What Global Markets Should Expect from China’s Slowdown
On the latest episode of our Foreign Press Podcast, the Association of Foreign Press Correspondents in the United States (AFPC-USA) explored China’s ongoing economic challenges—a situation that can be traced back decades.
There are few people better than Hinrich Foundation Senior Research Fellow Stewart Paterson to provide us with insights into China’s economic trajectory: understanding why the country’s investments have faltered and why consumption-led growth has thus far evaded it can offer a window into its future, as Paterson explored in two recent papers for the think tank.
In conversation with Alan Herrera, who oversees AFPC-USA’s editorial operations, he breaks down his latest research and cautions that aggressive stimulus measures are falling short in preventing a Japan-style "lost decade" and explores the potential long-term consequences if the country fails to transition to a more consumer-driven economy. His insights are crucial for foreign journalists seeking to grasp the nation's economic ambitions and shortcomings amid ongoing global trade tensions.
This episode of the Foreign Press Podcast was produced in partnership with the Hinrich Foundation. AFPC-USA is solely responsible for the content of this episode.
Alan Herrera: Hello and welcome to the Foreign Press Podcast! I'm Alan Herrera. This podcast is an educational program brought to you by the Association of Foreign Press Correspondents in the United States. That's AFPC-USA. This episode has been produced in partnership with the Hinrich Foundation. AFPC-USA is solely responsible for the content of this episode.
Today, we dive into China’s looming economic challenges with Stewart Paterson, Senior Research Fellow at the Hinrich Foundation. With decades in capital markets and significant experience in macroeconomics, monetary policy, and political economy, Stewart has a sharp eye on China’s financial trajectory. His latest analyses warn that aggressive stimulus efforts are failing to stave off a Japan-style ‘lost decade.’ and posits what the long-term consequences for the country would be if it does not shift toward a more consumer-driven economy. Why is China’s investment model breaking down? Is it serious about consumption-led growth? And what does it mean for global markets? Join us as we unpack the risks, the realities, and the road ahead.
Stewart, it’s great to have you here with me today on our Foreign Press Podcast. For anybody listening to us today, this is the first time actually that Stewart and I have gotten to meet face-to-face, albeit virtually after working together on some written pieces in the past. And today we’ll be discussing a mishmash of two papers, two recent papers that Stewart wrote regarding China’s “lost decade,” in which he essentially discusses how China's economic slow down has increasingly mirrored Japan's lost decade, of which we'll get into that, and another one in which we’ll tackle China’s consumption and growth, or lack thereof. So, this will be very interesting and very insightful for me. I really enjoy diving into this research, but the best part is talking to really cool and interesting people with much to say. So thank you, Stewart, for being here with me today.
Stewart Paterson: Well, thank you very much for having me on your program.
AH: Greatly appreciated, and thank you again to our lovely friends over at the Hinrich Foundation. So, to start again, I've mentioned this “lost decade,” if you will. What key similarities do you see between the two cases, Stewart, between China's current position and Japan's prior one?
SP: Well, I think that the overriding similarity, the most important one is that both countries pursued this very investment heavy-led growth model. And that's not a coincidence actually, because when China started to move away from its Maoist Orthodox economic policies and Deng Xiaoping, China looked around for role models basically, and they didn't copy anyone's blueprint directly, but there was a lot of Japanese influence in the design of the way the Chinese Communist Party decided that it wanted to structure its economy. Obviously there are significant differences as well. In Japan, you really have the economy being dominated by these big business groupings, the keiretsu. In China's case, it's really state owned enterprises that dominate the commanding heights of the economy. And that's obviously still very true today in areas such as petroleum, in telecommunications, in aerospace, to some extent in autos and shipbuilding.
So, that investment-led philosophy and the capital deepening is the main similarity. There are ramifications for that too, though in the sense that in both Japan's case, Japan through METI, the Ministry of Trade and Industry, in China's case through the NDRC [National Development and Reform Commission] and other planning organizations.
