China’s economic landscape is at a critical juncture as it grapples with the specter of deflation and the ominous specter of “Japanification.” Recent inflation data revealed stagnant consumer prices and a continued decline in factory gate prices, marking the ninth consecutive monthly decrease with a significant drop of 5.4 percent year-on-year.
In a departure from the norm since the 2008 financial crisis, China finds itself facing deflation driven primarily by domestic factors and structural issues rather than external influences, though the weakened global growth environment exacerbates the challenges at hand.
Debt serves as the core predicament, posing a significant hurdle to effective responses. China’s debt-to-GDP ratio has surged to approximately 280 percent, surpassing the average ratio of about 256 percent found in developed economies globally.
Contrary to popular belief, the central government bears little responsibility for this alarming debt burden. Instead, local governments, businesses, and households have played major roles in driving China’s debt levels to unprecedented heights. Local governments contribute around 30 percent to China’s GDP, with their financing vehicles accounting for an additional 40 to 50 percent, according to Fitch Ratings. These entities now face massive overleveraging and revenue shortfalls, relying heavily on property sales to developers as their primary income source.
President Xi Jinping’s 2020 crackdown on property developers—enforced through policies such as the “three red lines”—devastated the sector, resulting in a loss of revenue for local governments. In response, local governments often turned to their financing vehicles to replace developers as land buyers, further compounding the problem.
Despite Beijing’s efforts to alleviate the strains faced by local governments and better-managed developers through concessional funding and loan repayment holidays, the construction sector—previously a key driver of China’s growth—remains depressed. Consequently, local government finances are under increasing stress.
Furthermore, households and businesses, fatigued by the effects of the pandemic lockdowns and stringent “zero COVID” policies that persisted for two years until late 2021, have become more cautious. Initial expectations of a robust consumer-led rebound have given way to conservative spending habits. Given that household wealth in China is largely concentrated in property investments, the turmoil in the sector and the experiences of those who invested in uncompleted or yet-to-be-built apartments have had a chilling effect on consumer spending. In a system with limited social safety nets, consumers prioritize debt reduction over consumption.
The unemployment rate among urban youth stands at over 20 percent, while the rural-to-urban migration—previously a significant driver of China’s economic growth—has slowed. These factors further contribute to the challenges faced by businesses, particularly in the private sector, which are grappling with weak demand and apparent overcapacity within the economy. Retailers resorting to price cuts to stimulate demand are also squeezed, as these efforts undermine profit margins.
China’s policymakers are acutely aware of the Japanese experience, wherein the interaction between a property boom and debt led to three decades of economic stagnation. However, recent crackdowns on private businesses, particularly within the tech sector, and the shift toward state-owned enterprises under the banner of “common prosperity” have injected significant uncertainty into the private sector, which typically accounts for the majority of urban employment.
As the global economy slows and global supply chains undergo restructuring in response to the pandemic, tensions such as the conflict in Ukraine and escalating frictions between China and the United States have further dampened external demand for Chinese manufactured goods. Consequently, China’s weakening exports have adversely affected foreign investment, compounded by substantial losses experienced by foreign lenders in the property sector. The US and its allies have imposed restrictions on high-tech exports to China, and Chinese authorities have targeted foreign consultancies while tightening access to economic and business data.
The Chinese authorities have cautiously introduced measures to stimulate growth. The People’s Bank of China has gradually reduced policy rates and encouraged banks to lend more at lower costs to mortgage borrowers. Targeted measures have been implemented in the property sector, as well as in related industries such as home decor and white goods. Discussions of incentives for electric vehicle purchases have also emerged. However, the large-scale stimulus programs seen in response to the 2008 financial crisis are unlikely to be replicated. While those measures generated double-digit economic growth rates, they also left behind wasteful projects and ghost cities, prompting caution in implementing similar strategies.
Anticipating the next quarterly meeting of the Politburo later this month, it is expected that additional efforts to stimulate growth in the property sector and measures to boost consumer demand will be unveiled. However, large-scale cash handouts or tax cuts for households and businesses are unlikely, as recipients are more likely to save or use the extra funds to pay down debt rather than spend them.
China’s economic challenges pose risks not only to its own future but also to global trading partners such as Australia. As Australia closely monitors the trajectory of its largest trading partner’s economy, proactive measures are imperative to mitigate potential consequences. Australia must carefully strategize its response, safeguarding its economic well-being while contributing to global stability.
With China’s population now shrinking and aging, short-term relief measures alone will not suffice. Structural changes are necessary to prevent China from being ensnared in a low-growth, middle-income trap that would compromise Xi’s ambitions of toppling the US as the dominant global power. Moreover, such a scenario would elevate the risk of civil unrest. In the interest of all nations, particularly Australia, collaborative efforts are essential to help China avoid a downward spiral into persistent deflation. By achieving its targeted GDP growth rate and aiding global economic stability, China can play a vital role in moderating or avoiding a global recession.
