth, a natural consequence of China’s economy growing toward its productive capacity and operating costs rising relative to global levels, was accentuated by the gradual tightening controls of capital flows, production, regulations on global joint ventures, and increased allocations of capital into state-owned enterprises (SOEs). Of note, the government began clamping down on the large and highly innovative and productive social media companies because their platforms had become a threat to the government — they facilitated free thinking and communications that was antithetical with Chinese socialist ideals, and their size and influences had become a threat to the Chinese government. This adversely affected foreign capital inflows and joint ventures with foreign companies, and the exchange of knowhow and technology. Foreigners had become tired and wary of China’s unsavory business and trade practices which accentuated these trends.

China’s central planners targeted GDP growth too high and generated real estate excesses in their efforts to achieve them. As potential growth moderated, Beijing established unrealistically high GDP targets. Achieving them proved to be a classical error that led to the misallocations of resources and was the source of its excesses in real estate. Their widely announced plan (beginning in 2015) to transition from reliance on exports to domestic consumption and services didn’t unfold, and growth began to fall short of GDP targets. The government filled the gap and met the GDP targets by ramping up investment spending. Some of the investment was for infrastructure but a sizable portion involved investing heavily in real estate. Local governments, which play a heavy role in China’s fiscal policies, achieved their contributions to the GDP targets given to them by Beijing by selling land to property developers, providing significant leverage (directly and through Local Government Financing Vehicles, LGFVs) and direct investment. Real estate and economic activity flourished year-after-year. Under the surface of the high GDP growth, the misallocations of national resources and excesses in housing and debt created excesses in debt. (The LGFVs were revealed as effective shells for hiding the mounting government debt).

The real estate boom greatly lifted economic activity and wealth. Global observers (including Wall Street economists) marveled and took for granted China’s ability to achieve such high sustained GDP growth. But they failed to look under the surface and scrutinize the mounting misallocation of resources and what they would lead to. China’s investment remained in excess of 40% of GDP year-after-year, nearly double other nations, while domestic consumption remained soft. China’s National Bureau of Statistics (NBS) does not disaggregate the investment data and show separately government and private investment, but it’s clear that most of the excessive investment spending was in real estate that provided low (negative) rates of return.

Everything worked well as long as expectations of home prices remained positive, which supported more demand for housing and debt. People and businesses like it when the value of their real estate goes up, and it increases their propensity to spend. But the mounting excesses in the supply of housing relative to demand, and growing debt and debt service costs of China’s land developers and local governments finally led to a shift in expectations. Skeptical citizens stopped buying new (and partially built) homes. A sharp decline in housing demand accentuated the dramatic excesses in supply and generated a collapse in real estate finances. China’s reversal and subsequent adjustments to the excesses in real estate have had many similarities to the bursting of Japan’s bubble in housing and asset prices in the late 1980s and the U.S.’s adjustments following its debt-financed housing bubble of the early 2000s.

Real estate had become a key driver of China’s economy. Some estimates put real estate activity at its peak over 25% of GDP and as much as 75% of household net worth, multiples higher than in the U.S. and other advanced nations (Rogoff and Yang, “Rethinking China’s Growth”, 2023). When the real estate sector collapsed, it undercut two vital factors that had been driving the economy: 1) consumer finances and spending and 2) local government finances, which had relied heavily on revenues from land sales to developers.

The negative wealth effect.
The large hit to household net worth has lowered the propensity to spend, as households must save more to replenish their balance sheets. This further delays the plans and hopes of China’s leaders for a transition in the economy from exports to consumption. Ongoing declines of real estate values and clear evidence of the excesses — Chinese citizens now see half built and empty apartment complexes rather than building cranes and the read about government bailouts of the bankrupt land developers — reinforce negative expectations of home prices and reduce demand for housing. This will elongate the negative impact on consumption.