The state plays a big role in guiding resources in allocating resources to industries that it's been decided that the economy was to dominate. And the flip side of that is really the consumer, the household, the individual, their economic needs are subservient to those of the states. So unlike in say, the United States where you have this sort of consumer sovereignty and it's a consumer-led economy, the Japanese model and the one that the Chinese adopted and modified and changed tinkered with, it's really built around state objectives. And there are other similarities beyond that. I mean, for example, in both cases you've seen attempts at financial reform, which have sort of got stuck halfway through.
You've had real estate bubbles. And the financial systems in a way were quite similar in the sense that both financial systems were bank-dominated and China, obviously they're state owned; in Japan, they were associated with the various groups. But also real estate is a form of collateral against bank lending, another very strong similarity that will have ramifications we'll discuss as we go forward. What I would say is that China's experience of this model, the degree to which they've run with it, has been more sort of concentrated or elongated than Japan's. So, in the sense that investment to GDP ratios in China are higher now than they ever were in Japan, and they've been elevated for much longer. And so in a way, China is an example of Japan's business model on steroids. The final factor that has to be mentioned, I think, early on in the conversation, is that in both cases, a lot of this industrialization that stemmed from this state planned investment was aimed at exporting, deliberately building capacity in specific industries way beyond what the domestic market requires with a view to specializing in capturing those industries in a global sense. And so that too is another commonality between the two countries’ approaches.
AH: Thank you for that. That's very, very interesting because well, some people say that history repeats itself, and then there are others who say that history doesn't repeat itself, but it certainly rhymes. So it's interesting to see just how two countries, of course, wildly different, but in such close proximity, could—one has experienced this and the other one is currently going through this. And again, to our listeners, we’ll dive even further. I am curious, Stewart, from what you mentioned, why do you believe that China's economic stimulus measures continue to fall flat despite their scale? For instance, I remember that you highlighted a decline in the efficiency of Chinese investment. So how has this inefficiency contributed to the risk of a financial crisis?
Stewart Paterson
SP: Yeah, so if you think about it, when a company invests, it's using other people's savings usually to do this. And this is particularly true in China, actually. The proportion of investment that takes place from retained profits from companies themselves is relatively low by international standards. And in between the savers, which are generally households in China, people like you and I and the corporate stance, the financial system, which is intermediating, these savings in China's financial system. And the way of corporate finance is still very much dominated by the banking sector, which is in turn dominated by state banks who are effectively implementing the planning decisions that are made in the five-year plans. And then the industry level plans that follow on from that and the more detailed planning that's carried out by the ministries.
Now, when this investment piles up and generates poor returns, obviously the financial system suffers because the debts go unserviced; they can't be repaid. And so non-performing loans or underperforming loans mount up. On the other side of the bank's balance sheet is the depositor, the household who've put their money into these banks and are expecting a return. And so one of the ways that China has been able to elongate and prolong this investment-led or mal-investment-led growth boom, if you like, has been through a process of financial repression whereby savers are effectively forced into the state banking system through a lack of alternatives.
Now naturally market forces at work mean that the savers desperately look for alternatives, that at times they've gone to the shadow financial system to get higher returns from things like wealth management products. They've turned to the real estate market for speculative reasons. And in each case, the state has tried to clamp down on those. I mean, there was a lot of malfeasance in the wealth management products as well. So, a lot of that was justifiable clamping down. But the aim is to channel those savings where the state can control them in the financial system. But there comes a point of time where the capital stock, the accumulated pool of investments, which the financial investments are reflected in real things, high speed railway lines, power plants, factories, et cetera. Those real tangible assets are not generating sufficient returns to service the debt and therefore sufficient returns to give depositors a return on their deposit.
And so this is the juncture that China is starting to arrive at now. And I've sort of illustrated the maths in the report looking at how the capital stocked GDP ratio has been blowing out as the incremental return on capital has fallen, and how the returns on that capital stock, by definition, are therefore falling, and how those returns on capital have now fallen to levels where in aggregate it seems very hard to believe that that capital stock is generating sufficient returns to reward investors. And what we've seen in capital markets in China recently in the bond market has been this collapse in yields, which is seen, there are many different ways of interpreting this, but what it seems to be sort of discounting is deflation in the future and a flight to safety driven by the fact that there is this over capacity building up, which has obviously put downward pressure on prices, downward pressure on profitability, and therefore makes riskier assets, things like corporate bonds or equities or whatever, highly unattractive because the underlying physical assets those companies own are simply not generating sufficient returns.
