Editor's note: This is the first installment of a three-part series about China's economic rebalancing. Part 1 analyzes the problems Chinese policymakers are trying to solve, as well as those China's evolving economic model is causing.
China's economic rise over the past four decades has been nothing short of remarkable. With economic growth averaging nearly 10% annually since 1980, Chinese policymakers have proved adaptable and effective, in part due to China's state-capitalist economic system. This system offers a closed capital account, extensive state ownership and a prominent — even dominant — government position in the economy. As a result, policymakers can intervene forcefully and quickly to safeguard financial stability and maintain high economic growth.
However, China appears to have changed tactics and strategy. Instead of forcefully kickstarting the country's economic growth following the COVID-19-induced slump, the government has primarily limited itself to microeconomic reforms. Since then, most economists have downgraded China's growth potential to well below 5%, China appears to be on the verge of sliding into deflation, and recent defaults of major real estate developers have raised concerns about financial stability.
This shift in strategy is part of a broader rebalancing of China's economy as the country aims to stave off even greater economic and financial problems in the future. While policymakers have the tools to avoid a financial crisis as they manage this rebalancing, it remains risky, and it is far from clear what policies will replace China's defunct economic model in the coming years.
The problem of overinvestment
One major problem Chinese policymakers are trying to solve is the issue of overinvestment in unproductive sectors. This problem begins with China's high savings rates, which have underpinned the country's economic model for the last several decades and are currently at 45% of gross domestic product. By comparison, America's savings rate has not exceeded 20% of GDP in the past two decades.
In national accounting terms, savings are the share of national income that is not consumed. Savings can be converted into investments or exported in the form of current account surpluses. Since peaking at a massive 10% of GDP in 2007, China's current account surplus has declined to around 2% of GDP or less following the massive stimulus program launched at the height of the financial crisis in 2008. This leaves 43% of GDP (savings minus China's current account surplus) to be converted into investment.
China has invested most heavily in real estate and productivity-enhancing infrastructure projects, which boomed during the government's aforementioned stimulus program in 2008. For a while, China supported this boom, as housing and infrastructure projects were necessary parts of the country's urbanization. However, demand for real estate and infrastructure projects has since declined, leading to dangerous overinvestment.
Financially, overinvestment in real estate and infrastructure projects has increased financial risks. For example, excess apartments in cities with undeveloped real estate markets will remain unoccupied, at least for now, resulting in financial losses for investors and real estate developers. Additionally, unused real estate will not increase the productive potential of the economy. As a result, overinvestment in this sector is weighing on China's economic growth, relative to more productive, alternative investment elsewhere in the economy. Or at least, this type of economic growth is bound to be unsustainable and lead to significant financial losses.
These factors mean China is increasingly unable to convert part of its savings, which comprise a massive percentage of its GDP, into profitable investments. If this trajectory continues unabated, major medium- and long-term economic and financial risks will follow. To break this pattern, China needs to find alternative, profitable investment opportunities into which it can pour its excess savings. Structural economic reform would help aid this transition.
The risks of rebalancing
Until recently, China's government reluctantly intervened in the real estate and infrastructure sectors by bailing out debt-burdened developers and local government-related entities when their projects failed to provide sufficient returns. This interventionist policy prevented many investors from incurring too many losses and kept the real estate sector running smoothly. However, this strategy failed to motivate developers and investors to manage associated financial risk more wisely. As a result, they continued to invest money in unproductive projects, which helped prevent a broader macroeconomic adjustment.
To break this cycle, Chinese policymakers introduced the "three red lines" policy in 2020, which forced real estate developers to reduce the amount of borrowed money they use to make investments. This policy exposed developers' accumulated financial risks, and many large developers defaulted on their debt as a result. This time, the government did not bail them out, forcing developers to deal with the consequences of their poor risk management. These defaults have slowed investment in the real estate sector overall, which was a key goal of Chinese policymakers.
However, reduced investment and growth in the real estate sector (which, by some estimates, accounts for 25% of China's GDP), is slowing the country's overall economic growth. While Chinese policymakers view this slowdown as a reasonable price to pay to avoid further financial risks and the continued misallocation of savings, their economic rebalancing strategy has begun to have second-round effects. These include stagnating or falling real estate prices, as well as financial losses incurred by banks, individual investors and local governments.
Regarding the latter issue, a sharp reduction in housing-related income from land sales, on which local governments depend for revenues, will significantly restrict local governments' budgets. In addition, local governments often raise funds for infrastructure and housing projects through local government financing vehicles (LGFVs). If these investments go bad, local governments may have to bail out their LGFVs, incurring further financial losses. Therefore, economic rebalancing will put significant financial pressure on local governments.
Due to the risks of slowing investment in the real estate sector, Beijing must tread a fine line between rebalancing the economy and limiting the economic slowdown and financial losses. This requires a carefully calibrated policy that accounts for short-term and systemic financial stability, as well as medium- and long-term economic sustainability.
