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China’s Slowdown and Deflation Risks: Why it Matters for the Global Economy

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China’s post-pandemic economic recovery is slowing, following declining demand for the country’s exports and sluggish growth of domestic consumption. Ongoing real estate market problems spark concerns over the stability of China’s financial system, risking a deeper downturn for the Chinese economy. Weakening growth and rising risks in the world’s second largest economy can have significant impacts on the global economy, with important implications for global businesses and consumers.

Euromonitor International answers the most frequently-asked questions around China’s economic challenges.

What is happening with China’s economy?

After a dynamic post-pandemic recovery at the start of the year, China’s economic growth started to lose steam in Q2 2023. Exports, once a consistent growth driver, are now struggling. China’s exports contracted by 14.5% in July 2023 - the fastest decline since the outbreak of COVID-19. Weaker global demand and rising geopolitical tensions are hurting Chinese exporters.

On the domestic consumption side, ongoing real estate market problems dampen investments, while consumer spending is weakening, as Chinese consumers become more cautious about job, income and economic prospects. In June 2023, the youth unemployment rate rose to a record high of 20.0% of the urban population aged 16 to 24 years old. Retail sales in July 2023 slowed and expanded by 2.3% y-o-y, while weakening consumer demand also tipped consumer prices into deflationary territory (consumer prices fell by 0.3% in July y-o-y).

China’s GDP will grow by 5.3% in real terms in 2023 and 4.7% in 2024

Source: Euromonitor International Q3 2023 baseline forecasts

Projected growth rates for China in 2023-2024 are higher than the 3.0% growth the country recorded in 2022. However, a growth rate of around 5.0% is significantly lower than the economy’s pre-pandemic trend, which averaged 7.7% annually during 2010-2019. To stimulate the economy, the People’s Bank of China cut interest rates in June and July 2023. However, additional fiscal stimulus, in the form of tax breaks or incentives for manufacturers, is likely to be required to boost economic growth.China's Slowdown and Deflation Risks chart1.svg

Why is deflation in China a worry?

Consumer prices in China entered deflationary territory in July 2023, a typical sign of a weakening economy. The real danger is that as the expectations of falling prices become entrenched, companies postpone investing and consumers further postpone spending. This will in turn lower domestic demand, again hitting economic growth.

In China’s case, deflation can worsen the country’s debt burden, as the real value of debts rises amid falling prices. As a result, China’s companies and local governments will have to allocate greater financial resources to service debt, leaving fewer resources for spending and investment. According to the Bank of International Settlements, China’s total debt burden (private and public debt) is already high and reached almost three times domestic GDP in 2022, higher than the debt level of the US.

Although China’s deflation is likely to be temporary, given the base effects and a rise in core inflation, deflationary pressures are significant. The ultimate challenge for the Chinese authorities will be finding a way to stall the self-propelling spiral of lower prices, weaker demand, lower output and higher unemployment.

How is China’s manufacturing sector performing?

So far, the manufacturing sector in China has managed to sustain growth despite the challenges. However, growth is stalling.

Industrial production grew by 3.7% in July 2023 y-o-y, slower than 4.4% growth registered in June

Source: National statistics data

Similarly, investments in fixed assets grew by 3.4% in the first half of 2023 in comparison to 3.8% rate a year ago.

Chinese factories are struggling with weaker demand in the export markets and problems in the domestic construction industry. Excess capacity and inventories are also weighing on profit margins, resulting in declining manufacturers’ prices. Lastly, geopolitical tensions are adding to the challenges. National statistics data show that FDI in China in Q2 2023 stood at USD4.9 billion, the lowest since 1998, as political tensions and changes in regulations discourage foreign companies from investing in China.

Weaker demand and production growth is reflected in future expectations of Chinese companies. The official manufacturing Purchasing Managers’ Index (PMI) has stayed below the 50-point threshold since April 2023, indicating contraction in factory activities. Business confidence also remains on the downward trend. As domestic demand and exports struggle, manufacturing and the broader B2B sectors are predicted to show a subdued performance over the course of 2023.China's Slowdown and Deflation Risks chart2.svg

Can problems in China’s real estate sector lead to a financial crisis?

Construction and real estate sectors play an important role in China’s economy.

