Zero-COVID Is the Least of Xi’s Economic Problems

Xi Jinping formally secured an unprecedented third term as head of the Chinese Communist Party (CCP) at the recent 20th Party Congress. The replacement of pro-reform thinkers such as Wang Yang with Xi loyalists on the seven-man Politburo Standing Committee—the apex of China’s political power—casts a shadow on the trajectory of the Chinese economy and China’s economic relations with the rest of the world. The removal of Hu Jintao, the last Chinese leader personally chosen by Deng Xiaoping, at the closing ceremony signaled an end to China’s four-decade movement toward reform and opening up, initiated by Deng in the late 1970s. The market welcomed Xi’s new term with a meltdown on his first day, with Chinese stocks in Hong Kong tumbling by the most since 2008 and the yuan weakening to a 14-year low.

The Party Congress also signaled that Beijing is unlikely to lift the “zero-COVID” policy anytime soon despite the immense socioeconomic costs. In his speech to party cadres, Xi said that “firmly implementing the zero-COVID policy” allowed the CCP to “maximize the protection of Chinese people’s life and health.” Xi was silent on the policy’s costs. By sticking with zero-COVID, Xi and his loyalists can control China’s interactions with the rest of the world and prepare the Chinese people and economy for further isolation if the West imposes stricter economic sanctions against China. U.S. financial leaders have promised to exit China if it attacks Taiwan, which would effectively expel China from the U.S.-led global economic and financial system. By focusing on improving China’s self-sufficiency and expanding its dominance in strategic sectors, Xi hopes to raise the cost of sanctioning China to unbearably high levels for the West while developing China’s capacity to absorb the economic shock of sanctions.

The CCP’s obsession with zero-COVID will continue to weigh on the Chinese economy, but it is not the most challenging problem facing the economy right now. Even if Xi ends zero-COVID tomorrow, he cannot undo the damage it has already caused. Xi cannot command the Chinese economy to rebound quickly. Given the host of problems China faces, it will be very challenging for the Chinese economy to achieve the 8 percent annual growth that some economists, such as Justin Yifu Lin, still estimate to be within its long-term potential. The fundamental challenges holding back the Chinese economy are related to the four D’s: demand, debt, decoupling, and demography.

Abandoning zero-COVID is unlikely to stimulate global demand for Chinese exports or encourage a sustained expansion of domestic demand. For the rest of this year and the next, the Chinese economy faces strong headwinds from weak export growth due to a global economic slowdown and less external demand primarily because of soaring inflation and a shift away from buying the pandemic-related goods that China manufactures. Exports of goods and services as a percentage of Chinese GDP declined from 36 percent in 2006 to 20 percent in 2021, according to the World Bank. This share is about the same as in 2001, at the dawn of China’s ascendance to the World Trade Organization.

Chronically weak domestic demand tied to China’s troubled property market will further constrain the country’s economic growth over the next five years. Home sales volumes are trending down even though home prices have been slower to adjust, owing to robust government support. The slumping property market will have a broad ripple effect, suppressing demand for industrial materials such as steel, timber, and chemicals and consumer durables such as appliances, furniture, and fixtures. If government support cannot hold off a sharp decline in property prices, then aggregate demand will correspondingly fall in line with home prices, causing corporate profits to contract and credit default risk to increase across all sectors of the economy.

Some of these effects are already visible. A survey of 247 steel manufacturers in China showed that the proportion of profitable firms decreased by nearly 70 percentage points to 15 percent in the second quarter of this year from 84 percent in the first quarter. About 32 percent of China’s large and medium-sized steel manufacturers lost money in May. In Hebei, the largest steel-producing province in China, 38 percent of steel producers were unprofitable this year, recording a total collective loss of 6.56 billion yuan (about $900 million) in the first five months—more than six times the losses recorded over the same period last year. In Xi’s third term, loss-making Chinese companies are more likely to be allowed to fail, in contrast to the previous policy of propping them up. Since at least 2015, China has increasingly embraced U.S.-style bankruptcy procedures that aim to restructure or efficiently liquidate failed companies.

A troubled property market bodes ill for local governments and households because it would result in higher leverage and curtail consumption, making it more difficult to expand domestic aggregate demand. Local governments are highly dependent on revenues from land use rights sales, which accounted for more than 90 percent of revenue earmarked for public expenditure as of August. During the first eight months of this year, local governments’ revenue from land use rights sales tumbled 28.5 percent versus a year ago to 3.37 trillion yuan (about $460 billion), mainly owing to the property market slowdown. This reduction in revenue, combined with higher public health expenditures related to COVID-19 and social welfare expenses related to demographic shifts, is a recipe for higher deficits and more indebtedness.