AH: Well, on the subject of returns, Stewart, I mean, and this is just for my own edification, I love to spitball on occasion, we're discussing this heavy reliance on—what's the word here?—on investment-led growth, right? So how likely is it then that China can transition to a more balanced economic model without severe disruption?
SP: So it's a very difficult transition to undertake because your starting point is one where investment is about 45% of GDP. So when you're looking at the pie as a whole, you've got domestic consumption in there, and then you've got net exports. And in Japan's case, as Japan's economies started to undertake this stagnation, Japan became increasingly reliant on dumping surplus production overseas. Obviously that was met with pushback elsewhere. And this is even more true in the case of China, right? We're seeing this, and it's not just an American thing here. I mean, it might be tempting sitting in the United States to believe that you are the only people pushing back against China's dumping of surplus capacity elsewhere.
But this is the case also in Europe, but it's also the case in large parts of the Global South as well. Countries that themselves have embryonic industries that they wish to protect or have aspirations to grow their industrial base are well aware of the fact that this flood of cheap Chinese goods has the potential to stamp out and cripple their own attempts to develop an industrial structure of any sort of magnitude. So there is significant pushback against dumping this excess capacity overseas. So then you have to boost consumption, and this is something that the Chinese authorities have spoken about on and off really for the last 20 years.
But I think there are some fundamental problems with the attempt. The structure of the Chinese political economy is really orientated around producer interests and investment. So the household saver gets a derisory return from the banks, as we've pointed out already. Wages as a share of GDP are low to crowd in the profitability that is required in order to carry on servicing this hugely mal-invested capital stock. The exchange rate is chronically undervalued on a purchasing power parity basis. So what that means is that Chinese households with their low share of GDP is a wage and are facing an international price level that is much higher than their domestic price level. They are largely cut out from the purchase of internationally made goods by that undervaluation of the exchange rate and the domestically made goods. Well, the whole planning process orientates domestic production to fit with the state directed plans, the industries of the future, the strategic industries.
So consumption is if you keep low by the structure of the political economy, and unless you're prepared to unravel that structure, what you are left with is tinkering at the edges. So the Chinese authorities try things like, for example, schemes that have raised similar to the "Cash for Clunkers" kind of program that you had in the United States. If you trade in your washing machine early and buy a new one, there'll be a subsidy for it. And these kinds of things, what those measures do is just change the replacement cycle of those goods that would naturally have happened anyway. So it brings that replacement cycle forward, but it doesn't really add to economic welfare. In some cases, you're throwing away something that's perfectly good a year early in order to benefit from the subsidy, and that brings forward the demand. But of course, in 12 months time, that demand has already been satiated.
So, it's not a sustainable way of increasing consumption. This time they are trying a few things that arguably are different. We are looking at minimum wage hikes and state employees getting significant wage increases. So these in themselves have the potential to stimulate consumption. But the problem here is that the propensity to save, particularly amongst this sort of urban middle class is high, and the propensity therefore to consume is correspondingly low. So again, these sort of state measures might make a difference at the margin, but what we're really talking about here is having to increase consumption share of GDP by, well, a minimum of 10 percentage points and more realistically perhaps 20 percentage points. And that is not going to be achieved with these sort of tinkering measures. Some measures can be taken by the government in its own right. So for example, social transfers in kind, which means basically when the government pay for a household's service.
So, an example of that would be state-funded education, state-funded healthcare, for example. So these are transfers from the state sector to the household sector in kind, not in cash. Now these are pretty low in China. They're exceptionally low relative to North European norms. They're not that dissimilar to those in the United States, but obviously the United States has a long tradition of small government, which is in sort of contrast to what you might expect from a communist party in China. But these increases are well within the gift of the party. And ironically, they're in keeping with some of the objectives of Xi Jinping's stated ideology. So for example, universal prosperity, common prosperity. And so it is slightly surprising that they haven't put more emphasis on state-funded healthcare and education to get the level of consumption up in aggregate in the economy. What appears to be holding them back is a fear of welfare.
