In 2024, China's economy managed to achieve a growth target of around 5%, but it still faces significant headwinds in 2025.
What is behind the stress on the Chinese economy? Will recently announced policies be able to spur growth? Can China reverse two consecutive years of deflation in 2025? What kind of policies are needed to continue hitting the 5% growth target? Most importantly, will 2025 be a turning point for China's economy? In this article, CEIBS Professor and Santander Chair in Economics Zhu Tian explores these questions and more.
In 2024, China's economy managed to achieve a growth target of around 5%. The nominal growth rate, however, calculated at current prices, hovered around 4%, lower than the 4.6% nominal growth rate recorded in 2023. Over the past two years, China's nominal GDP growth rate has been lower than its real growth rate (the figure published by the country's National Bureau of Statistics). Given that inflation is the difference between the nominal growth rate and the real growth rate, this indicates deflation.
This marks the first time since the 1998 Asian Financial Crisis that China has experienced two consecutive years of deflation. Moreover, it is a phenomenon unprecedented among major economies outside of Japan in the past 65 years. It must, therefore, be given significant attention by the country's policymakers.
Two Politburo meetings in September and December 2024 signaled a marked shift toward more proactive macroeconomic policies, explicitly calling for "strengthening unconventional counter-cyclical adjustments." The policy shift has led to early signs of stabilization in both the stock and real estate markets.
Will 2025, therefore, become a turning point for China's economy? Specifically, can the country achieve 5% real growth and, more importantly, reverse the trend of deflation and to achieve an inflation rate of 2%, thereby reaching a 7% nominal growth?
Achieving these goals will require exceptionally proactive policy responses, which I will explore later in this article. First, however, we must understand why, exactly, China's economy is experiencing its current downturn.
01
The Cause of the downturn
In the two years since the lifting of pandemic restrictions (2023-2024), China's real economic growth rate (5%) decreased by 1.4 percentage points compared to the two years prior to the outbreak of COVID-19 (2018-2019). At 4.3%, the nominal growth rate decreased by 4.6 percentage points. The comparison is night and day when held against the country's growth rate during the first four decades of reform and opening up, 1978 to 2017, during which China averaged annual real growth of 9.6% and nominal growth of 15.1%.
The direct cause of this severe economic downturn is not difficult to pinpoint: the significant contraction of the real estate sector. In 2021, authorities implemented a stringent deleveraging policy in the real estate industry, which resulted in negative growth of about 10% in real estate investment for three consecutive years. This directly reduced GDP growth by about 1.5 percentage points. Coupled with extensive indirect effects, including impacts on upstream and downstream enterprises and local government revenue, not to mention impact on consumption given the high proportion of the population's wealth tied up in property, the real estate industry's rapid decline may have lowered China's annual economic growth rate by 3 percentage points or more.
Post-COVID deflation has largely been caused by the deleveraging of the real estate industry, rather than by broader structural factors. Although the direct cause of the sluggish recovery of China's economy post-pandemic is the real estate downturn, however, its impact on incomes and asset prices has significantly dampened consumption growth.
In 2019, the growth rate of total retail sales of consumer goods and fixed asset investment was 8% and 5.4%, respectively; in January-November 2024, these rates dropped to 3% and 3.3%. More worryingly, consumption in the first-tier cities of Beijing, Shanghai, Guangzhou, and Shenzhen was even weaker than the national average. Between January and November 2024, total retail sales of consumer goods in Shanghai and Beijing decreased by 3.1% and 2.8%, respectively, while Guangzhou and Shenzhen recorded modest increases of only 0.3% and 1%.
The lack of confidence that we see among consumers and enterprises is both a cause and a result of the current downturn. The longer deflation persists, the lower the confidence, and the more the economy struggles. Breaking this negative feedback cycle requires unconventional macroeconomic policies.
China's exports remain one of the few bright spots, growing by 6.7% between January and November 2024, exceeding a growth rate of 5% in 2019. However, if the incoming Trump administration significantly increases tariffs on Chinese goods in 2025, China's overall export growth could decline by about 5 percentage points. This underscores the urgency for Chinese authorities to take decisive action in 2025 and make every effort to promote the recovery of domestic consumption and investment if the 5% GDP growth target is to be met.