Since Xi ascended to power in 2012, the Chinese government has struggled to implement demand-side reform. It is unlikely to finally succeed in Xi’s third term by transforming China’s economy from being overreliant on investment to being demand-driven. The greatest obstacle to achieving this goal is the substantial mortgage debt burden of Chinese households that depresses consumption.

China used to enjoy a reputation as a country of savers, but increasingly this is no longer the case. In September, China’s total household debt was 62.4 percent of GDP. A report released by China’s central bank, the People’s Bank of China, showed that in 2019, mortgage loans, still mostly used for presales of unfinished apartments, made up more than 75 percent of household debt. Statistics from the central bank also showed that at the end of the second quarter of this year, mortgage loan balances reached nearly 39 trillion yuan (about $5.3 trillion), which is, for comparison, almost 10 times the entire annual economic output of Shanghai. The heavy mortgage burden of Chinese households means less money is available for other types of consumption. Chinese households can augment their consumption by taking out personal loans. By June, personal loan aggregate balances had grown to nearly 17 trillion yuan (about $2.3 trillion), more than 40 percent of the size of the mortgage loan market.

China’s debt problems are more than just local government funding and the mortgage market. A growing source of concern is China’s enormous Belt and Road Initiative (BRI) lending program. As many as 1 in 4 dollars lent by Chinese institutions as foreign loans have already come up for renegotiation, about $94 billion in total. Many BRI loans were arranged by Chinese firms motivated by winning political favor at home for financing a project that had Xi’s personal stamp of approval. The rapid origination of BRI loans without much consideration for risk management has become a big problem for China. If Chinese lenders were to seize the collateral that backs defaulted BRI loans, that would bolster the undesirable narrative that China has engaged in predatory lending that puts developing countries into a “debt trap.” Alternatively, restructuring defaulted loans or forgiving the loan balance would impose a loss on Chinese lenders. The Chinese government faces a dilemma: It must choose between suffering reputational damage and monetary losses.

There is no easy fiscal solution to stimulate demand in China without expanding debt and exacerbating leverage. China’s State Council encouraged local governments to complete the issuance of 500 billion yuan (about $68 billion) in special purpose bonds by the end of October. It also decided to add another 300 billion yuan (about $41 billion)—via bond issuance—to the existing 300 billion yuan of policy-oriented development finance instruments intended to boost consumption. There is no easy solution in terms of monetary policy either. The global monetary tightening cycle has constrained the Chinese government’s policy options to stimulate demand by expanding low-cost credit. The central bank cannot easily pursue large-scale monetary easing to boost the Chinese economy. The People’s Bank of China relaunched its Pledged Supplementary Lending (PSL) program to increase the lending capacity of China’s policy banks. It added a net 108.2 billion yuan ($15.2 billion) of PSL funding to the China Development Bank, Agricultural Development Bank of China, and Export-Import Bank of China. The central bank’s stimulus measures, taken together with the State Council’s wide-ranging fiscal stimulus package, run the risk of countering the inflation-taming effort of central banks in the West.

On top of weaker demand and growing debt balances, China faces a challenge in managing the possible decoupling of its economy from the economies of the West, specifically the United States. To be sure, decoupling between China and the West is unlikely to take the form of a sudden and complete stop of trade and investment flows. However, preparing the Chinese economy to withstand severe Western sanctions is a prerequisite if Xi forces so-called reunification with Taiwan by military action.

While Chinese policymakers and financial institutions do not want to be excluded from the existing global system, they have laid the groundwork for an alternative financial system based on the Chinese yuan. This alternative system includes an independent payment and settlement network supported by Chinese financial institutions, regional groupings, and multilateral institutions. Furthermore, China is pushing the rapid development of financial digitization using the digital yuan. Once this alternative financial system gathers sufficient users, it could mitigate much of the pain that Western sanctions may cause and increase China’s geoeconomic influence. However, Xi cannot just command the rest of the world to abandon the U.S.-led dollar-based financial system. China’s alternative financial system is still limited in its capacity and coverage, and at present, it cannot fully immunize the Chinese economy from the effects of potential Western sanctions.