The experiences in Japan and the U.S. following their housing and asset price bubbles suggest that the negative wealth effect will constrain China’s consumption for several more years. Japan’s 75% decline in housing values and the Nikkei following their late-1980s boom (that was generated by the BoJ’s efforts to pump up the economy) led to the “lost decade of the 1990s” of soft growth marked with several recessions and on-and-off mild deflation. Of note, however, Japan’s government and Bank of Japan were very slow to address the problems and insolvencies of large Japanese banks, and finally recapitalized the largest banks and insurance companies in 1997. The BoJ’s policy interest rate was reduced from 6% in 1990 to 0% in the late 1990s. The recapitalization was financed by government issuance of bonds that involved soaring debt. It took 34 years for the Nikkei to regain its December 1989 high.

The negative wealth effect in the U.S. that resulted from the collapse of the debt-financed housing bubble of the early 2000s — during the financial crisis, household net worth fell sharply, reflecting the 40%+ declines in both home prices and the S&P500 — contributed to the slow recovery of consumption and the economy, despite the Fed’s zero interest rates and quantitative easing that suppressed bond yields, and the 2009 fiscal stimulus. Despite these stimulative efforts along with private banks writing off nearly all home equity loans, the damage to the economy resonated for years. Real GDP regained its earlier 2007Q4 peak in 2011Q3 and new and existing home sales still remain well below their 2006 peaks. The Case Shiller Home Price Index that peaked in late 2007 through early 2012 and finally regained its prior peak in late 2016.

Government finances.
The sharp curtailment of new construction has reduced local government land sales to developers and undercut a major source of revenues. This has revealed the fragile local government finances and their high indebtedness and undercapitalization of LGFVs. This has constrained the central government’s capacity to stimulate the economy. Lacking demand, there has been a collapse in sales of land to developers. The fall in housing construction has been a negative for government finances, economic activity and jobs. Beijing has rolled out a series of modest stimulus packages, hoping they would stabilize housing and buoy the consumer. However, they have been insufficient to stabilize the decline in real estate values and activity and offset the negative wealth effect. The government faces a sizable challenge: estimates of empty and partially build apartments in China are around 90 million units. That’s a staggering imbalance that will take years (and probably much more government deficit spending and debt) to work down to manageable levels.

With the current sizable stimulus package, the national government has signaled that will incur large deficits and borrow heavily to support housing, reduce the costs of consumer debt and provide financing support to local governments.

The impact of the stimulus.
The package has provided a big boost to China’s financial markets, with stocks up sizably. Whether the announcement proves to be a credible “Draghi moment” — “whatever it takes” Euro rescue moment — remains uncertain, reflecting the unreliability and unpredictability of China’s leaders. But its magnitude is decidedly insufficient to materially reduce the enormous overhang of excess supply of housing or generate a sustained increase in consumer spending. While it provides financial incentive to purchase homes, housing excesses in supply will remain, as will expectations that home prices will fall further. The stimulus package does ease some debt service burdens, but most household balance sheets remain dominated by real estate and will continue to suffer from the earlier declines in household net worth. Accordingly, the need to save will remain high, squeezing consumer spending.

The Peoples Bank of China’s lower interest rates and cuts in bank reserve requirements (by 50 basis points) will ease the debt-service costs of existing homeowners and have some marginal positive impact on lending. However, demand for loans is weak. The PBoC is also reducing the borrowing costs for existing mortgage holders and lowering the minimum down-payment on new home purchases to 15% from 25%. These will modestly reduce the debt service costs on current homeowners and encourage new home purchases. But this will not materially narrow the supply-demand imbalance in housing. The PBoC will cover 100% of the loans for local governments to buy unsold homes with cheap funding. Effectively, the central bank will make cheap loans to local governments to buy unsold homes and take them off the market. This “warehousing” of unsold homes only shifts the holdings of the excess supplies and postpones the necessary adjustments.

This stimulus package acknowledges China’s languishing economy and reflects the willingness of the government to deficit spend more and incur rising debt to resolve the problem, but the excesses the government created will continue to weigh heavily on consumption and domestic demand.