They are worried, having seen how a growing welfare state in other countries, particularly other middle income countries that are developing, has coincided with a stagnation of growth and a sort of middle income trap. The authorities in China want to avoid that, and they're worried about that. So in summary, I'd say the best way to get consumption up is to dismantle the state control over industry, make the consumer sovereign, and do away with industrial planning and subsidies. But that's not going to happen. So what you are left with is attempts to tweak around the margin and we'll see if any of these things can gain sort of lasting traction. But as I said right at the beginning, the party has talked about this for the last 20 years, and they clearly haven't met with any success because the economy is as lopsided towards investment as it ever has been. So we'll see.
AH: Yeah, there are so many moving parts here. And another thing that comes to mind, you mentioned this phrase just now, right? “Being lopsided on investments.” So what I'm thinking of right off the top of my head right now is, if returns on investments remain below borrowing costs, how significant then is the risk of a financial crisis overall?
SP: Yeah, so it's very significant. I mean, it becomes an almost certainty, yeah, the saving grace from the Chinese perspective is that the financial system is largely state-owned and almost entirely state-controlled to some degree or another. And so the options available to them are, well, the option available is printing the difference, printing the money. And there are ingenious ways of doing that. You don't have to just literally come clean and say, we're printing the difference. In previous banking crises in China in the early '90s, what you had was these asset management companies were set up by the state and they went into the banks and bought the bad loans off. The banks had inflated prices. I mean, they weren't worth anything, but they paid for them. So, injecting good bonds into the banks in lieu of the bad assets, which then the asset management companies worked out of their system over time.
And so that is the method that will be used. And obviously the PBOC, the People's Bank of China, can buy bonds issued by asset management companies in order to give them the funds with which they then go and buy the bad assets. So it is effectively money printing, but it's reasonably disguised if you like. Obviously the ultimate constraint on their ability to do that is if that creates inflation. But clearly the problem in China is not inflation at the moment. The problem is deflation, the bad debts are associated with excess capacity and putting downward pressure on prices. And so that is an option that is open to them. I mean, one of the things to consider is what is the pecking order in terms of creditors here?
And clearly utmost in the party's mind is the mass of the population who saved through the banks and the banking deposits, and they will have to be made whole in their deposits. You cannot have, the regime would probably not survive a situation in which households felt that they were being robbed and their deposits were not, state banks were not whole. So they will be the key beneficiary of this. But it does beg a question of where does foreign capital fit into this? Because obviously one would expect foreign capital to be right in the back of the queue in terms of being bailed out, which obviously increases the jurisdictional risk for foreign investors being in China and the risk associated with foreign banks operating in China.
AH: This sounds, again, it sounds like a very, of course, it's a very difficult situation and it sounds like a very contentious situation. And you mentioned that there are different analysts with different points of view. There are many different points of view on how to approach this issue, how to perceive it, to see how it'll affect not just China, but the region and certainly the world at large. And there are some people who argue that China still has policy tools to avoid prolonged stagnation. So do you think that Beijing has viable alternatives or do you think that they're running out of options? How does China's—and again, spitballing here—current economic trajectory impact its geopolitical ambitions, of which it has many, particularly in relation to the US in global trade? Of course at the moment we have the US president, Donald Trump, launching trade wars left and right. It's a very delicate balance that we're seeing here that's been disrupted, and I've discussed this in prior podcasts, particularly with your Hinrich Foundation colleague, Keith Rockwell. Great guy, for anybody who's listening. So could you just give me some insight into all that?
SP: Yeah, so clearly from China's perspective, a lot of its clout and influence in the rest of the world stems from its rising economic power. I mean, without the transformation of China's economy, China's voice would not carry nearly such loud, resonating voices. It does in the Global South particularly.
And therefore, there is an element to which economic stagnation threatens China's ability to continue to put financial resources behind its rhetoric of being a leader in the Global South. There's a caveat to that, which is that as Chinese domestic demand has shrunk, and as China's trade surplus is widened, and we're looking at a trillion dollar trade surplus here, the flip side of that is a trillion dollars of capital exports. And so that is in part BRI [Belt and Road Initiative] and the lending to developing countries for infrastructure and what have you. So perversely the slowdown in China's economy, while it manifests itself in a widening current account surplus, actually produces more resources for BRI and state-led investment overseas. That's one of the ironies. But over the longer term, clearly, if China is not importing and from the countries that it's trying to influence, then it starts to lose that influence, right?
