Beijing Tests Our Patience

Chinese entrepreneurs are frustrated. Chinese investors are impatient. Global investors, too. The Chinese government is testing our patience, as it has taken only incremental steps to restore confidence in its economic policies. It is likely that patience will eventually be rewarded, but probably not until well into 2024.

Since the mid-1990s, Chinese leaders have been fairly successful in managing their unique version of state capitalism. They’ve made plenty of mistakes, but usually course-corrected quickly. This time, however, corrective action has come slowly and incrementally.

The leadership in Beijing may believe the economy is healthy enough that bigger changes aren’t warranted. They may believe that the Chinese stimulus in response to the Global Financial Crisis went too far, so they are cautious about doing anything significant today.

In the first half of 2024, however, it is likely that the leadership will recognize that a lack of confidence by entrepreneurs and households is creating significant risks and slowing growth, and that a robust policy response can be effective without being excessive. At that point I expect to see more aggressive policy changes. 

I also expect stability in U.S.-China relations in 2024, which should reduce concerns among investors, including those in China, that a worsening political relationship might hinder an economic recovery in China.

What’s the matter with the Chinese economy?

The Chinese economy is weak, but not in crisis. The IMF forecasts that in both 2023 and 2024, China’s GDP growth rate will be second only to India’s among major economies.

Recent data is pretty good when compared to pre-pandemic 2019. Retail sales in November were up almost 12% compared to November 2019. Industrial value-added was 21% higher than four years ago, and electricity consumption was 26% higher.

In the third quarter of this year, real (inflation-adjusted) per capita household income rose 6% year-over-year (YoY) and was 21% higher than during the third quarter of 2019.

Chinese consumers are facing very modest inflation, but not deflation, which economists define as a sustained fall in overall price levels. In November, the headline consumer price index (CPI) declined 0.5% YoY, but that largely reflected a 32% YoY fall in the price of pork, the main protein source in China. Pork prices are very volatile, and were up 34% YoY a year earlier. Core CPI, which excludes food and energy prices, increased 0.6% YoY in November, the same as in October and a year earlier. For the first 11 months of this year, core CPI increased at an average pace of 0.7% YoY, compared to a 0.9% increase during the same period last year, 0.8% two years ago, and an increase of 1.6% during the first 11 months of 2019.

China’s share of global exports remains healthy. In the first half of 2023, China accounted for 14.2% of global exports by value, up from a 12.8% share in 2017, before President Trump launched his trade war.

Confidence, however, is weak

Conversations with entrepreneurs during a recent trip to China made clear that their confidence has been shaken by poorly explained and poorly implemented economic and regulatory policy changes by the Chinese government. Rather than hoping for stimulus or subsidies, entrepreneurs are looking for the government to simply get out of their way.

The confidence problem is reflected in the steady increase in household savings since the start of COVID, even though Chinese families did not receive checks from their government. Since the beginning of 2020, family bank balances have risen 65%, a net increase equal to US$ 7.4 trillion, which is greater than the GDP of Japan in 2022, and greater than the value of China’s 2019 retail sales. (Once confidence returns, this savings could be significant fuel for a continuing consumer spending rebound, as well as a recovery in mainland equities, where domestic investors hold about 95% of the market.)

The confidence problem is also reflected in the residential property market, where homebuyers are shunning new construction because of worries that developers won’t deliver. Most new homes in China are sold on a pre-sale basis, which means buyers put down 30% cash and immediately begin servicing their mortgage, while builders pledge to use those funds to complete construction, usually within 18 to 24 months. Recently, however, many developers have failed to meet that contractual obligation, leaving buyers with little recourse.

Fear of non-delivery is a key reason why, in the 25 largest cities, new home sales, on a square meter basis, declined 28% during the first three quarters of this year, compared to the same period in 2019.

But, in those cities, sales of existing homes, on a square meter basis, were 13% higher than during the same period in 2019. 
 
There is decent demand for property, but buyers now prefer existing homes because they lack confidence in developers, many of whom are in financial distress. To restore confidence, I’d like to see the central government create an insurance program for pre-sale down payments, similar to the U.S. Federal Deposit Insurance Corporation (FDIC), which was established in 1933 to restore household trust in American banks. Developers and mortgage lenders could contribute to this Chinese fund as U.S. banks support the FDIC.

Weak confidence is also apparent from the 0.5% YoY decline in investment by private companies in the first 11 months of the year. Private investment rarely declined YoY in the past.

But confidence is not terrible

Confidence among households and entrepreneurs is weak, but the problem isn’t severe at this time.

