The End of China’s Economic Miracle

As 2022 came to an end, hopes were rising that China’s economy—and, consequently, the global economy—was poised for a surge. After three years of stringent restrictions on movement, mandatory mass testing, and interminable lockdowns, the Chinese government had suddenly decided to abandon its “zero COVID” policy, which had suppressed demand, hampered manufacturing, roiled supply lines, and produced the most significant slowdown that the country’s economy had seen since pro-market reforms began in the late 1970s. In the weeks following the policy change, global prices of oil, copper, and other commodities rose on expectations that Chinese demand would surge. In March, then Chinese Premier Li Keqiang announced a target for real GDP growth of around five percent, and many external analysts predicted it would go far higher.

Initially, some parts of China’s economy did indeed grow: pent-up demand for domestic tourism, hospitality, and retail services all made solid contributions to the recovery. Exports grew in the first few months of 2023, and it appeared that even the beleaguered residential real estate market had bottomed out. But by the end of the second quarter, the latest GDP data told a very different story: overall growth was weak and seemingly set on a downward trend. Wary foreign investors and cash-strapped local governments in China chose not to pick up on the initial momentum.

This reversal was more significant than a typical overly optimistic forecast missing the mark. The seriousness of the problem is indicated by the decline of both China’s durable goods consumption and private-sector investment rates to a fraction of their earlier levels, and by Chinese households’ increasing preference for putting more of their savings in bank accounts. Those trends reflect people’s long-term economic decisions in the aggregate, and they strongly suggest that in China, people and companies are increasingly fearful of losing access to their assets and are prioritizing short-term liquidity over investment. That these indicators have not returned to pre-COVID, normal levels—let alone boomed after reopening as they did in the United States and elsewhere—is a sign of deep problems.

What has become clear is that the first quarter of 2020, which saw the onset of COVID, was a point of no return for Chinese economic behavior, which began shifting in 2015, when the state extended its control: since then, bank deposits as a share of GDP have risen by an enormous 50 percent and are staying at that high level. Private-sector consumption of durable goods is down by around a third versus early 2015, continuing to decline since reopening rather than reflecting pent-up demand. Private investment is even weaker, down by a historic two-thirds since the first quarter of 2015, including a decrease of 25 percent since the pandemic started. And both these key forms of private-sector investment continue to trend still further downward.

Financial markets, and probably even the Chinese government itself, have overlooked the severity of these weaknesses, which will likely drag down growth for several years. Call it a case of “economic long COVID.” Like a patient suffering from that chronic condition, China’s body economic has not regained its vitality and remains sluggish even now that the acute phase—three years of exceedingly strict and costly zero-COVID lockdown measures—has ended. The condition is systemic, and the only reliable cure—credibly assuring ordinary Chinese people and companies that there are limits on the government’s intrusion into economic life—cannot be delivered.

China’s development of economic long COVID should be recognized for what it is: the result of President Xi Jinping’s extreme response to the pandemic, which has spurred a dynamic that beset other authoritarian countries but that China previously avoided in the post–Mao Zedong era. Economic development in authoritarian regimes tends to follow a predictable pattern: a period of growth as the regime allows politically compliant businesses to thrive, fed by public largess. But once the regime has secured support, it begins to intervene in the economy in increasingly arbitrary ways. Eventually, in the face of uncertainty and fear, households and small businesses start to prefer holding cash to illiquid investment; as a result, growth persistently declines.

Since Deng Xiaoping began the “reform and opening” of China’s economy in the late 1970s, the leadership of the Chinese Communist Party deliberately resisted the impulse to interfere in the private sector for far longer than most authoritarian regimes have. But under Xi, and especially since the pandemic began, the CCP has reverted toward the authoritarian mean. In China’s case, the virus is not the main cause of the country’s economic long COVID: the chief culprit is the general public’s immune response to extreme intervention, which has produced a less dynamic economy. This downward cycle presents U.S. policymakers with an opportunity to reset the economic leg of Washington’s China strategy and to adopt a more effective and less self-harming approach than those pursued by the Trump administration and—so far—the Biden administration.

