On the Eve of the Party Congress, What’s Ahead for China’s Economy?

The Chinese economy has been struggling in recent months, and has indeed been quite gloomy of late. To give just one example, the contract sales of the top 100 property developers in China fell for 16 months consecutively through September. Beijing’s economic challenges owe principally to a combination of adverse shocks. Some have been external, such as Russia’s invasion of Ukraine and ongoing trade and tech tensions with the U.S. But most of the shocks have been domestic, including a rapidly aging population and excessive leverage in the property sector. The heavy indebtedness of China’s property sector has been mostly associated with developers, in contrast to the U.S. subprime crisis which had more to do with individual home buyers’ over-borrowing. More importantly, some of China’s economic difficulties arose as a direct result of government policy: zero-COVID measures, the abrupt enforcement of the three red lines on financing of property developers, and a hasty and poorly-executed regulatory reset over the mostly private IT platform sector. These policy-induced shocks have tended to amplify one another.

As the Party Congress approaches, the interactions between politics and economics have become trickier and less stable. Poor economic performance weakens the legitimacy of the Party leadership at this crucial juncture. Meanwhile, the advent of the congress puts both politics and economics into a straightjacket, making it harder to meaningfully adjust and adapt the “signature” economic policies. In this atmosphere, few are willing to suggest more pragmatic approaches lest they be perceived as a form of political competition. But the rigid, sharp-edged measures currently in place may only aggravate the economic woes and thus add to the underlying political tension.

After the congress, China’s overall economic policy regime will face two distinct possible paths. One will entail less rigid, more pragmatic policymaking, with enhanced roles for both the market and private sector. (The private sector is the most dynamic segment of the Chinese economy, while the market is typically the most efficient way of allocating resources.) This should help make the economic challenges facing China more manageable. A second path, however, would entail a blunter and more rigid type of economic policy approach, with a bigger role for the state. When the market’s role diminishes, the economy will have to be managed with greater political and personal authority. The new economic team to be ushered in after the congress may provide some useful hints as to which of these two policy paths may dominate going forward, yet the reshuffling may last well into March 2023.

During the past four decades, it was long the case that economic development was the, or at least among the, very top priorities. Even in the aftermath of the 1989 political shock, economic development and market reform returned as the core task of the Party within one or two years. However, in recent years, economic development in China appears to have most often ranked noticeably lower in importance in relation to other policy goals. The question is: Will this continue or reverse after the Party Congress?

The past decade has provided a guide to Xi Jinping’s vision for China’s future. Viewed cumulatively, the economic policies and regulations of the past decade show that China’s leaders have decided the country needed to shift course. They judged that the post-Deng era gradualism of reform and opening was not putting China on a path to “national rejuvenation.” Instead, China’s leaders have elevated the role of industrial policy, privileged state-owned enterprises, and advanced the concept of “common prosperity” to help smooth out social disparities. Gone are the days of “unleashing animal spirits” to spur rapid economic expansion with faith that a rising tide will lift all boats. This period is one of tighter Party-level control over economic decision-making.

To many outside experts, these policy shifts have proven costly. China’s rate of economic expansion has cooled, entrepreneurial dynamism has faded, productivity has flagged, debt has piled up, the property sector has grown wobbly, China’s zero-COVID posture has proven disruptive and costly, and unemployment—particularly among youth—has risen. While there certainly are many Chinese citizens who share similar concerns about the impacts of China’s economic policy shifts, I don’t see persuasive evidence that Beijing is beholden to any sense of alarm.

In recent years, China’s leaders have extolled their success in eradicating extreme poverty. They have highlighted gains in achieving greater economic self-sufficiency. They have entered new free trade agreements, such as the Regional Comprehensive Economic Partnership (RCEP), an agreement that covers nearly one-third of the global population and around 30 percent of global GDP. This has aided their rebalancing of trade flows toward their neighbors; China now trades considerably more with its RCEP partners than it does with the European Union and the United States. Beijing also is pursuing entry into the Digital Economy Partnership Agreement (DEPA).

China’s leaders also have celebrated the country’s achievements in becoming the world leader in solar and wind energy production. Annual inflows of foreign direct investment have continued to rise. Despite its declining rate of GDP growth, the country has been experiencing larger incremental expansions in the size of its economy year-over-year than at any point in history, owing to the broader base upon which growth is occurring.

In other words, China’s leaders remain capable of telling themselves and their citizens a soothing story about the country’s continuing rise. They also appear keen to move beyond the previous implicit compact that the Chinese Communist Party would deliver fast economic growth in return for public acceptance of their monopoly on power. In its place, Beijing now stokes nationalism. Official media outlets have echoed Xi’s admonition for national struggle to win the future. They rally national efforts to overcome hostile foreign forces seeking to subvert China’s rise. They justify state interventions in the economy on national security grounds. And when all else fails, Beijing employs repression to limit challenges to the Party’s authority.