In 2022, construction and real estate industries accounted for 13% of total output and directly employed 11% of workers

Source: Euromonitor International from national statistics

Therefore, a crash of the real estate sector will severely affect economic growth and could cause broader problems in the financial sector.

According to national statistics, property investment in China fell by 8.5% over January-July 2023, while new construction starts plunged by almost 25%. Consumer demand for real estate remains subdued. People’s Bank of China data show that the amount of loans issued to households, mostly consisting of mortgages, fell by CNY200.7 billion in July 2023.

Turmoil in the housing market is causing liquidity problems for developers and can spill over into the broader financial markets. One of the largest surviving Chinese developers Country Garden Holdings missed two dollar bond interest payments in August 2023, fuelling broader problems in the financial markets. Chinese banks already opened USD430 billion of credit lines to troubled developers back in 2022, though ongoing problems for real estate may require more resources. In the short term, both banks and government authorities must develop debt restructuring plans for real estate developers to prevent the problems from spreading into financial markets and the broader economy.China's Slowdown and Deflation Risks chart3.svg

What if China sees a deeper economic downturn?

Euromonitor International’s China Slowdown scenario captures the outcome of a worsening of China’s short-term growth outlook and long-term growth potential, and its consequences on China and the global economy. A deeper slump in China’s property market along with declining asset prices could lead to defaults, erode confidence in the financial system and cause capital flight, currency depreciation and rise in unemployment. Meanwhile, a faster population decline and slowdown in productivity growth would undermine China’s long-term growth potential. Under this scenario, China’s real GDP growth could be shaved off by 0.3-1.2 percentage points in the first and second year, relative to the baseline.China's Slowdown and Deflation Risks chart4.svg

A sharper slowdown of China with weakening consumer spending and investment would have negative spillover effects on global economies through trade and commodity linkages. As such, in Euromonitor International’s China Slowdown scenario, the global economy could see slower growth by 0.1-0.5 percentage points in 2023-2024 relative to the baseline. Developing economies - especially countries with a high trade exposure to China - will be more affected by a Chinese slowdown.

Does China’s economy face the risk of a lost decade?

Mounting problems in the real estate sector, turmoil in the financial markets, stalling domestic consumption and deflation risk are fuelling the fears that China might face a “lost decade” with stagnation, just as Japan did in the 1990s when the real estate bubble burst.

Oversupply of housing combined with falling consumer demand is leading to concerns of long-term decline for the real estate sector. Structural demand problems, such as shrinking and ageing population, are also adding to the challenges. For example, the total population in China is predicted to shrink by 1% over the next decade, while the number of people aged 65+ years is forecast to grow by 44%. This indicates that long-term demand for housing and real estate will remain suppressed and the real estate sector would face a prolonged period of decline.

The situation between China today and Japan in the 1990s is different as China’s economic downturn and debt problems are not at the level of Japan’s crisis three decades ago. In the long term, however, China is unlikely to return to its pre-pandemic growth trajectory of 7.0-8.0%, given its ageing population and related structural demand problems. Nevertheless, there is an opportunity for more sustainable growth that is not led by a construction boom.

How can China’s slowdown and deflation risk impact economies and businesses?

While a slowdown of China’s economy will lead to overall slower growth for the global economy, its impact on different economies and businesses is mixed. On the negative side, weaker B2B and private consumption growth will hit exporters to China and retailers in the country. China is one of the largest consumers of machinery, hi-tech goods, as well as luxury goods. In addition, slower growth in China will negatively affect commodity exporters, especially Latin American countries and Australia.China's Slowdown and Deflation Risks chart5.svg

Higher cost of imported goods was one of the reasons causing higher inflation; thus lower prices of manufactured goods in China can help to ease price pressures.

Lower production prices and depreciation of China’s yuan renminbi can contribute to lower global inflationary pressures

Source: Euromonitor International

Slower economic growth in China could also benefit Europe, as it will reduce competition in the global energy and especially, natural gas markets. European countries are particularly vulnerable to natural gas price shocks and lower prices can help to ease energy price pressures.

There are also fears that falling prices of Chinese goods will increase competition and hurt foreign companies. However, this is unlikely to cause any significant changes to the global competition landscape over the medium term as it requires a prolonged period of deflation and currency depreciation to feel the effects.

Further insights into China and global economic outlook are available at Global Economic Forecasts: Q3 2023.

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