The sluggish growth in consumption and investment in China over the past two years is regrettable and could perhaps have been avoided had the policy on the real estate industry in 2021 been focused on restricting developers with high leverage from purchasing land and expanding their businesses, rather than borrowing money. Most major economies have enjoyed a clear recovery after the pandemic, with economic growth basically returning to the pre-pandemic levels or better. China's economy should have been able to do the same. Even if real estate investment had grown by a mere 5%, rather than contracting by 10% as it in fact has, China's GDP growth over the past two years could have reached 8%, higher than in 2019.
One of the top priorities for China's economy in 2025 is, therefore, to arrest this decline and stabilise the real estate market. The second priority is to vigorously promote the recovery of consumption. These are the policy goals set by the Central Economic Work Conference and reflect the consensus of many economists. Where China's economy goes from here depends on the strength and speed of policy implementation.
02
Insufficient demand for both investment and consumption
In most cases, for a country to be experiencing an economic downturn, both consumption and investment must be declining. It follows that macroeconomic policies should aim to both increase consumption and stabilise investment. The question is how.
There is a popularly held view that China's relatively low consumption rate is responsible for the current economic downturn. Supporters of this view attribute the low consumption rate to long-term structural factors, such as insufficient social security or household incomes accounting for a low proportion of GDP. However, the consumption rate is a relatively stable long-term variable. China's consumption rate has been low for 40 years, during which the country has achieved the world's fastest income and consumption growth. It is, therefore, implausible to assert that low consumption is the cause for the current economic downturn. In fact, China's consumption rate has generally been rising since 2010. From 2015, the growth rate of total retail sales of consumer goods has exceeded the growth rate of fixed asset investment in most years, except during the pandemic years of 2020 and 2022 when stringent controls were in place.
Currently, China is facing a problem of insufficient aggregate demand, i.e. a shortfall in both consumption and investment. Put simply, this means that demand for both consumer and investment goods is significantly lower than the country's production capacity. This has little to do with the relative rates of consumption and investment. Macroeconomic policies must address the total volume of consumption and investment rather than their proportions.
Stimulating consumption: Mass distribution of consumption vouchers
Macroeconomic policies are typically short-term measures. The primary goal of China's 2025 macro policy is to increase the total volume of consumption and investment during the year. The most direct and effective way to increase consumption is through the large-scale distribution of consumption vouchers financed by the central government, rather than relying solely on increasing social welfare benefits or household incomes of specific groups. While these measures are desirable, they are long-term policies, and their immediate impact is too small to stimulate consumption significantly in the short term.
Over the past two years, some local governments have experimented with distributing consumption vouchers, achieving modest results. The scale of these initiatives, however, has been insufficient. A nationwide durable goods trade-in policy has also had some positive effects, but with a budget limited to 100-200 billion yuan, the impact on the overall economy has been negligible.
In 2020, during the pandemic, the Hong Kong Special Administrative Region (HKSAR) distributed HK$5,000 in consumption vouchers per person to all adult residents in two batches. According to rigorous research by a team led by Professor Song Zheng at the Chinese University of Hong Kong, this produced significant results, boosting consumption powerfully and quickly. The marginal propensity to consume (MPC) was found to be as high as 80%, meaning that every HK$100 worth of vouchers resulted a net consumption increase of HK$80.
If the Chinese government distributes RMB 3,000 in consumption vouchers set to expire by year-end to every Chinese resident regardless of age, fiscal expenditure would amount to RMB 4.2 trillion, equivalent to 3% of GDP. Even if the marginal propensity to consume among mainland Chinese residents turns out to be only 50% (a median value based on various empirical studies), this could generate an additional RMB 2.1 trillion in consumption, effectively boosting GDP by 1.5%. This is only the direct effect; such an increase in consumption would also lead to positive indirect effects on investment.
Alternatively, consumption vouchers could be distributed as discount vouchers. If the discount rate is 50%, then residents can use RMB 50 worth of consumption vouchers for every RMB 100 worth of goods purchased. In this way, RMB 3 trillion in discount vouchers could potentially achieve the same stimulative effect as RMB 4.2 trillion in cash vouchers.
Implementation details may be decided by a team of experts, including methods of distribution, whether to distribute vouchers equally to all people, whether to distribute vouchers in stages, how long the validity period should be, what restrictions to impose on the use of the vouchers, and so on. However, the overall scale of the scheme must be large and broad enough to be effective. The policy should also be fully funded by the central government through the issuing of special treasury bonds, as local governments do not have the financial capacity for such large-scale stimulus measures. Moreover, since consumption has a large leakage effect (meaning that a considerable proportion of consumption in one region will likely be used to purchase products from elsewhere), local governments have less incentive to promote consumption.