It would be premature to conclude that China will remain on this policy course forever. At the same time, there is little evidence that the country will shift away from its current trajectory any time soon.

As China’s government confronts economic challenges from weakened domestic demand, rising employment, the housing market crisis, increasing government debt, currency depreciation, and the risk of increasing restrictions on China’s access to global technology, capital, and market, one may notice a shift in its policy style and how it coordinates across different policy domains. To understand this shift, it’s important to recognize the distinctive policy style of Xi Jinping’s administration in its first two terms.

Under the previous two administrations—headed by technocratically minded Jiang Zemin and Hu Jintao—policy was characterized by careful research, cautious planning, incremental experimentation, and close monitoring of implementation. While their administrations retained traces of what Elizabeth Perry and Sebastian Heilmann call “guerrilla policy style,” they were always embedded in a technocratic approach. The Xi administration, by contrast, exhibits what can be called a “laobing (Original Guard) policy style”: quick, bold, ambitious, determined, abrasive, and often able to catch people by surprise—yet short on rigorous planning and monitoring of implementation. This style underlies everything from the Belt and Road Initiative, to the Xiong’an project, to the “common prosperity” campaign.

“Laobing” refers to the first wave of high school students who, in the summer of 1966, formed the first Red Guard organizations and whose rallying cry, “rebellion is justified,” was instrumental in the opening chapter of the Cultural Revolution. Mainly children of revolutionary cadres, they distinguished themselves from subsequent Red Guards by referring to themselves as the “Original Guards” (“laobing”).

The laobing policy style was best exemplified by the Western District Red Guard Picket Corps (Xijiu), a group of laobing who found themselves in charge of much of Beijing for several weeks in August and September 1966: running schools, smashing the “Four Olds,” and arranging Mao’s reception of Red Guards in Tiananmen. They issued 10 “general orders,” which often combined stylized heroism with the kind of willful determination that is characteristic of states of emergency. These “orders” often created messes that Premier Zhou Enlai would have to clean up.

Although none of the Xi administration was involved in the Xijiu, some of them spent their formative years imbued in its ethos. Since 2012, this style, with its contempt for technical considerations, has been crucial to Xi’s increasing dominance, enabling him both to overcome systemic challenges from civil society and competing factions and to preempt pushback from technocrats. As a result, under Xi, rather than contributing to research, or recommending and designing policies, technocrats more often find themselves charged with executing or cleaning up after policies made without their input.

Two conditions of the thriving of this laobing policy style will likely change after the 20th Party Congress. First, the mounting economic challenges have decreased disposable resources and shrunk Xi’s policy toolkit, making it harder to disregard technical considerations. Second, as competing factions recede, the Party bureaucracy will be politically more submissive. This will make it possible for Xi to yield more policymaking autonomy to technocrats, who will be able to coordinate across domains to research, recommend, and make policies, just as Mao yielded more policymaking autonomy to Zhou Enlai and the State Council after the 9th Party Congress in 1969.

China’s zero-COVID policy has become a chokehold on the country’s economy, stomping on consumer and investor confidence. Though China is also reckoning with other headwinds at present, I do not see a real economic turnaround becoming possible without abandoning zero-COVID.

Zero-COVID has damaged private consumption and foreign investment, fostering a sense of uncertainty amid mounting costs. A few months ago, the Economist Intelligence Unit (EIU) estimated that regularized COVID testing may be costing China one billion renminbi per day. In August, we estimated that at any given moment that month 1-3 percent of China’s population (around 10-40 million people) were under some form of lockdown. When COVID spiked in early September, an estimated 65 million people were under lockdown across 33 cities. Although we expect China’s zero-COVID approach will ease in 2023 through a recalibration of terms and tactics, I do not see consumer and investor sentiment being buoyed as long as the specter of lockdowns lingers.

China’s economy may have already bottomed out in the second quarter of this year, but its recovery remains fragile. The EIU is forecasting 3.3 percent GDP growth for China in 2022, and we are more optimistic than many. The floundering property sector is not only eroding faith in the system, it is increasing pressure on local governments that are being asked to shoulder the burden of zero-COVID costs while no longer being able to rely on land sales for revenue—deepening a serious debt challenge. The central government’s responses to the real estate crisis have been too disjointed or slow to breathe life back into the sector, which previously accounted for some 25 percent of GDP. And with 70 percent of Chinese household wealth connected to real estate, the housing market slump is not only dragging economic growth but also causing household distress.

China’s adherence to zero-COVID makes plain that politics and security come above economics in Xi Jinping’s administrative hierarchy. A third term secured, might the president recover his pragmatic touch? A return to pragmatism and predictability in the Chinese market would be most welcomed by investors. But I am not holding my breath.

