China's growth scare

By Peter S. Kim

Since China announced its relaxation of the "zero COVID" policy early this year, many considered the event a final confirmation of the world returning to normal. However, the economic boon from China's reopening has been most underwhelming, with the expected bounce in consumption, overseas travel and corporate investments disappointing at best. The negative surprise from China is leading to talks of China following the footsteps of Japan's "lost decades," where, despite countless stimulus efforts, stagnant growth persisted for almost 30 years.

If China enters anything close to Japan's low growth phase, it would have a seismic impact on the rest of Asia, whose growth has depended heavily on China for the past 20 years.

Throughout the pandemic, China has restrained from massive stimulus seen in most of the world, preferring harsh lockdowns without government stimulus checks or monetary loosening. It would seem that the brutal lockdown, coinciding with a shift in its political regime, may have caused greater structural damage than Beijing expected. Even before the COVID outbreak, President Xi Jin-ping warned his people of the need for a "long march" as anti-China sentiment swirled around the world. Among many changes the pandemic has imposed on the world, perhaps the biggest one could be China's U-turn on its market reform.

The fears of deflation are primarily centered on the plummeting birthrates seen from Japan and now hitting China and Korea. For over a decade, Korea was often the candidate for following Japan's lead in lost decades due to the abrupt drop in birth rates and declining export sector, with Japan leading by some 20 years. As Japan and Korea began to enter massive growth via industrialization, the financial burden of raising children weighed on couples whose social standing and consumption patterns became a higher priority than the previous generation. The rising cost of private education is paramount for Asian couples whose emphasis on social status is directly derived from academic achievement.

As we saw from Japan, its demographics certainly played a part in the slow growth and will act as a structural drag on China and Korea in the coming years or even decades. However, it does not explain the sudden drop in consumption from China, noting that Korea did not see a sudden abrupt decline when it entered the demographic cliff. Demography is a slow-moving ship that does not deliver sudden shock; instead, it is a slow and gradual drag that is hard to reverse once in motion.

The critical drag on Japan's economic woes started with its domestic property market collapse that coincided with the birthrate decline. One could even argue that Japan's "balance sheet recession" could have been the cause, not the result, of the falling birthrate. The balance sheet recession describes the decline in economic growth caused by negative returns on assets, causing falls in consumption and investments. Japan's debt problem exploded in the 1990s after years of excess, forcing the entire Japanese banking sector and its central bank to mobilize all measures to avoid a financial crisis, similar to the COVID stimulus we just had. The crisis was successfully avoided but led to decades-long deleveraging, causing permanent damage to long-term growth.

For China, the debt is related to its corporate sector and state-owned enterprises, which took on the burden of driving investment-driven growth since the Global Financial Crisis of 2009. The excesses in its property market and corporate debt have forced Chinese policymakers to prioritize stability over growth to control the debt problem. Even today, China refrains from embarking on major stimulus despite talks of slowing demand. Instead, most government spending is focused on social spending and welfare. China seems not yet ready to use the silver bullet of infrastructure spending and real estate, which could cause another long and painful deleveraging taking many years. After more than 20 years of property price declines, Japan's property market has finally begun to rise with the stock market over the past few years. It is no coincidence that Japan's recovering property and stock markets also see improving birth rates, which are now higher than Korea and similar to China.

Japan's growth decline was also exacerbated by the weakening of the yen from the Plaza Accord in 1985, which crippled its export sector. The U.S. overreaction to Japan's emergence as an export powerhouse led to the accord, similar to the U.S.-China tensions today. Not only did Japan have to contend with decades of property market decline crushing the domestic economy, but the strengthening of the yen was a fatal blow to its export growth. Since then, Japan Inc. has busily diversified its manufacturing capacity overseas to ease the currency pressure. Since the pandemic, the Japanese yen has weakened by almost 40 percent, boosting exporters just when China is facing global resistance to its exporters.

While the above economic parallels between Japan and China draw long-term comparisons, it does not explain the abrupt China's slowing growth.

To me, China's recent growth scare is mainly linked to the slumping consumer and corporate sentiment caused by the political scrutiny from its communist regime. After President Xi successfully extended his ten-year term to an unlimited one, the future of its political and economic planning lost its transparency. A nation whose most senior officials disappear without explanation will cause every citizen to fear the political repercussions of every action, including conspicuous consumption. The lack of spending seen from its outbound travelers is an example of how China has changed during the pandemic, whose citizens morphed from consuming with exuberance to paranoia. In that sense, China's challenges in reflating the economy may require political reform rather than economic boosting measures.

Peter S. Kim (peter.kim@kbfg.com) is a managing director at KB Financial Group.