There's an interesting article in today's July 7 South China Morning Post that has far-reaching implications for China’s efforts to stimulate its economy and its imperative to strike a trade deal with the U.S.: "China urged to take bolder steps to tackle price wars, deflation and weak demand". The article reports that China's Central Financial and Economic Affairs Commission, the Communist Party's highest economic policymaking body, has identified "disorderly low-price competition" as a substantial negative, and argued for the need to end the cycle of mild deflation and weak demand.
This officially acknowledges that China's domestic economy remains quite weak, well below where China's leaders’ desire. The article also implies and describes how Chinese leaders rely on central command efforts to manage and guide the economy, rather than market forces. Their policies created the excesses in real estate and China’s economic slump, and are now inhibiting the recovery.
One important issue created by China's weak domestic demand is the admission by its leading policymakers that the trade war with the U.S. imposes a heavy negative weight on China. As the article states, the ongoing trade war with the U.S. "could further intensify China's "involutionary dynamics", an awkward term used to describe what its leaders perceive as intense and self-defeating domestic competition. While its leaders understand that the basics of market supply and demand work to affect economic outcomes, they rely on central control, directives and coercion to achieve desired economic and social objectives. This generates inefficiencies and undercuts the government’s credibility, as Chinese citizens understand the shortcomings of the policies. China is extraordinarily good at certain things—it is a true world leader in efficient manufacturing, with striking advances in high technology, including AI. But its Communist dictatorship that eschews free markets and U.S.-style capitalism undercuts China’s economic performance.
In 2021-2022, I argued that China's strong growth was unraveling, and its economy would weaken sufficiently to challenge its role as global leader of economic growth and trade (China Is About to Fall Into the Middle-Income Trap, October 26, 2022). In 2023, after China's real estate excesses had crumbled and major land developers had filed for bankruptcy, I argued that the Chinese economy would be in the doldrums for many years, similar to Japan's following its asset-price bubble in the late 1980s and the U.S. following its debt-financed housing bubble of the early-2000s (China’s Bill Comes Due, September 19, 2023). All of that is now unfolding, as western companies and nations reduce their supply chain exposures to China.
At least two implications seem clear. First, while China is a tough global negotiator, it clearly would benefit from a favorable trade agreement with the U.S. that would lower tariffs and trade barriers on their imported goods. Doing so would be a plus for China, the U.S. and global trade. Second, similar to Japan's and the U.S.'s historic experiences, China will have to stimulate its domestic economy through increases in deficit spending to lift consumption and businesses. As China stimulates, it will provide interesting investment opportunities in its stock market.
Mild deflation and domestic demand. China is experiencing mild deflation: its GDP deflator has been falling since the third quarter of 2023 and the year-over-year percentage change in its CPI has fallen for four consecutive months (Chart 1). This is a direct reflection of insufficient domestic demand relative to productive capacity. The Chinese leaders’ public allegation that the deflation is due to destructive price competition is misguided by ideology and misleading.
It’s hard to provide a clear numeric analysis because the China’s National Bureau of Statistics (NBS) provides statistical data that are not reliable, and occasionally stops providing the data public, or changes its definition, if the trend of the data is inconsistent with the objectives of the Communist Party. Its official data on GDP growth are far too strong to be realistic with its components and economic logic.
Three trends are clear: 1) China’s mild deflation is a direct result of insufficient domestic demand, 2) the weak demand stems from the earlier excesses in real estate that have unraveled and severely harmed household balance sheets and forced consumers to save rather than spend, and 3) residential real estate remains in the doldrums, with low expectations, despite government efforts to stimulate it.
Prior to and into the Covid pandemic, at the direction of China’s leading economic policymakers, different layers of China’s government pumped up real estate investment through a variety of equity and debt schemes in an ongoing effort to achieve unrealistically high GDP targets. This worked to stimulate robust economic growth and boost local government finances and create an upward spiral in activity, real estate development and prices and household net worth. But the strategy relied on expectations that home values would keep rising. In this regard, the role of home price expectations in China’s real estate boom were strikingly similar to those in the U.S. during its debt-finance housing bubble in the early 2000s, and Japan’s asset price bubble of the late-1980s. Chinese citizens came around to realize the excesses beginning in 2021, and once home price expectations started to erode, they collapsed.
The government scheme unraveled, and left a huge negative gap in China’s household net worth, the largest portion of which was in real estate (estimates ran as high as 75%, more than triple the U.S.’s current 22%). Mirroring Japan in the 1990s and the U.S. following the collapse of its housing bubble, China’s households raised their rate of saving and cut spending to replenish their balance sheets. Many Chinese businesses similarly suffered, including those in land development activities and others that had relied on loans collateralized by real estate. This followed the same pattern as Japan in the 1990s and the U.S. through and following the Great Financial Crisis.
Unlike Japan, which denied it had a problem through much of the 1990s and allowed zombie banks (those that were effectively insolvent) to continue making loans to keep inefficient companies afloat, China quickly acknowledged its problem, but underestimated its severity, and addressed its economic malaise too tentatively. In addition, it tried to directly manage household behavior to try to lift the morbid housing market. For example, some local governments forced select government employees to buy homes while constraining any declines in home prices. Such non-market strategies have had only limited success, harmed credibility and have inhibited rather than facilitated the necessary adjustments that would stabilize real estate and lead to recovery.
One tell-tale indication that the economic recovery is tentative is the ongoing negative expectations of home values. Current data show that residential real estate prices continue to fall (Chart 2) and no leading cities are experiencing an increase in home values while 100% are showing prices that are flat or declining (see Chart 3). Until expectations of home values turn up, households’ propensity to spend will be constrained.
The healthiest way to generate a positive sustained improvement in home values is to stimulate aggregate demand in the economy that boosts consumption and increases jobs that results in rising demand for housing that will absorb excess inventories. This requires a significant increase in deficit spending. Both Japan and the U.S. incurred large increases in government debt and sustained periods of zero interest rates to stabilizing their real estate sectors.
Chinese leaders already face high debt (in various government levels and artificial entities such as Local Government Financing Vehicles) and are reticent to take on more. (Another way to reduce China’s housing excesses would be to destroy a massive number of vacant apartment buildings, but that would harm government credibility and be anti-growth…remember President Obama’s “cash-for-clunkers” which offered financial incentives to people who had their motor vehicles destroyed in an effort to stimulate energy-efficient cars?)
President Trump’s misguided tariffs come at a particularly bad time for China. In 2018, when Trump first imposed high tariffs on China, its economy was strong and its leaders confident. Now, China’s domestic economy is weak. It relies heavily on exports for sustaining growth in its high wage manufacturing sector. It can only sell overseas so many EVs. While China’s exports to non-U.S. trading partners have picked up, its exports to the U.S. have fallen sharply since 2023. Importantly, China relies heavily on its high value-added exports of high-tech materials and components to the U.S., including computer chips and smart phones.
Trump has placed a deadline of July 9 for imposing higher tariffs, but at this writing is indicating that deadline may adjust to August 1. Trump likes negotiating deals and likes to be popular. As I have emphasized, this is a terrible approach to conducting economic policy. But China’s domestic dilemmas make it open to negotiating with the U.S. to lower tariffs and trade barriers. The result—backing off from Trump’s threats and lowering the U.S.’s average effective tariff—would be a positive and is expected within a month.