Instead, I am observing October’s Party Congress for signs of reforms related to zero-COVID, stronger interventions to stop the property sector landslide, and policy support for the beleaguered private sector. Thus far it seems more likely that ideology will continue to dominate policy decisions resulting in less-than-ideal economic outcomes.

China’s slowdown was a long time coming and inevitable—no country can maintain high, predetermined levels of GDP growth in perpetuity—but the pain of 2022 has been partially self-inflicted. With the right messaging and policy agility, this transition to more modest growth could be managed in a manner that maintains trust in the system. But if zero-COVID is emblematic of the centralization trend under Xi, the inability to change course could indicate that rigidity is hampering effective governance. This undercuts Xi as an indispensable, transformative leader uniquely qualified to help China “get strong” and achieve its “great rejuvenation” by 2049.

According to Xi, China is close to its rejuvenation despite “great struggles” looming. To many in China, it may feel as though the struggles have arrived. In terms of an economic turnaround, the greatest contest may be between ideological and pragmatic rule with zero-COVID as the focal point.

Before digging into potential drivers of a Chinese economic turnaround, let’s first step back and look at the most recent quarterly data.

Second quarter GDP growth this year came in at 0.4 percent—the worst in the reform era, save for the globally infamous first quarter of 2020, at the start of the pandemic. The situation will have improved by the time third quarter data drops, but the trends are largely the same.

What drove and dragged growth last quarter?

Trade grew at a solid 8.1 percent, driven by strong exports, while fixed asset investment rose 4.2 percent, as infrastructure stimulus started to wind its way through the economy. The primary downside culprits were consumption and property. Value-added output in the wholesale and retail, and accommodation and catering sectors fell 1.8 percent and 5.3 percent, respectively, while real estate activity also registered a 6.9 percent nominal drop, the biggest quarterly fall on record. (Considering that consumption accounts for around 40 percent of GDP, these declines have an outsized negative impact on growth.)

How will this picture look in the coming months?

Consumption growth has remained anemic for months and there is no reason to expect that it will mount a major turnaround, with consumer confidence in the doldrums and zero-COVID still looming. There is also no indication that the fortunes of the real estate sector will turn. Ultimately, property will likely bottom out in the next few months, but it will simply never be the 25 percent contributor to GDP growth that it was in the past—and it won’t be even a marginal engine of growth in the near-term. Then there’s the exports outlook, which is set to turn bleaker as much of the developed world stares down recession.

The big hope is infrastructure spending. As of October 7, the Trivium team has back-of-the-enveloped that the government has rolled out over 10 trillion renminbi in stimulus measures this year—most of which went to support infrastructure construction. If China is going to stage a turnaround in this year’s fourth quarter, it is going to come on the back of that 10 trillion renminbi, which is (inflation-adjusted) 1.5 times the size of the 4 trillion renminbi stimulus rolled out by the People’s Bank of China in the wake of the 2008 Great Financial Crisis.

Unfortunately, that latter stimulus already built most of the high-speed rail, airports, and residential housing China needs. It’s become apparent that China’s industrial economy simply doesn’t have the capacity to absorb this magnitude of cash infusion.

What the Party needs is what it has known it needs for years: to reorient the economy toward domestic consumption, ascend into higher value-added industries, and allocate household savings away from the property sector and into capital markets.

But these initiatives take time—and the pressure is on. The population is aging. The West seems determined to make it harder for China to rise up the value chain. Local governments are dealing with real-deal budget issues.

Today, the Chinese Communist Party remains popular and Xi Jinping is strong, a fact that will be reflected unequivocally at the 20th Party Congress. But, there’s no sugarcoating it: The next five years are going to be some of the toughest the Party has faced in decades. Beijing’s ambitions necessitate substantial investment and need to be realized on an increasingly tight timeline—and each bad growth number requires a reallocation of resources away from longer-term goals to fight short-term fires.

Many expect an eventual relaxation of the strict zero-COVID policy will bring economic rejuvenation. Yes, but only up to a point. China’s economic woes run much deeper than the pandemic. For the past decade, ever since Xi Jinping took the helm, China’s economic growth has slowed down significantly. The pandemic only aggravated the problem the economy already had.

The root cause of this problem is the imbalance of an economy that relies overwhelmingly on export and investment as engines of growth. As former Premier Wen Jiabao famously remarked in 2007, China’s economy was “unstable, unbalanced, uncoordinated and ultimately unsustainable.” For over two decades, China raked in foreign exchange reserves through export and foreign investment inflow. These ballooning foreign exchange reserves backed the expansion of renminbi liquidity via bank loans. State banks made most loans to state enterprises and politically well-connected enterprises, which invested these loans in all sorts of construction, such as infrastructure projects, coal plants, steel mills, and apartment complexes.