NO POLITICS, NO PROBLEMS, NO MORE

Before the pandemic, the vast majority of Chinese households and smaller private businesses relied on an implicit “no politics, no problem” bargain, in place since the early 1980s: the CCP ultimately controlled property rights, but as long as people stayed out of politics, the party would stay out of their economic life. This modus vivendi is found in many autocratic regimes that wish to keep their citizens satisfied and productive, and it worked beautifully for China over the past four decades.

When Xi took office in 2013, he embarked on an aggressive anticorruption campaign, which along the way, just happened to take out some of his main rivals, such as the former Politburo member Bo Xilai. The measures were popular with most citizens; after all, who would not approve of punishing corrupt officials? And they did not violate the economic compact, because they targeted only some of the party’s members, who in total make up less than seven percent of the population. A few years later, Xi went a step further by bringing the country’s tech giants to heel. In November 2020, party leaders made an example of Jack Ma, a tech tycoon who had publicly criticized state regulators, by forcibly delaying the initial public offering of one of his companies, the Ant Group, and driving him out of public life. Western investors reacted with concern, but this time, too, most Chinese were either pleased or indifferent. How the state treated the property of a few oligarchs was of little relevance to their everyday economic lives.

The government’s response to the pandemic was another matter entirely. It made visible and tangible the CCP’s arbitrary power over everyone’s commercial activities, including those of the smallest players. With a few hours’ warning, a neighborhood or entire city could be shut down indefinitely, retail businesses closed with no recourse, residents trapped in housing blocks, their lives and livelihoods put on hold.

Economic long COVID will likely plague the Chinese economy for years.

All major economies went through some version of a lockdown early in the pandemic, but none experienced anything nearly as abrupt, severe, and unrelenting as China’s anti-pandemic measures. Zero COVID was as unsparing as it was arbitrary in its local application, which appeared to follow only the whims of party officials. The Chinese writer Murong Xuecun likened the experience to a mass imprisonment campaign. At times, shortages of groceries, prescription medicines, and critical medical care beset even wealthy and connected communities in Beijing and Shanghai. All the while, economic activity fell precipitously. At Foxconn, one of China’s most important manufacturers of tech exports, workers and executives alike publicly complained that their company might be cut out of global supply chains.

What remains today is widespread fear not seen since the days of Mao—fear of losing one’s property or livelihood, whether temporarily or forever, without warning and without appeal. This is the story told by some expatriates, and it is in keeping with the economic data. Zero COVID was a response to extraordinary circumstances, and many Chinese believe Xi’s assertion that it saved more lives than the West’s approach would have. Yet the memories of how relentlessly local officials implemented the strategy remain fresh and undiluted.

Some say the CCP’s decision to abandon zero COVID in late 2022 following a wave of public protest indicated at least some basic, if belated, regard for popular opinion. The about-face was a “victory” for the protesters, in the words of The New York Times. Yet the same could not be said for ordinary Chinese people, at least in their economic lives. A month before the sudden end of zero COVID, senior party officials told the domestic public to expect a gradual rollback of pandemic restrictions; what followed a few weeks later was an abrupt and total reversal. The sudden U-turn only reinforced the sense among Chinese people that their jobs, businesses, and everyday routines remain at the mercy of the party and its whims.

Of course, many other factors were at play in the immense, complex Chinese economy throughout this period. Business failures and delinquent loans resulted from a real estate bubble that burst in August 2021, and remain a persistent drag on growth and continue to limit local government funding. Fears of overregulation or worse among owners of technology companies also persist. U.S. trade and technology restrictions on China have done some damage, as have China’s retaliatory responses. Well before the onset of COVID, Xi had started to boost the role of state-owned enterprises and had increased party oversight of the economy. But the party had also pursued some pro-growth policies, including bailouts, investment in the high-tech sector, and easy credit availability. The COVID response, however, made clear that the CCP was the ultimate decision-maker about people’s ability to earn a living or access their assets—and that it would make decisions in a seemingly arbitrary way as the party leadership’s priorities shifted.

