China’s economy is underperforming and things could get worse

Unlike most developed economies, China doesn’t have an inflation problem.

China has been, sporadically, trying to stimulate grow via infrastructure investment, incentives and slightly cheaper credit. The measures don’t appear to have gained any traction, perhaps because corporate and individual borrowers are in a defensive mood amid falling house prices – property prices have fallen for 12 consecutive months – relatively weak consumer spending and the pervasive fear of the draconian COVID lockdowns.

There are tens of millions of people in more than two dozen regions currently under full or partial lockdown, with the whole city of Chengdu and its 21 million people locked down this month after a relative handful of COVID cases. The authorities have recently recommitted to their COVID policies, dashing hopes that there might be a change of strategy after the national congress.

So far, China’s response to the slump in its growth rate – its own forecast for this year was a modest, by historical standards, 5.5 per cent that has turned out to be overly optimistic –has been restrained, perhaps because the authorities believe it would be futile and wasteful to try to push against the headwinds of their COVID policies and a property market collapse that the World Bank said could be “structural”.

They may also be concerned about the impact on the yuan if monetary policies are loosened too much.

Unlike most developed economies, China doesn’t have an inflation problem. Its headline rate of 2.5 per cent in August was inflated by energy and food costs but core inflation (which excludes them) was only 0.8 per cent.

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The absence of excessive inflation likely relates to the deflationary effects of the COVID policies and the property industry’s woes – influences that caused China Beige Book International, an independent provider of China’s economic data, to say the economy faced an increasing risk of deflation. CBBI described the COVID policies as “crushing”.

The yuan doesn’t float freely, with the People’s Bank of China allowing the currency to trade within a narrow band against the daily value it sets against the US dollar. Nevertheless, the yuan has been steadily depreciating against the US dollar through most of this year and broke through the seven yuan to the US dollar level last week for the first time since the early months of the pandemic.

It started this year at 6.35 yuan to the US dollar.

The authorities appear to be trying to manage an orderly devaluation against a rampant greenback, which is at more than 20-year highs against America’s major trading partners – rather than attempting to either absolutely defend the currency or allow it to fall freely.

They recently significantly reduced the amount of foreign currency their banks must hold in reserve to try to increase dollar liquidity and could, if they wished, deploy some of their $US3 trillion of foreign exchange reserves or tighten capital controls to try to underpin the yuan’s value.

With capital flowing from around the world towards the US and its higher interest rates and appreciating currency, the Chinese authorities would be mindful of the capital flight their financial system experienced in 2015, when an estimated $US1 trillion-plus fled the system amid diverging monetary policies in China and the US.

A disorderly fall in the value of the yuan would generate financial instability at a time when China’s financial system is, while not acutely vulnerable, more vulnerable than it has been.

The property market’s implosion and the losses emanating from it, widespread boycotts by mortgagors, huge losses on Xi’s $US1 trillion “Belt and Road” program (on some estimates more than half the loans have been to countries now in financial distress and will now need to be restructured), the severity of the impact of the COVID lockdowns on businesses, spiking energy prices and floods and droughts have made this a very difficult year for China’s economic policymakers.

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The global economic slowdown is gathering pace, which will impact the demand for China’s exports that boomed during the worst of the pandemic and, while tapering, has remained strong until quite recently.

The probable recession in Europe and the potential recession in the US as the Federal Reserve keeps ratcheting up interest rates will create an offshore dimension that will add to China’s domestic difficulties. This is not the backdrop Xi would ever have envisaged when he removed the presidential term limits in 2018 so that he could gain a third term and cement his place in China’s history at next month’s party congress.

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