China’s Recovery Is Struggling. There’s an Upside for the Fed.

While this hardly bodes well for China’s long-term economic outlook, it does offer the Federal Reserve and the European Central Bank hope of much-needed inflation relief.

A host of recent economic data paint the picture of a Chinese economy in trouble. Over the past year, consumer prices have flatlined while producer prices have fallen by 5.4%. Manufacturing output, exports, and investment are all falling. Youth unemployment has risen to a worrying 20.8% in May.

China’s economic policy makers spent the past decade pursuing a highly unbalanced growth model. The result was an enormous property and credit-market bubble that is now at the heart of China’s economic malaise. 

Chinese credit expansion to the nonfinancial private sector has increased by almost 100% of gross domestic product since 2008, according to the Bank for International Settlements. That is a faster pace of credit expansion than that which preceded Japan’s lost economic decade in the 1990s and that which preceded the U.S. 2007-2009 financial-crisis recession.

The flip side of the Chinese credit-market bubble has been a housing-market bubble. The Chinese property sector has come to account for almost 30% of the Chinese economy, according to a study by Harvard’s Kenneth Rogoff and the IMF’s Yuanchen Yang. That compares with 20% or less in the U.S. and other developed countries. At the same time, home prices in relation to income in a number of major Chinese cities well exceeded those in London and New York. Around 65 million Chinese dwellings were estimated to be unoccupied in 2021.

Yet another indication of economic imbalance has been the overreliance of the Chinese local governments on land sale revenues. In 2021, at the peak of the Chinese housing market boom, those sales accounted for over 40% of the local government’s overall revenues.

The end of Xi’s zero-Covid policy last year helped burst the property and credit market bubble. China’s economic growth slowed to barely 3%, its second-slowest growth rate in more than 40 years. Meanwhile, a number of major Chinese property developers, including most notably Evergrande, have defaulted on their debts, as foreign confidence in the Chinese economy has waned.

Chinese home prices have been declining for the past year. A number of important Chinese local governments appear to be in financial difficulty due to dwindling land sales.

The Chinese government now appears to find itself in an economic-policy box. Further monetary and fiscal policy support to the housing market might provide short-term economic relief. However, that would exacerbate the eventual day of reckoning from the property and credit market bubbles. The central bank might consider aggressive interest-rate cuts. But causing the Chinese currency to depreciate might invite further U.S. trade restrictions. The Chinese currency has already depreciated by around 7% percent against the dollar over the past year.

This adds up to a grim long-term economic outlook for China. But there may be a silver lining for the rest of the world’s struggles with sticky inflation.  China is the world’s largest goods exporter. Falling Chinese producer prices and a depreciating Chinese currency could make a meaningful dent in the rest of the world’s import bill. Similarly, China is the world’s largest consumer of internationally traded commodities. Prices have already declined by around 21% this year. A slowing Chinese economy could exert further downward pressure.

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