China: 2023 May Be Even Tougher than 2022

28 October 2022

At China’s recently concluded 20th Communist Party Congress, Xi Jinping was re-elected to an unprecedented third term as Party leader. Xi now appears set to lead both the Party and government for the next five years, and likely even longer.

With political power now secured, can the same be said about the economic outlook? To be sure, 2022 has been tough everywhere. And, reflecting the impact of ongoing efforts to contain Covid, no one mentions China’s 5.5% GDP target anymore. Indeed, the IMF expects only 3.2% growth this year. However, the better-than-expected 3.9% rebound in Q3 GDP (compared to a 2.7% contraction in the preceding interval) has raised hopes that the worst may be over. Indeed, the IMF projects China’s output to rebound 4.5% in 2023.

I have serious doubts. First of all, the Q3 2022 result was flattered by extra government spending implemented to create a favourable backdrop for the Party Congress. China confronts formidable structural and cyclical headwinds, which will continue to be a drag on growth again in 2023. And, new initiatives aimed at addressing these issues were not introduced at the Party Congress. Arguably, several well-intended government priorities actually may impede efforts to solve these problems.

Therefore, in the absence of further monetary and fiscal policy stimulus, Chinese GDP may even struggle to expand 2% in 2023. Fortunately, however, I do expect government policy action. As a result, however, the Chinese yuan may continue to slide, especially as long as generalised US dollar appreciation continues.

Cyclical Headwinds: Both Global and Home-Grown

Even though China aims to reduce its reliance on exports, the external sector has been an important contributor to GDP growth during each of the past four years (Chart above). The international environment, however, is unlikely to be as friendly in 2023. In particular, Europe and the USA collectively account for one-third of Chinese foreign sales. And, China has enjoyed 17% and 9% export growth to Europe and the USA respectively in 2022. However, as both regions are likely to dip into recession next year, such performance is unlikely to be repeated.

In addition, US-China trade tensions may escalate in 2023. Rather than declining as planned, China’s bilateral surplus with America has expanded 13% in 2022, primarily resulting from a meagre 0.5% increase in purchases of US products. Likewise, the Biden Administration may become increasingly frustrated by China’s 50% surge in Russian imports, largely energy products. Overall, I expect China’s foreign sector’s contribution to GDP growth to be negligible, if not negative, in the coming year.

In addition, China confronts formidable headwinds closer to home. Indeed, domestic spending will advance a paltry 2.5% this year. The Chart above emphasises the role of subpar consumer spending during the post-Covid rebound. And, household outlays remain weak in 2022, e.g., retail sales have gained only 0.7% this year. China’s zero-Covid program and the removal of pandemic-related fiscal support have led to a collapse in comsumer confidence (which now is at an all-time low).

Meanwhile, the government’s initial pandemic support centred on boosting public investment (rather than helping hard-hit households). In 2021 and into this year, however, the focus has shifted to reducing China’s high corporate debt levels. Policy and media attention has centred on the real estate sector, and some progress has been made in 2022 (Chart above). But, the problem is far more widespread. For example, corporate debt as a percent of GDP remains at 150% compared to 95% amongst G-20 countries. As a result, successful corporate deleveraging may be a drag on growth for another several years.

Putting the pieces together, I suspect Chinese local spending may struggle to advance 2-2.5% in 2023.

Structural Agenda: Losing Momentum?

After several years of progress, key elements of China’s economic reform strategy appear to have lost momentum during the Covid pandemic. Unfortunately, leaders did not address this issue meaningfully at the Party Congress. Arguably, some of the Congress’s priorities appear at odds with these long-term goals. First of all, China aims to rebalance economic activity: reducing reliance on exports, investment, and industry, while shifting output to the consumer and service sector. In the previous section, however, we observed that consumer spending has been depressed, while net exports have been driving growth. Likewise, the Chart above illustrates the relative size of the industrial sector has increased, while the service (tertiary) area has declined. This pattern has continued in 2022: industrial output growth (4%) has outpaced services sector gains (2.3%).

Meanwhile, China is experiencing a sharp deceleration in its underlying growth potential, reflecting both poor demographic trends (an aging population leading to a declining labour force) and weak productivity growth (Chart above). As productivity is nearly 30% lower in State-Owned Enterprises (SOE), shifting output to the private sector would boost overall efficiency even without additional innovation. During the pandemic, however, the government provided large-scale support to the SOEs. Fortunately, that is now changing as focus shifts towards SOE deleveraging.

At the Party Congress, China reiterated its laudable pursuit of “common prosperity”, including enhancing competition and strengthening consumer privacy and security. However, the government’s unpredictable, heavy-handed approach to private firms in key industries (especially technology) continues to upset business confidence, fixed investment, and innovation; with potentially deleterious long-term effects on productivity.

China’s climate challenge is immense. Indeed, despite considerable progress in recent decades, China’s CO2 per unit of GDP is 2X to 4X the level in developed nations (who also have a lot of work to do) — Chart above. And, while China’s climate strategy is taking shape, its goal to cap emissions in 2030 and reach carbon neutrality in 2060 are relatively unambitious. Furthermore, in response to the Ukrainian war, China’s leaders appear to be prioritising energy security (procuring future fossil fuel supplies from foreign producers, including Russia) at the expense of aggressively pursuing its climate agenda.

This shift reflects a belief that there is a tradeoff between GDP growth and transitioning to a green, sustainable economy. Europe’s experience suggests that emissions can be cut meaningfully without negative consequences for growth. Given China’s environmental degradation, the longer the transition is delayed, the larger the eventual economic and financial costs will be. A successful economic rebalancing from industry to services will contribute to the climate goals: as emissions are far lower in the service sector.

Policy and Market Considerations

  • 2023 may be an even tougher economic year than 2022. In the absence of additional monetary and fiscal stimulus, Chinese GDP may struggle to advance 2-2.5% next year.
  • Unlike most of the rest of the world, inflation does not pose a serious risk in China. As a result, the PBOC could cut interest rates another 50bp in by the end of 2023.
  • Unlike past cyclical downturns, China has limited fiscal space to expand policy. The government suggests public sector debt remains a manageable 50% of GDP, but the IMF’s estimate of “augmented debt” (liabilities of all levels of the public sector) stands at 110% of GDP. Likewise, the IMF’s projection of the budget deficit is twice the government’s forecast (Chart above).
  • As a result, the government will need to set priorities. The focus must be to support households (pension reform, expansion of the social safety net, etc.) to encourage spending and lower precautionary savings. This supports the goal of economic rebalancing.
  • Weak productivity growth lowers China’s long-term growth potential to 4-4.5%. Accelerating SOE reform will encourage the transfer of resources to private sector firms, which should boost efficiency.
  • Additional monetary and fiscal stimulus points to further CNY weakness, especially as long as the US Federal Reserve raises interest rates and the US dollar experiences generalised appreciation.