Debt-financed investment has been a quick boost to employment and economic growth. The stimulus after the 2008 global financial crisis followed the same investment-driven-growth-on-steroids model and fostered an impressive rebound of the economy. But it also left the economy with worsening indebtedness and overcapacity. The problems of unsold apartments in ghost towns and the unsustainable debt level of real estate giants like Evergrande are among the latest, vivid illustrations of the problem.

Since Zhu Rongji’s premiership (from 1998 to 2003), the Chinese government has realized this investment- and debt-driven growth was not sustainable. For more than 20 years, reining in debt and boosting household consumption were Beijing’s declared policy goals in rebalancing the economy. When Xi first came to power, his government attempted to introduce accelerated urbanization as a way to boost private consumption. Beijing also floated the idea of a “supply-side structural reform” to clamp down on excessive loans and overcapacity. But like the attempts of his predecessors, these efforts were hampered by the institutional inertia of vested interests in debt-driven investment growth—such as banks, real estate developers, and local governments heavily reliant on land revenue. China’s political system does not favor the kind of direct cash transfers to the poor that might address the problem effectively, like Brazil’s internationally acclaimed Bolsa Familia program under Lula. As such, China’s household consumption share of GDP has continued to fall, from about 50 percent in the 1990s to below 40 percent in the 2010s. Total debt share of GDP rose continuously and is approaching 330 percent (above 270 percent according to China’s official statistics), which is among the highest in the world.

The pandemic, while aggravating the structural problems of China’s economy, has also supplied a rationale for excusing the dire situation as the result of a “natural disaster.” But the pandemic will eventually end. By that time, Beijing will have had to confront the structural economic imbalance head-on again. Pumping up debt-financed investment may be tempting, but it will only worsen the problem in the long run. Under Xi’s third term, China’s government will need to take a leap of will and capacity to undertake the necessary and painful work of restructuring the Chinese economy.

The legitimacy of the Chinese Communist Party (CCP) is intimately linked to economic success. This is the deal once brokered by Deng Xiaoping and the Chinese people: We’ll make sure you get rich, but you stay out of politics. And for a long time, it worked. China defied all the theory-based predictions by political scientists, in particular that economic opening and structural reforms will inevitably lead to political reforms, or that a growing middle class will inevitably start demanding democracy. Neither has happened. So far. In 2021, the Party celebrated the achievement of its first centenary goal, the eradication of absolute poverty and the establishment of a “moderately well-off society.” The second centenary goal, scheduled for 2049, is making China a “fully developed, rich and powerful” country. This is what Xi Jinping has called the Chinese Dream of the great rejuvenation. It is unlikely that Chinese people will wait that long.

At times, one gets the impression that Chinese politics is a kitchen full of pots boiling over. The strict zero-COVID policy has not only economically paralyzed Chinese mega-cities (including the symbolic powerhouse of the Chinese economy, Shanghai), it has also caused huge mental (and sometimes physical) suffering, along with many civil protests across China. Only a fraction of these challenges have made it into international media, and then mainly from Shanghai, where many residents are Twitter users. The social media platform is banned in China and can only be accessed through a VPN. There were even rumors that the Shanghai authorities intentionally let the situation escalate to signal to Zhongnanhai that they were unhappy with its COVID policies.

Then, there is the real estate crisis. In the summer, homebuyers in over 100 Chinese cities stopped paying their mortgages. COVID lockdowns led to a slowdown in housing construction, and after the Evergrande debt crisis buyers started to worry they might never be able to move into the apartments they were paying for. Along with the Evergrande crisis came a bank run after six banks froze deposits in mid-April. In Zhengzhou this summer, protestors outside the People’s Bank of China held banners that read: “No deposits, no human rights!”

In August, China experienced its worst heatwave and drought in 60 years, stressing power supplies and causing production cuts in affected provinces and energy intensive sectors. This threatens China’s food security and casts shadows on China’s energy transition, where hydropower plays a central role.

It’s not only the people who are grumbling, Xi also has critics within the Party. In December 2021, the Chinese Communist Party (CCP) mouthpiece People’s Daily published a commentary on the resolution of the Party history—without mentioning CCP Chairman Xi Jinping once. Instead, the text praised the wisdom and collective leadership of Deng Xiaoping and all of his successors except Xi. There is no clearer way to criticize someone you are not allowed to criticize than to praise the one who stood for the opposite political direction.

As a Fudan University economist pointed out recently, the secret behind China’s “economic miracle” has been local-level policy innovation and experimentation. In recent years, however, this has become increasingly rare, as local officials fear political consequences. The economic problems China faces now are too numerous to be solved by Beijing. Unless China’s leaders start again incentivizing decentralized approaches and policy innovation, the prospects for the recovery of the Chinese economy—and the sustained legitimacy of the Party—look bleak.