Because a key part of China's narrative has been, "We are the future economically, therefore you must hitch your wagon to us." And the reality of China's import growth over the last decade or so has been that unless you are Russia producing hydrocarbons or you are the Congo producing cobalts, lithium, or a handful of countries with big iron ore exports or what have you, it has been a terrible disappointment. I mean, outside of food hydrocarbons and minerals, there has been almost no growth in Chinese imports over the last decade. And so if you are one of the countries that has a surface of any one of those three things, brilliant. You've had a growing market to sell into in China, but there's a relatively small number of countries that have benefited. On the other side of the equation, if you are an Indonesia, a trillion dollar economy with what was a sort of embryonic industrial base, and prior to the Asia crisis, you were building up to be a manufacturing superpower in your own right then, clearly China's rise has actually negatively impacted the degree to which you've been able to develop your manufacturing sector because they've sort of eaten your lunch, so to speak.
And so it's a mixed bag in terms of how China's economic stagnation will play out in the international arena, but clearly it does create a window of opportunity for market economies to push back on some of China's narratives.
AH: China has long acknowledged, right, the need for consumption-led growth, yet progress has certainly been very slow. So again, another thing that comes to mind here, I feel like you've touched on this a little bit just now, but what would you say are the biggest political and structural barriers to achieving this shift?
SP: Yeah, so politically, I think it's quite clear that the party are very reluctant to give up control of the commanding heights of the economy. They want to know where savings are being allocated. They want those savings allocated to achieving party driven goals, and to move to a more market orientated allocation of capital where people lent based on the prospect of immediate returns rather than of achieving national goals is not in the conversation as far as the Communist Party are concerned. And the other structural bar which goes with that is this obsession with running trade surpluses and therefore having an undervalued currency, and that immediately prices the Chinese consumer out of a lot of international goods. And so without a real exchange rate appreciation in China, it seems unlikely to me that it's ever going to balance its current account position, and therefore it will be running these savings surpluses, which are the flip side of suppressed consumption.
AH: And do you think, Stewart, that Chinese leadership at the moment, do you feel that they fully understand the magnitude of reform that's required in order to address this?
SP: Yeah, so I think they fully understand what the arguments I've just articulated are. But for them, what we've seen in China over the last 10 years in particular since Xi Jinping assumed power is a downplaying of economic success as being the sole source of political legitimacy for the party. So the party's narrative has changed from "We have a monopoly on political power, but the quid pro quo for that is that we will make you wealthy." It's now changed to, "We have a monopoly on political power and we will make China great again." So it's national rejuvenation, it's the China dream, which is as much about shaping a global order. It's about respect for China abroad. It's about making China central to the functioning of global systems. It's about technological leadership and pride in your country's achievements. It's as much about those things as it is actually delivering higher living standards to the man on the street.
And so the risks they're taking is obviously that the man in the street is prepared to buy into that, or if he isn't that at least he can be controlled and coerced into not doing anything about it. And so it's no coincidence, I don't think, that as China's been faced with this pretty stark choices to either really undertake root and branch reform of the economy or give up on rapid growth, and they've chosen giving up on rapid growth, that the rise of the surveillance state, the clamping down on political dissent, et cetera, has also increased commensurate with that trend.
AH: Well, you mentioned that this state directed economic model has overall prioritized investments over consumer welfare, so apologies to the man on the street, right? Do you see any signs of this changing and what policy changes Stewart, would you say could most effectively boost consumption in China without destabilizing its broader economy?
SP: Yeah, so if you rule out the politically unacceptable, and I mean the politically unacceptable from the party's point of view, then really the most effective way will probably be to address income inequality and precautionary savings. Those are the two broad categories. So income equality is obviously a great inequality, and it's a divide within the urban area and between urban rural, and that probably requires a breaking down of the Hukou system. It requires a progressive tax system because China raises a very small percentage of government revenue from income tax. That's a starting point, but also the social security contribution element to it. And if you combine that with the way property income is taxed, so by property income, I mean dividends, interest payments, rentals on investment properties, et cetera, it's actually quite regressive China's tax regime. And so a complete overhaul of that tax regime to make it more progressive, which would move money down into the lower deciles of earning families who have a higher propensity to consume.