China's strong digital capabilities, developed during the pandemic, make it possible to easily distribute electronic consumption vouchers to the entire population. The scope of the use of consumption vouchers should not be overly restrictive and should include all retail, catering, and general service industries, rather than being limited to specific types of products and services. They could, however, exclude utility bills, school tuition, and medical expenses. This would ensure the policy is simple, transparent, and easy to implement.
Even if such a large-scale voucher program fails to achieve the desired economic impact, there is little risk in trying. After all, the funds are distributed equitably to every citizen, and no money is wasted.
Stabilising investment: The real estate sector remains the key
There is ongoing debate among economists about whether China should rely more on consumption or investment to stimulate its economy. While many believe that continuing to stimulate the economy through large-scale infrastructure investment is an outdated method, others believe that China still has considerable room for improvement in its infrastructure
However, in the current environment, which emphasizes returns on investment and accountability, even if policies and funds for infrastructure investment exist, they would be difficult to implement as quickly and effectively as in 2008 or 2009. Therefore, mass distribution of consumption vouchers may at present be the fastest and most effective way to stimulate aggregate demand.
Infrastructure investment is only one type of fixed asset investment, however, and there are other areas for investment such as manufacturing, real estate, and service industries. But which areas are appropriate candidates?
China's manufacturing investment grew by 9.3% during January to November 2024, suggesting it does not require additional stimulus. In fact, there is currently insufficient demand and hence excess capacity in many manufacturing industries.
China's investment in education, culture and sports, however, only grew by 1% in 2024. Fixed investment in the medical and health industry decreased by 10%. China is clearly lagging in high-quality education, medical, and cultural facilities, meaning that there is still a lot of room for investment. As this type of investment would not produce obvious immediate economic returns, it should rely on government rather than private investment.
However, investment in education, healthcare, and cultural and sports facilities accounts for only a small proportion of total fixed asset investment. Increasing spending in these areas would have a limited impact on overall economic recovery. The most critical area for stabilization is real estate investment, with the goal of reversing the industry's downward trend and restoring growth.
China's real estate industry still has a lot of room for high-quality development. To stabilise the market, the Ministry of Housing and Urban-Rural Development has outlined tasks for 2025, including cancelling various demand-restricting policies, increasing financing for "whitelisted" real estate projects, accelerating the development of affordable housing, and promoting urban renewal and renovation projects. These are all positive measures, but the key is to secure sufficient financial support. Otherwise, the downward trend will not be reversed.
For real estate to cease being a drag on economic growth in 2025, it must return to a positive growth of at least 5%. This may require an additional RMB 1.5 trillion in financial support. A real estate whitelist measure introduced in 2024 is a promising method, but many projects remain ineligible for inclusion. Abandoning projects under construction due to funding shortages would be wasteful, but the usual market mechanisms cannot be counted on to finance these projects. At this point, government funding is essential to address liquidity issues.
Given the limited financial resources of local governments, the Ministry of Finance should consider leveraging mechanisms such as subordinated debt or preferred shares to mobilize funds from local governments, banks, state-owned enterprises, and the private sector to complete these ongoing projects and acquire completed ones. The central government, as the holder of such securities, would rank behind all creditors in terms of priority when the project is liquidated, thereby reducing risk for other creditors and encouraging their participation in financing these projects.
03
Marshalling both fiscal and monetary policy
There has been a long-held misunderstanding that China's debt ratio (also called the leverage ratio) is already too high, and that the country should not add leverage, nor stimulate the economy through issuing more debt.
However, the fact is that China's government debt as a percentage of GDP is not high by global standards, with central government debt only slightly over 20% of GDP (which is far lower than other major economies), there remains significant room to add leverage.
The debt of China's non-financial enterprises as a percentage of GDP is relatively high, but in a country with such a high savings rate, a high macro leverage ratio (i.e., ratio of debt to GDP) is natural. High savings and high leverage are two sides of the same coin. High savings are channelled into high investment through corporate borrowing, which is an advantage for China's economic growth rather than a problem that needs to be solved.