SAME OLD STORY

After defying temptation for decades, China’s political economy under Xi has finally succumbed to a familiar pattern among autocratic regimes. They tend to start out on a “no politics, no problem” compact that promises business as usual for those who keep their heads down. But by their second or, more commonly, third term in office, rulers increasingly disregard commercial concerns and pursue interventionist policies whenever it suits their short-term goals. They make examples of a few political rivals and large multinational businesses. Over time, the threat of state control in day-to-day commerce extends across wider and wider swaths of the population. Over varying periods, Hugo Chávez and Nicolás Maduro in Venezuela, Recep Tayyip Erdogan in Turkey, Viktor Orban in Hungary, and Vladimir Putin in Russia have all turned down this well-worn road.

When an entrenched autocratic regime violates the “no politics, no problem” deal, the economic ramifications are pervasive. Faced with uncertainty beyond their control, people try to self-insure. They hold on to their cash; they invest and spend less than they used to, especially on illiquid assets such as automobiles, small business equipment and facilities, and real estate. Their heightened risk aversion and greater precautionary savings act as a drag on growth, rather like what happens in the aftermath of a financial crisis.

Meanwhile, the government’s ability to steer the economy and protect it from macroeconomic shocks diminishes. Since people know that a given policy could be enforced arbitrarily, that it might be expanded one day and reversed the next, they become less responsive to stimulus plans and the like. This, too, is a familiar pattern. In Turkey, for instance, Erdogan has in recent years pressured the central bank into cutting interest rates, which he hoped would fuel an investment boom; what he fueled instead was soaring inflation. In Hungary, a large fiscal and monetary stimulus package failed to soften the pandemic’s economic impact, despite the success of similar measures in neighboring countries.

The same trend is already visible in China because Xi drove up the Chinese private sector’s immune response to government intervention. Stimulus packages introduced since the end of the zero-COVID policy, meant to boost consumer spending on cars and other durable goods, have not gained much traction. And in the first half of this year, the share of Chinese companies applying for bank loans remained about as weak as it was back in 2021—that is, at half their pre-COVID average—despite efforts by the central bank and finance ministry to encourage borrowing at low rates. Low appetite for illiquid investment and low responsiveness to supportive macroeconomic policies: that, in a nutshell, is economic long COVID.

Once an autocratic regime has lost the confidence of the average household and business, it is difficult to win back. A return to good economic performance alone is not enough, as it does not obviate the risk of future interruptions or expropriations. The autocrat’s Achilles’ heel is an inherent lack of credible self-restraint. To seriously commit to such restraint would be to admit to the potential for abuses of power. Such commitment problems are precisely why more democratic countries enact constitutions and why their legislatures exert oversight on budgets.

Deliberately or not, the CCP has gone farther in the opposite direction. In March, China’s parliament, the National People’s Congress, amended its legislative procedures to make it easier, not harder, to pass emergency legislation. Such legislation now requires the approval of only the Congress’s Standing Committee, which is made up of a minority of senior party loyalists. Many outside observers have overlooked the significance of this change. But its practical effects on economic policy will not go unnoticed among households and businesses, who will be left still more exposed to the party’s edicts.

The upshot is that economic long COVID is more than a momentary drag on growth. It will likely plague the Chinese economy for years. More optimistic forecasts have not yet factored in this lasting change. To the extent that Western forecasters and international organizations have cast doubt on China’s growth prospects for this year or the next, they have fixated on easily observable problems such as chief executives’ fears about the private high-tech sector and financial fragility in the real estate market. These sector-specific stories are important, but they matter far less to medium-term growth than the economic long COVID afflicting consumers and small businesses at large, even if that syndrome is less visible to foreign investors and observers. (It may be apparent to some Chinese analysts, but they cannot point it out in public.) And although targeted policies may reverse problems limited to a particular sector, the broader syndrome will persist.

China today is gripped by widespread fear not seen since the days of Mao.