So that would be that side of it. And the other side of it I touched on already, which is the provision of services in kind, as things stand Chinese families save and save for children's education, for every health eventuality, et cetera. What would be more efficient in terms of reducing the savings rate, therefore based in consumption, would be actually if the state perhaps undertook more of this directly or at least subsidized it more for lower income families, which might in time has trust built up that that social contract was in place would encourage people to consume more, to save less because this part of their future consumption profile was taken care of.
AH: So if China doesn't shift toward a more consumer driven economy, what are the long-term consequences that it could face? That's just something that comes to mind right now.
SP: Yeah, so if we assume that the option of exporting evermore quantities of goods is off the table, that the world is simply not prepared to see China's trade surplus double again.
Then you will continue to see more marginal investments take place with lower returns on capital. And you'll see this sort of stagnation of returns as the capital stock produces less and less, an incremental return on capital deteriorates more until they have to print huge amounts of money to get themselves out of that financial problem. If they don't really succeed in at least partially rebalancing this economy, you could see how the crisis that comes out the other end is a threat to the regime because you've had this imbalance now for so long, and the buildup of bad assets are so big that it will be a fairly groundbreaking crisis when it comes. And the key thing is, can they manage this without igniting inflation? Because if inflation comes back, then that could be very problematic for them. Obviously if the deflation remains, then you will just have stagnation and a lost decade.
When you look at the mistakes that Japan made and why it ended up, of course, with basically two lost decades, bad capacity wasn't destroyed. So you had bankrupt companies competing with solvent companies until they dragged the solvent ones down. You had these sort of zombie companies and whole zombie industries developing, so there was no clearing mechanism. And the banks, as nominal interest rates collapsed towards zero, the banks were earning wafer-thin margins on their lending, so they didn't have a profit cushion against which to write off bad loans. You then had collapsing collateral markets in Japan. Well, China's market prices are not collapsing, but they are soft and falling honestly. But if you see that gathering momentum and turning into a fully freed crisis, remember a lot of this property is collateral against loans. So you could end up in a very nasty liquidation cycle, and it remains to be seen how the party will manage to handle that. But obviously part of that, the toolkit, is definitely clamping down on information and making it more opaque as to what exactly is going on.
AH: And do you envision a scenario, Stewart, in which China—let me get my thoughts together for a second—so is there a scenario in which China successfully transitions into a consumer driven economy without relinquishing significant state control over the economy?
SP: Well, I think there's a chance of it making a partial migration in that direction. Yeah, particularly if they were to go down the policy suggestions I mentioned about social chancellors in kind, but a more progressive tax system, those policies could increase consumption reasonably dramatically. And the concerns that are unaddressed by that are the mechanisms for allocating the savings and therefore deciding what investment does take place with the remaining savings, as it were. Because reducing gross fixed capital formation from 45 to 35% of GDP, great, that's a good start.
But then how is that 35% allocated? Are you going to carry on with the high speed rail and other sort of infrastructure investments that are probably of spirit's economic value, debatable economic value anyway? And if so, where does that leave the private sector? Where does that leave the entrepreneurial SMEs that actually built China's success story really in the export industry in the '90s and the 2000s before we moved into the sort of big SOE period of export domination? So, it certainly would be a better outcome than doing nothing, but whether it certainly won't herald a return, I don't think, to the 7, 8% real GDP growth numbers that we have become rather used to. I think that kind of rebalancing is what is required really just to maintain the 4 to 5% rate.
AH: Stewart, I want to just thank you so much for your time today. This has been very educational for me. What I really enjoy about, well, my organization's partnership with the Hinrich Foundation, is that over time, I've just developed a keen interest in all of these topics. So thank you so much for that. I'm really grateful to the Hinrich Foundation for contributing to my own personal education, and I really appreciate all of your insights, and I think that many members of our community of foreign correspondents will take much from that as well. So thank you for being here with me today on our Foreign Press Podcast.
SP: Well then, thanks very much for having me on.