A more appropriate leverage indicator is in fact the micro leverage ratio of companies, that is, their debt-to-asset ratio. By this metric, China's corporate leverage ratio is relatively low compared with other major economies, indicating that borrowing is not easy for Chinese companies in general, and that banks tend to favour customers who do not lack money while those who genuinely need loans often struggle to obtain them.
China must of course guard against the risks of a financial crisis. But financial risks typically arise from asset devaluation and/or declining income. Therefore, the focus of risk prevention should not be on reducing debt but on halting further asset devaluation and preventing continued declines in income growth.
The current debt issues facing real estate companies and local governments are mainly liquidity problems stemming from asset devaluation and income declines brought about by deleveraging and economic downturns. Only by accelerating economic recovery and promoting income growth and asset appreciation can the debt crisis be fundamentally resolved.
China's economy, especially at the national level, currently needs and is well-positioned to increase leverage rather than reduce it. The priority should be to prevent a downward economic spiral rather than to worry about high debt levels. Real estate companies and local governments urgently need financial support, but given their high debt burdens, the market is unlikely to voluntarily provide funds for them. Only the central government has the capability to step in and offer such support.
Over the past two years, central and local governments have issued a net debt of about RMB 10 trillion a year. In 2025, the net debt should be exceeding RMB 15 trillion (about 12% of GDP) in order to significantly reverse the current economic downturn. Only such large-scale policy intervention could be truly effective.
While the scale of the stimulus seems large it is not completely out of the ordinary. The US federal government, for example, added $4.2 trillion in new debt in 2020 in response to the COVID-19 pandemic, accounting for 20% of GDP.
China has been issuing more government bonds in recent years, but the interest rate has declined, to 1.7% for ten-year bonds. On the one hand, this indicates people's low expectations for the economy; on the other hand, it also indicates an abundance of savings and excess demand for government bonds, with supply remaining insufficient. The Chinese market is fully capable, therefore, of absorbing more government debt.
In addition to a proactive fiscal policy, China's monetary policy must also be more accommodating. Over the past decade or so, under the so-called "prudent monetary policy", real interest rates have been pro-cyclical; that is, when the economy is weak, real interest rates (equal to the nominal interest rate minus the inflation rate) are high; when the economy is strong, real interest rates are low. Now, amid deflationary pressure, the average real loan interest rate exceeds 4%, whereas in 2021 when the economy was thriving, real interest rates were negative.
Moreover, China's deposit interest rates have remained unchanged for a decade, despite significant changes in the economic environment. In the current situation, there is still at least a 100 basis point (i.e., 1 percentage point) room for the nominal interest rates to go down, and there is also room for cuts in reserve ratios.
The central bank should support proactive fiscal policy and significantly increase the proportion of government bonds in its balance sheet. At present, government bonds account for only 5.5% of the People's Bank of China's total assets, whereas they exceed 60% of the Federal Reserve's assets in the US. In 2020, most of the new $4.2 trillion government bonds were purchased by the Federal Reserve. Substantial purchases of government bonds by the central bank can both increase money supply, stabilize government bond interest rate and prices, and reduce the risk to the financial system brought about by bond price fluctuation.
04
Conclusion
China's economy faces severe challenges in 2025, but this downward trend is not inevitable. With high savings and strong production capacity, China has the abilities and tools to increase leverage and stimulate demand. The central government in particular should take bold steps to drive domestic consumption and investment.
In addition to bold short-term macroeconomic policies, long term structural reforms should not be neglected. China needs to redesign its fiscal system, balancing the rights and responsibilities between the central and local governments. More importantly, China should turn the pronounced reform goals of marketisation, rule of law, and internationalisation into concrete and actionable policies. Efforts should be made to mobilise the enthusiasm of local government officials, SOE cadres, and private entrepreneurs, with more positive incentives and fewer punitive measures.
By implementing these measures, China can restore confidence across all sectors of the economy. In that case, barring unforeseen events, China's economy is likely to recover in 2025, and is also likely to return to an upward growth trajectory in the years ahead.
Zhu Tian is Professor of Economics, Santander Chair in Economics, Associate Dean and Director of EMBA Program at CEIBS. He is an expert on the Chinese economy and the author of Catching Up to America: Culture, Institutions, and the Rise of China.
Recommended Reading
Want to learn more about CEIBS programmes? Click 'Read more' below
No comments:
Post a Comment