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Over the past decade, I’ve been notably bullish on China, driven by its remarkable growth trajectory since the 1970s and the potential for its equities to dominate globally. However, post-2020, certain events prompted a reevaluation of this stance.

The emergence of the pandemic in 2020, coupled with the unchallenged ascendancy of Xi, has cast doubts over the sustainability of the Chinese economic model. As I delved deeper, it became evident that the current trade setup, which heavily favors China, has significant repercussions for the global economy.

Historically, China’s high savings and investment-driven growth model has been a boon. Yet, this very model has now led to overinvestment, burgeoning asset bubbles, and a concerning rise in debt. The need for reform is palpable. A failure to adapt could lead to societal issues, underscored by suppressed internal demand, which is eerily mirrored in declining fertility rates – a challenge not unfamiliar to the West. Without reform, we might witness an accelerated rise of India on the global stage.

China’s meteoric economic ascent wasn’t solely a product of private enterprise but was significantly shaped by government interventions. These included policies to bolster savings, a tightly regulated banking sector, and substantial subsidies to the manufacturing domain. However, mere reduction in government intervention isn’t the panacea. The crux of the issue lies in the distortion of income distribution, which stifles domestic demand and curtails business investment. This perspective, long championed by Michael Pettis, resonates with me. More on this can be found here.

The pressing concern is China’s struggle to transition from its investment-centric growth paradigm and its entrenched mercantilist tendencies. This is largely attributed to the imperative to export its surplus capacity to offset the economic ramifications of its non-viable infrastructure. As Pettis elucidates in “Trade Wars are Class Wars“, the political ramifications of such a shift are profound. A transition would necessitate local governments to liquidate assets and downscale, challenging the status quo.

China’s current economic conundrum is not just a cyclical downturn but a deflationary spiral, exacerbated by a stringent zero-COVID strategy and the crumbling property sector. Historical policy responses to similar deflationary episodes might not offer a clear solution this time:

• 1998: Asian Financial Crisis – Addressed via property market liberalization.
• 2002: US recession aftermath – Mitigated by China’s WTO accession.
• 2009: Addressed with a “four-trillion stimulus” and LGFVs.
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• 2015: Countered through shantytown renovations and augmented household borrowing.
• 2020: Pandemic-induced deflation – Offset by US fiscal stimuli and a domestic property boom.

The looming question is: How will China navigate the current decline in both domestic and international demand?

Drawing parallels with Japan, the impending implosion of China’s real estate sector could mirror Japan’s descent into deflation. Both nations, despite their technological prowess, grapple with institutional and governance challenges that hinder growth and innovation. The need for political and economic reforms in China is evident, yet there’s inertia in implementing them.

In conclusion, there are still less understood drivers that might change dynamics, but while, for instance, the BRIC currency might offer a potential solution, it’s evident that without substantial internal reforms, which currently seem improbable, China’s economic challenges will persist.

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