In recent months, Bank of America, the Economist Intelligence Unit, and Goldman Sachs, for example, have each adjusted downward their forecasts for Chinese GDP growth in 2023, shaving off at least 0.4 percentage points. But because the persistence of economic long COVID has not yet sunk in, and because many forecasts assume, erroneously, that Beijing’s stimulus programs will be effective, China watchers still overestimate prospects for growth in the next year and beyond. Forecasts of annual GDP growth in 2024 by the Organization for Economic Cooperation and Development (5.1 percent) and the International Monetary Fund (a more modest 4.5 percent) could be off by 0.5 percent or more. The need to correct downward will only grow over time.

China’s private sector will save more, invest less, and take fewer risks than it did before economic long COVID, let alone before Xi’s second term. Durable goods consumption and private-sector investment will be less responsive to stimulus policies. The likely consequences will be a more volatile economy (because macroeconomic policy will be less effective in inducing households and smaller businesses to offset downturns) and more public debt (because it will take more fiscal stimulus to achieve the desired impact). These, in turn, will drive down average economic growth over time by reducing productivity growth, in addition to reducing private
investment in the near term.

Yet Xi and other CCP leaders may simply take this as vindication of their belief that the country’s economic future lies less with the private sector than with state-owned enterprises. Even before the pandemic, government pressure was leading banks and investment funds to favor state-owned enterprises in their lending, while investment in the private sector was in retreat. Research by the economist Nicholas Lardy has found that the share of annual investment going to China’s private-sector firms peaked in 2015 and that the state-owned share has risen markedly since then, year-over-year. Economic long COVID will reinforce this trend, for two reasons. First, private investors and small businesses will err on the side of caution and remain liquid rather than make large loan-financed bets. Second, any tax cuts or stimulus programs aimed at the private sector will deliver less immediate bang for the buck than investment in the state sector. Add to this Xi’s ongoing push for self-sufficiency in advanced technology, which is subjecting a growing share of investment decisions to even more arbitrary party control, and the outlook for productivity growth and returns on capital only dims.

OPEN-DOOR POLICY

U.S. and allied officials, some of whom see strong Chinese growth as a threat, might take heart from the country’s current ailment. But a slower-growing and less stable Chinese economy will also have downsides for the rest of the world, including the United States. If the Chinese continue to prefer saving in bank deposits rather than investing and continue to spend more on domestically delivered services than on tech and other durable goods that require imports, their overall trade surplus with the rest of the world will keep growing—any Trump-style efforts to curtail it notwithstanding. And when another global recession hits, China’s growth will not help revive demand abroad as it did last time. Western officials should adjust their expectations downward, but they should not celebrate too much.

Neither should they expect economic long COVID to weaken Xi’s hold on power in the near future. As Erdogan, Putin, and even Maduro can attest, autocrats who break the “no politics, no problem” compact tend to remain in office despite slowing, sometimes even cratering, growth. The perverse reality is that local party bosses and officials can often extract yet more loyalty from a suffering populace, at least for a while. In an unstable economic environment, the rewards of being on their good side—and the dangers of drawing their ire—go up, and safe alternatives to seeking state patronage or employment are fewer. Xi might take economic measures to paper over the cracks for some time, as Orban and Putin have done successfully, using EU funds and energy revenues, respectively. With targeted government spending and sector-specific measures, such as public-housing subsidies and public assurances that the government’s crackdown on tech firms is over, Xi might still temporarily boost growth.

But those dynamics will not last forever. As many observers have rightly pointed out, youth unemployment in China is troublingly high, especially among higher-educated workers. If CCP policies continue to diminish people’s long-term economic opportunities and stability, discontent with the party will grow. Among those of means, some are already self-insuring. In the face of insecurity, they are moving savings abroad, offshoring business production and investment, and even emigrating to less uncertain markets. Over time, such exits will look more and more appealing to wider slices of Chinese society.

Washington should think in terms of suction, not sanctions.