A bifurcated technology ecosystem between China and the West is already in the making, including different technology standards and fragmented supply chains. The vulnerabilities of Chinese tech companies to U.S. export control restrictions were demonstrated when Huawei suffered its worst revenue decline ever in 2021 after it was sanctioned by the U.S. government. To survive, Huawei had to sell its lucrative smartphone business to a government-backed consortium. As part of its plan to regain its lost market share, Huawei has redesigned its products to use not-so-smart chips and suboptimal technology that is not impacted by U.S. export restrictions. Chinese policymakers and businesspeople find it increasingly difficult to access advanced Western technology due to broader U.S. export control restrictions. As of August, there were about 600 Chinese organizations on the U.S. Commerce Department’s Entity List—a list of banned importers—more than 110 of which were added after the start of the Biden administration.

The Commerce Department’s Bureau of Industry and Security recently developed a sweeping set of new export control regulations and added 31 new Chinese semiconductor entities to its Unverified List, a precursor to being added to the Entity List. If these Chinese entities fail to prove their compliance with U.S. regulations, they will be moved to the Entity List. The Biden administration is reportedly exploring expanding export controls to restrict China’s access to cutting-edge artificial intelligence and quantum computing technologies.

While demand, debt, and decoupling pose immediate challenges for Xi’s third term, China’s demographic change will shape the long-term prospects of the Chinese economy. Looking ahead, China faces the real challenge of getting old before it gets rich. The direct economic impact of demographic changes on the Chinese economy comes through two channels. First, a diminishing labor force and loss in human capital will further reduce China’s comparative advantage in labor cost and undermine China’s long-term growth potential. Second, a growing population of older adults will increase pension costs and social welfare expenditures. While demographic change is not necessarily a crisis in itself, the absence of a proper policy response can undermine the growth potential of any country, China included.

Fertility rates in China fell to their lowest level in nearly six decades in 2020, putting the working-age population on track to peak before 2025. In addition to factors such as a falling marriage rate—a possible indication that the size of the current working-age population is overestimated—the high costs of child-rearing in China are a critical driver of its looming population decline and labor shortage. The national average cost of raising a first child to the age of 18 in China is nearly seven times the national per capita GDP (485,000 yuan, or about $66,000). By comparison, in the United States the cost is only four times the per capita GDP. Child-rearing costs in Beijing and Shanghai are close to double the national average and more than triple the rural average. Without robust policies for affordable child support, Chinese families will not follow the “three-child policy” initiated during Xi’s second term.

An aging population also has to be cared for, which was the mandate given to China’s social security fund when it was introduced in August 2000. In 2021, 300 million people were receiving benefits from the fund, which is estimated to have a funding shortfall of 700 billion yuan (about $96 billion). China’s pension gap may increase to 8-10 trillion yuan in the next five to 10 years. The State Council decided in 2017 to recapitalize China’s social security fund by transferring some state-owned assets, including shares of state-owned companies and financial institutions, into the fund. By 2020, a total of 1.68 trillion yuan (about $230 billion) in state-owned capital was transferred to the fund from 93 central enterprises and financial institutions. Despite this recapitalization, the Chinese Academy of Social Sciences, a government-sponsored research institution, still predicted that assets in China’s urban worker pension fund would drop to zero by 2035 without additional intervention.

Altogether the four D’s—demand, debt, decoupling, and demography—will pose a serious challenge for Xi in his third term both at home and abroad and in both the state-led and private sectors. The future of the Chinese economy and China’s relationship with the West depends less on market dynamics and more on the direction taken by China’s domestic politics. That said, not all is lost for the Chinese economy. If Xi can reset China’s politics to focus again on the economy, reaffirm his commitment to reform and opening up while returning to a less combative foreign-policy narrative, and resume genuine and substantive communications with the West, it will still be possible to save the Chinese economy from sleepwalking into a deep slump and further isolation. Unfortunately, there was very little sign given at the Party Congress that Xi is prepared to walk this higher path. It remains unclear whether Xi was sincere when he said last week that China was willing to find ways to get along with the United States to the benefit of both countries ahead of a possible meeting with U.S. President Joe Biden at the G-20 summit in Indonesia in mid-November.

The dominance of politics over economic incentives in Beijing will likely motivate lawmakers in Washington to be more critical of China, forcing U.S. corporations to reassess the risk-reward payoff for doing business in the Chinese market. That said, the United States should not abandon China—not its people or its market—because of just one person and his small group of loyalists, no matter how powerful they appear. Despite all the growing tensions, trade with China is still crucial for the U.S. economy and the American people. U.S. exports of goods and services to China supported an estimated 758,000 U.S. jobs in 2019. Policymakers in both Beijing and Washington should resist the temptation to escalate tensions further by playing the blame game. While the discourse of domestic politics on both sides suggests a bumpy road ahead for U.S.-China relations, it is still too early to give up trying for a better relationship and not too late for Washington to influence the policy options available to Xi as he starts his third term.