After Xi Jinping abruptly nixed a host of repressive COVID-19 restrictions at the beginning of 2023, life in China was supposed to return to normal. But its economy is looking anything but. The central problem at the moment is a long-gestating real-estate crisis, but there are plenty of other indicators flashing red in a country that has become accustomed to steady growth, not crisis. And Xi, an ideologue whose crackdowns on private enterprise and pandemic measures have helped fuel widespread uncertainty, may be exactly the wrong leader to solve the problem. To understand the state of play in China and how it might affect the rest of the world, I spoke with economist Brad Setser, a senior fellow at the Council on Foreign Relations and former staffer at the Treasury Department, who frequently writes on the subject.
Every day seems to bring another headline about the weakness of China’s economy. Consumer spending is down, youth unemployment is way up — the government even stopped publishing statistics on that. Is there one concrete thing you can point to as a reason for this malaise? Or do you think this is mostly a vicious cycle where everything is going wrong at once because overall confidence has been shattered?
I think there is one fundamental reason for the malaise, and in some sense it is concrete. It is the slowing down of China’s property sector, the fall in new construction, the modest fall in housing prices. A lot of housing prices are artificially being maintained at a high level through various regulations. They’re not being allowed to fall. The property sector, property development, building new apartments, associated infrastructure, furnishing those apartments and the like — had been the biggest component of China’s economy, close to 25 percent of it. That sector is now shrinking. It’s probably between 5 and 10 percent. So you just have a really substantial drag on overall activity coming from the property sector. And of course, that is spilling over and having some impacts on broader household confidence. But I think fundamentally, this is about a long-term downshift in the pace of sustainable residential and commercial-property development and the associated adjustments in China’s economy.
Was this a predictable outcome in some way, since the boom times had lasted so long and they perhaps weren’t sustainable? Or did it come as a surprise to you and other people who follow this closely?
I think it’s been a surprise that this downturn has persisted for as long as it has and that there hasn’t been a stronger policy response to date. That said, there was clearly going to come a time when new construction, which was tightly linked to a series of financial excesses, was going to come down, and that was going to pose a challenge to China’s economy. But the precise timing of the slowdown was clearly initially a policy choice. The “three red lines” policy that triggered the initial property correction was an intentional attempt to deflate a property bubble. And the persistence of this downturn does seem to reflect the fact that the Chinese political system has had some difficulty coming up with a coherent response. But fundamentally, this was both a predictable crisis, and the timing and persistence has been a little bit of a surprise.
Zero COVID-19 had limited the activities of ordinary Chinese households during certain periods, and that had deeply isolated China from the rest of the world. I think the overarching assumption six months ago was that the end of those restrictions would lead to some modest recovery along the lines that other economies experienced when COVID-19 restrictions were lifted. So it certainly has been a surprise that in a sense the negative spillovers from the weak property market on consumer confidence have been stronger than any of the expected rebound in consumption.
President Xi appears philosophically opposed to the kind of direct stimulus that the U.S. carried out during COVID-19 — and you’ve called his stance “troubling.” Is that because you think it’s pretty much the only way out of this crisis for the central government given that local governments are so tied up with debt?
I don’t know if it’s the only way out. I think it’s the best way out. There are two striking things to me about China’s economy. One is that household consumption is an incredibly low share of overall activity. In that sense, China’s economy has been fundamentally different from other ones. In China, property investment, infrastructure investment, manufacturing investment are much bigger drivers than household consumption. Usually, it’s the reverse. In the U.S. and Europe, household consumption drives the cycle. And then the second striking factor is that the central government has essentially no debt. Central government debt has different definitions, but including the railway ministry, it’s 25 percent of GDP, which is a fraction of the debt of the U.S. federal government. It’s a fraction of the debt of France. It’s well below the debt of Germany, which is by far the most frugal of the major advanced economies.
So you combine those two things, and the obvious response to a downturn is to use the fiscal capacity that the central government retains to directly help households, whether that’s sending out checks or rebating China’s version of the payroll tax. Or you could even think of it as finding a way to reduce out-of-pocket health-care expenses in the way that the U.S. government picked up the costs of COVID-19 shots. But there’s different ways of directly supporting households and household income or expanding unemployment insurance, for example. And it is striking that China has shied away from those measures. It also shied away from those measures after the initial COVID-19 shock, but strong global demand helped China recover without the household stimulus that the U.S. and Europe provided.
But that would be harder now because demand has gone down for Chinese goods in places like the U.S., right? They can’t export their way out of this like before.
I would say it’s normalized in the U.S. It’s starting to normalize in Europe. If you look at China’s exports to Europe, they’re still well above where they were in 2019. Way above. They’re just no longer growing. So, it’s a bit of a correction. To me, “it’s going down” has a connotation of a deeper fall than an adjustment. The level is going to remain quite strong. But China had gotten used to being able to grow by selling to the rest of the world. Net exports have contributed a very significant part of China’s growth in 2020, 2021, even 2022, and that’s not going to be the case this year.