Family bank deposits, for example, are growing less rapidly, up 16.3% YoY in October compared to an 18.3% rise in February, and the savings rates for urban and rural households have declined slightly this year, compared to 2022. This signals slightly greater willingness to spend.

Real per capita household consumption expenditure in 3Q23 was 25% higher than the same period in 2019, compared to an 18% expansion in 2Q23 and 13% expansion in 1Q23. In each of the first three quarters of this year, household consumption growth on a YoY basis was faster than income growth, which signals an improvement in consumer confidence.  

Per capita spending on services, which account for 46% of total household consumption, rose 13% YoY in real terms during the first three quarters.

And, while total investment by private companies declined 0.5% YoY during the first 11 months of this year, that slowdown was confined largely to real estate developers. Private investment in manufacturing rose 9.2% YoY and private investment in infrastructure was up 14.2%.  

Confidence can be restored by pragmatic policy changes

In my view, confidence can be restored if Beijing takes steps that convince entrepreneurs and households that the government is getting out of the way of business, is fully supporting the private sector and markets, and is creating a more transparent regulatory environment. Basically, Beijing needs to return to the pragmatic economic policies that led to the expansion of the private sector—which now employs about 90% of the urban workforce—and which made China rich.

In July, the government acknowledged this problem and began taking a series of incremental steps to restore confidence. The most significant signal of a course correction back to pragmatism came in the residential property sector. Given Xi’s history of concern about speculation in the housing market and the social issues stemming from high prices, as well as his use of aggressive measures to force consolidation of the fragmented developer sector (which contributed significantly to the industry’s current problems), it is remarkable that Xi recently gave local officials the authority to lift all restrictions on new home purchases.

Restrictions on new home sales were relaxed in many cities, and the average mortgage interest rate was cut by 160 basis points (1.6%) compared to the end of 2019.

In November, additional incremental policy changes were announced. Shenzhen, one of China’s major cities, reduced the cash downpayment requirement for second homes to ‘only’ 40% of the purchase price, and the central government encouraged banks to lend to privately owned developers.

On November 27, the central bank and several other agencies announced 25 measures intended to improve private company access to credit.

But, those measures clearly have not been enough to rebuild trust.

When asked why the government hasn’t done more, Chinese economists—most of whom advocate more policy changes and stimulus—have provided us with two explanations.

The first is that Party chief Xi Jinping doesn’t appear to believe that more is necessary, largely because he expects the economy to hit his GDP growth rate target of 5% this year.

The second explanation is that Xi may believe that China’s massive stimulus in response to the Global Financial Crisis was overdone and created negative side effects. This may make him reluctant to undertake even a much more modest stimulus today.

So, why am I still optimistic that more pragmatic policy changes are coming in 2024?

I’m optimistic because recently Xi has been signaling increasing concern about the health of the economy. In early December, he publicly acknowledged that, “at present, our country’s economic recovery is still at a critical stage.” A few days later, he chaired a meeting of his senior leadership team, the Politburo, which issued a statement calling for “prioritizing development before addressing problems” and efforts to “inject impetus into high-quality development.”  Xi then chaired the annual Central Economic Work Conference on December 11-12, which pledged a pro-growth agenda for next year, including support for the private sector. Neither of those meetings, however, announced any specific policy changes.

While the absence of a detailed policy roadmap for restoring confidence is disappointing, I believe that during the first half of 2024, pressure will build for Xi to do more. 

Most importantly, GDP growth in the first quarter of 2023 was fast, creating a difficult base for the first quarter of 2024, especially given that we anticipate Xi will again set a 5% target for the year. The challenge of hitting that target absent significant policy changes should become increasingly clear in the early months of the year.

The prospect of missing that ambitious target, added to recommendations by many Chinese economists to do more, is likely to lead Xi to course correct and return to the kind of pragmatic economic policies that delivered an average annual real GDP growth rate of 6.2% during his first 10 years as Party chief. (Of course, China won’t return to that pace, but the base effect means that 5% growth in 2023 will generate as much incremental economic expansion as 7.8% growth 10 years ago.)

Xi is likely to recognize that if he does not do a lot more to correct past policy mistakes, confidence among households and entrepreneurs will deteriorate further, leading to a sharper growth slowdown. The longer that persists, the harder it will be to generate a turnaround. Recognition of this risk should, I believe, lead to the pragmatic course correction that entrepreneurs and investors have been impatiently waiting for.

