AEI: China at Risk of Japanese Style Lost Decade

The Chinese economy, once the driving force of global growth, is now facing a series of formidable challenges that could reshape the economic landscape not just for China, but for the entire world. These issues, ranging from a housing market collapse to demographic shifts and geopolitical tensions, suggest that China might be on the brink of a prolonged economic slowdown reminiscent of Japan's lost decade. The implications of this shift are significant, influencing global trade, commodity prices, and international economic policies.

The most immediate and visible challenge is the bursting of China's housing and credit market bubble. The magnitude of this bubble surpasses those seen in both Japan during the 1980s and the United States before the 2008 financial crisis. Persistent declines in housing prices, coupled with widespread loan defaults by major property developers like Evergrande and Country Garden, have led to a contraction in land sales, further straining local government finances. Compounded by a declining GDP deflator over the past five quarters, these indicators highlight a downward spiral in China’s real estate sector—a critical pillar of its economy.

This downturn in the property market is exacerbated by China's demographic challenges. The country’s population is now declining rapidly due to the legacy of its one-child policy.

A shrinking population, coupled with deflationary pressures, complicates efforts to manage China’s substantial household debt levels and its vast inventory of unoccupied dwellings. Estimates suggest there are between 65 million and 90 million vacant homes, reflecting both overbuilding and declining demand. The risk of deflation further amplifies the real burden of existing debt, placing additional stress on households and developers alike.

Adding to these structural issues is the erratic economic policymaking under President Xi Jinping. His zero-tolerance approach to COVID-19 significantly slowed economic growth, and his response to the bursting housing and credit market bubble has been criticized as delayed and insufficient. Instead of deploying aggressive fiscal and monetary policies to stabilize the economy, Xi's administration has focused on consolidating political power and controlling major industries, especially in the high-tech sector.

This approach has rolled back many of the market-oriented reforms introduced by Deng Xiaoping, which were instrumental in China's economic rise. Consequently, foreign investors have become increasingly wary, leading to a sharp decline in investment inflows.

Geopolitical tensions and rising protectionism are also complicating China’s economic prospects. Both Europe and the United States are taking steps to curb China's influence in global markets, particularly in sectors like electric vehicles, where China’s manufacturing overcapacity poses a competitive threat. The reluctance of the Biden administration to roll back tariffs introduced under President Trump underscores a bipartisan stance in the U.S. to reduce dependence on Chinese imports.

Moreover, if Donald Trump or another like-minded politician gains power in the United States, the likelihood of even harsher trade measures increases. Trump's proposal for a 60 percent tariff on all Chinese imports, if enacted, would likely push the Chinese economy into recession. Such a move would be particularly damaging given China’s current struggle to manage its housing and credit crisis.

In addition, both the United States and Europe are implementing policies aimed at bringing manufacturing back home, further reducing China’s export opportunities.

The culmination of these factors—economic mismanagement, demographic decline, geopolitical isolation, and rising protectionism—suggests that China may face a prolonged period of stagnation akin to Japan’s lost decade.

This scenario poses significant challenges not only for China but also for the global economy. For decades, China has been a key growth engine, especially for its Asian trade partners and commodity exporters. If China’s economy slows substantially, these countries will need to adjust their growth models and seek new markets.

However, there is a silver lining in China’s economic troubles: the potential for lower global inflation. As China’s demand for commodities wanes, international prices for goods like oil and metals are likely to decrease. This could offer relief to economies battling inflationary pressures, particularly in the West, where central banks are struggling to control price levels.

Additionally, as China attempts to boost its export competitiveness, consumers worldwide might benefit from lower prices on Chinese goods, further easing inflationary concerns.

In summary, while China's economic slowdown could disrupt global growth patterns, it may also contribute to stabilizing global inflation. The world’s second-largest economy is navigating a critical juncture, and its trajectory will have far-reaching consequences. Investors and policymakers alike must closely monitor China's policy responses and global economic shifts, as the balance of risks and opportunities continues to evolve.