But going back to the bigger point, it does seem like the most plausible explanation for why China hasn’t responded to the COVID-19 shock with direct support for household income and why it hasn’t responded to the current downturn with more direct support for household income is that the folks at the top, President Xi included, just don’t believe in it. And that is, to me, worrisome. The other ways that China can recover are more dangerous, either more dangerous to China or riskier for the world.
What else can they do?
There are other options. I think they’re unappealing, but there are other options. The preferred option that Chinese policymakers seem to be hinting at is that they will just accept somewhat below-target growth. There’s an argument that the outside observers are more worried than Chinese policymakers are and that Chinese policymakers simply have accepted that resolving the excesses in the property market and implementing some of Xi’s long-term policies to strengthen China’s technical autonomy will have some short-term costs. And they’re not too worried about an economy that isn’t growing as fast as it has in the past.
Another option is to relax a series of regulatory requirements — push the state-banking system really hard to lend to the property sector, to lend to support local governments, to disregard concerns about long-term solvency, and try to get more growth from infrastructure to stabilize the property sector. And the banking system is still fundamentally state-dominated, so this is not an implausible option. China does seem reluctant to do that because it likely means doubling down on a series of risky bets and probably adds to the long-term losses that this banking system faces.
And the third is to let the currency fall quite significantly, deal with the associated effects on internal confidence, and try to export your way out of a property downturn. Countries around the world in the face of big construction booms and busts often see very large swings in their current account or their trade balance tied to the property cycle. And so, even though China has a big trade surplus today, you could imagine that China might try — I think there’ll be some constraints on this — but they might try to export their way out of this downturn. So I think that there are options, just the other options aren’t as constructive, so to speak, for both the Chinese economy and the global economy.
And of course, there’s no election to deal with.
Xi just got five years, and presumably he’ll get another five years. There’s no successor who’s been designated.
The consensus seems to be that this crisis won’t affect the U.S. much right now, but that if things devolve, there could be more ripple effects. Do you agree with that?
If you’re not the owner of a company that gets a lot of its profits from Chinese sales, the direct impacts of a Chinese slowdown on the U.S. economy are pretty modest. China’s economy has already slowed over the past nine months, and the U.S. economy has continued to grow. Relative to the size of its economy, China remains a pretty modest market for U.S. exports. Manufactured exports to China are only a half point of U.S. GDP because China just doesn’t import that many manufacturers. If you’re an American working in parts of the economy that produce commodities, you should be paying a lot of attention to China because it’s by far the biggest source of global demand for many commodities and commodity markets. Those markets respond to many things, including supply conditions, but a structural slowdown in China will have some impact there.
Financial interlinkages are small, but the big way I think China could negatively impact the U.S. economy is that if China decides to export its way out, the U.S. is still the biggest market for consumer goods and the biggest market for imported goods globally. And while there are tariffs, the tariffs are imperfect. It’s easy to get around a tariff on China by assembling Chinese parts in Malaysia and Vietnam and the like.
And so I think that if China really wanted to export its way out, let its currency go, there would be a big further depreciation in the Yuan. And the Yuan’s already a 15-year low, more or less. If the Yuan goes back to the levels where it was when China joined the WTO, without an enormous ratcheting up of trade restrictions, there would be pressure on certain parts of the U.S. economy that I think would be meaningful. So, to me, it does still matter how China reacts, how China responds. If it’s just a growth slowdown, the direct impact on the U.S. is pretty modest, just because China never allowed American companies to produce in the U.S. for sale through China. The only big company that succeeded at doing that was Boeing, and China stopped buying Boeing several years ago.
But U.S. companies do compete with China. And third-party markets compete with China to make certain goods for sale in the U.S. There’s no doubt that China has the biggest manufacturing base in the world. And those parts of the U.S. economy that compete with it may face difficulty if China can’t find a way to recover other than exports.
Are there any other major economies more intertwined with China that might see worse effects?
Sure. Among the advanced economies, Germany has significantly more connections. Germany’s been much more successful selling capital goods and luxury cars that are made in Germany to China than other major economies have been at selling goods made in their countries to China. So Germany has a substantially more direct trade exposure. The rest of Europe is a little bit more like the U.S. — China is not that important a market. It’s not a trivial market, it’s just not such a big market that it’s going to drive activity. A lot of Southeast Asia and East Asia is tightly connected to China. A big part of that connection, though, is producing components that go into the Chinese export machines.
They wouldn’t necessarily be hurt if China ends up exporting its way out, but there would be more spillovers just naturally from the Chinese slowdown. And then it depends how the commodity market reacts. So far, we haven’t had a big commodity market correction for complex reasons, but there’s lots of other shocks happening around the world: Russia and Ukraine on the grain market, the Saudis managing the price of oil, and so on. But the commodity exporters typically have the largest direct exposure to internal Chinese demand. And so there could be more spillovers there.
This interview has been edited for length and clarity.