China-US Relations: Pragmatic Stability 

In a recent survey of global public pension and sovereign wealth funds by the Official Monetary and Financial Institutions Forum, 73% of respondents said that concerns about geopolitics were one of the key factors dissuading them from investing more in China. It is therefore significant that the November 15 meeting between Joe Biden and Xi succeeded in stabilizing the bilateral political relationship, reducing significantly the risk that an accident might spiral out of control into a crisis that neither leader desires. This development should reduce concerns among investors, including those in China, that a worsening political relationship might hinder an economic recovery in China. 

Pragmatism on both sides 

The Biden administration began recalibrating its approach towards China last spring, leading to more engagement as well as more clarity about U.S. policy on Taiwan. At what the White House is now referring to as the “Woodside Summit,” Xi Jinping reciprocated, agreeing to both of Biden’s key objectives during the four-hour meeting—curbing fentanyl production and resuming military-to-military communication.
 
Fentanyl and other synthetic opioids accounted for over 70,000 overdose deaths in the U.S. between May 2022 and April 2023, according to the U.S. Centers for Disease Control and Prevention (CDC). Prior to the breakdown in the bilateral political relationship in early 2020, China had cooperated on dealing with this problem. “Prior to 2019, China was the primary source of U.S.-bound illicit fentanyl, fentanyl-related substances, and production equipment,” according to the Congressional Research Service (CRS). Most of that was shipped directly from China to the U.S. via mail and express package services, until, in May 2019, the Chinese government cracked down on that illegal trade. While shipments of fentanyl from China stopped, trafficking patterns changed, and “Today, Mexican transnational criminal organizations are largely responsible for the production of U.S.-consumed illicit fentanyl, using primarily China-sourced materials, including precursor chemicals that are not internationally controlled (and are correspondingly legal to produce in and export out of China),” according to a CRS report published in September.
 
At the historic Filoli estate in Woodside, California, Xi announced that production, transport and sale of these precursor chemicals would no longer be legal in China. New regulations were issued immediately after the Xi-Biden meeting, and a Biden administration official told me that the Chinese government began shuttering some chemical companies in the weeks prior to the meeting. This effort, if as successful as Beijing’s earlier ban of fentanyl production, should disrupt cartel supply chains in the near term, although production of precursor chemicals is likely to appear in other countries before too long.
 
Military-to-military communications channels are important for building relationships and trust through the ranks, which are key to resolving problems before they escalate. These mil-mil channels had been shut down in recent years, as the overall bilateral political environment deteriorated, especially after then-Speaker Pelosi’s August 2022 visit to Taiwan. An increasing number of close encounters between military planes and ships had made restoring this communication channel a priority for Biden, but his efforts had been rebuffed. At the Woodside Summit, however, Xi agreed to reopen military communications at both the operational and senior officer levels.
 
Taiwan issues have always been the most contentious topic in U.S.-China relations, but an American official who attended the summit told me that the temperature and tone of Xi’s comments on Taiwan were lower than in past meetings. Xi was probably responding to recent U.S. efforts to reassure him that American policy on Taiwan has not changed. In my view, recent reiteration by senior American officials of long-standing U.S. policy that Washington does not support Taiwan independence was a key factor. One Biden administration official told me that another factor was that they have stopped taking some symbolic acts which Beijing might have incorrectly interpreted as policy changes, and which had not, in any event, contributed to Taiwan’s security. That official said Xi does not appear to have a timeline for eventual reunification, and, in public remarks, Treasury Secretary Yellen, who attended the meeting, said Xi “certainly expressed the desire to have that [reunification] occur by peaceful means." A second U.S. official, who also attended the summit, told me he is now less concerned about the use of force by China against Taiwan. In the meeting, Biden made clear that he expects Beijing to not interfere in Taiwan’s presidential election, scheduled for January.
 
Pragmatism. It is also clear, however, that both sides face political constraints on how far they can go to improve the relationship, especially the Biden administration, which is in full campaign mode. Commerce Secretary Raimondo made this explicit recently, when she said, “make no mistake about it, China’s not our friend, and we need to be eyes wide open about the extent of that threat.”

Still, the Woodside Summit was a welcome development, in line with what we wrote prior to the meeting, in the November 8 Sinology: Because I “expect Xi to continue to take a pragmatic approach to the relationship, the increase in bilateral engagement should restore some trust. While this won’t make the relationship a lot better in the near term, it should stabilize it, reducing the risk that an accident spirals into a crisis that neither side desires.” This should be reassuring to investors, who can focus more on economics and markets.

Andy Rothman
Investment Strategist
Matthews Asia