Even if outflows of Chinese financial assets remain limited for now, the long-term incentives are clear: for average Chinese savers, who hold most, perhaps even all, their life savings in yuan-denominated assets, buying assets abroad made sense even before the pandemic. It makes even more sense now that prospects for growth at home are diminishing, and the risks from CCP caprices are rising.

The United States should welcome those savings, along with Chinese businesses, investors, students, and workers who leave in search of greener pastures. But current policies, enacted by both the Trump and the Biden administrations, do the opposite. They seek to close off American universities and companies to Chinese students and workers. They restrict inward foreign investment and capital inflows, and they discourage Chinese companies from moving into the U.S. and allied economies, whether for production or for research and development. They reduce downward pressure on the yuan and diminish, in the eyes of ordinary Chinese people, the contrast between their government’s conduct and that of the United States. These policies should be reversed.

Easing these restrictions need not involve reducing trade barriers, however much this might benefit U.S. economic and foreign policy on its own terms. In fact, if the American economy did a better job of attracting productive Chinese capital, labor, and innovation, those inflows would partly make up for the substantial economic costs incurred as a result of the U.S. trade conflict with China. Neither would Washington need to water down national security restrictions on critical technologies. To prevent illicit technology transfers by Chinese investors, the United States and its allies should, of course, restrict access to some specific sectors, just as they restrict certain sensitive exports. In truth, however, most Chinese intellectual property theft from U.S. companies takes the form of cybercrime, reverse engineering, and old-fashioned industrial espionage—that is, for the most part, it needs to be addressed directly by means other than restricting inward foreign investment.

Removing most barriers to Chinese talent and capital would not undermine U.S. prosperity or national security. It would, however, make it harder for Beijing to maintain a growing economy that is simultaneously stable, self-reliant, and under tight party control. Compared with the United States’ current economic strategy toward China, which is more confrontational, restrictive, and punitive, the new approach would lower the risk of a dangerous escalation between Washington and Beijing, and it would prove less divisive among U.S. allies and developing economies. This approach would require communicating that Chinese people, savings, technology, and brands are welcome in the United States; the opposite of containment efforts that overtly exclude them.

Several other economies, including Australia, Canada, Mexico, Singapore, the United Kingdom, and Vietnam, are already benefiting from inflows of Chinese students, businesses, and capital. In so doing, they are improving their own economic strength and weakening the CCP’s hold at home. That effect would be maximized if the United States followed suit. If Washington goes its own way instead—perhaps because the next U.S. administration opts for continued confrontation or for greater economic isolationism—it should at the very least allow other countries to provide off-ramps for Chinese people and commerce, rather than pressuring them to adopt the containment barriers that the United States is installing. When it comes to Chinese private commerce, the United States should think in terms of suction, not sanctions, especially as the CCP exercises firmer control of Chinese businesses.

The more Beijing tries to stave off outflows of useful factors of economic production—for instance, by maintaining strict capital controls and limiting listings of companies in the United States—the more it will deepen the sense of insecurity driving those outflows in the first place. Other autocrats have tried this self-defeating strategy; many were forced to keep temporary capital controls in place indefinitely, only to drive people and companies to make more efforts to get around them. As seen repeatedly in Latin America and elsewhere, including during the final decline of the Soviet Union, such policies almost invariably spur more outflows of people and capital.

The Chinese economy’s affliction with economic long COVID presents an opportunity for U.S. policymakers to change strategy. Instead of trying to contain China’s growth at great cost to their own economy, American leaders can let Xi do their work for them and position their country as a better alternative—and as a welcoming destination for Chinese economic assets of all kinds. Even knowledgeable officials tend to overlook how well this strategy served the United States in facing down systemic rivals in the twentieth century. It is often forgotten that it was far from evident during the Great Depression that the U.S. economy could outperform fascist regimes in Europe, and similar uncertainty about relative growth performance recurred throughout much of the Cold War. Despite that uncertainty, the United States emerged victorious in part because it maintained an open door for people and capital, siphoning off talent and investment and, ultimately, turning autocratic regimes’ own economic controls against them. As the CCP struggles with its self-afflicted economic long COVID, that strategy is worth reviving today.