It was inevitable that China’s economy would eventually slow down: No country in modern times has grown so fast for so long. The Middle Kingdom expanded its GDP from 7.6 percent the size of the U.S. at the time of Deng Xiaoping’s 1992 commitment to economic reform to one that is 70.6 percent the size of the American economy just three decades later. But the juggernaut is finally succumbing to the laws of economic nature. And while China’s GDP did grow by 5.2 percent in 2023, the IMF forecasts the pace will slow to 4.1 percent in 2025. Predictions for growth beyond 2030 hover around 3 percent.

China’s old formula for growth, based on ever more investment to propel the economy, is simply running out of steam. Consider just a handful of the signs of imbalance:

• Labor productivity growth, once the envy of Asia, is coming down to earth.
• China’s science and technology establishment provide pathbreaking innovation, even as many in the countryside have not received a high school degree.
• Local governments face mountains of debt yet lack realistic plans for servicing it.

Clearly in transition, the Chinese economy is difficult to characterize. It is in a state of becoming, but views differ on what it will become and what that means for the rest of the world. While some insist that China is recovering nicely from the bewildering dislocation of the Covid-19 pandemic, others see an economy in deep, if temporary, trouble – and yet others predict a long, gradual decline. What pretty much everyone agrees on is that the timing of the slowdown could hardly be worse for transition to an ambitious new growth model.

China’s businesses remain scarred by the zero-Covid lockdowns, its households fear the next big shock to their livelihood and freedoms, and its labor force shrinks as young workers from the one-child generation can’t make up for rapid aging at the other end of the demographic curve. As the old crumbles, the big question is whether China can summon the confidence to embrace the new era that its president, Xi Jinping, promises is on the horizon.

China, in short, is switching to a new playbook while remaining firmly reliant on the old. Its leaders muddle through, invoking a new era while deploying familiar but problematic tools to both stimulate growth and control the socioeconomic consequences. The central contradiction is that of market and state: how can the invisible hand allocate resources efficiently while the government’s heavy hand is poised to nullify outcomes it doesn’t foresee?

The headwinds are external as well as internal. The foreign reception to this tortured transition does not resemble the benign welcome offered to China upon its accession to the World Trade Organization in 2001. Indeed, many of China’s closest trading partners are acting to protect their factories and workers from what they fear will be another economic disruption as China emphasizes high-tech exports and threatens to crowd other countries out of leading global markets.

China’s leaders do seem to understand – and have long prepared for – the end of the era of high growth at any price. Beijing is now stressing the importance of quality growth over rapid growth, doubling down on efforts to nurture new economic engines through innovation and the rapid diffusion to the domestic economy of productivity-enhancing technology. Traditional labor- and resource-intensive sectors such as textiles and furniture are downplayed while the “new three” – electric vehicles, lithium-ion batteries and solar cells – are cited as exemplars of China’s evolving comparative advantage.

One big catch is that the road to the new era is littered with detritus from the old. Internally, excesses of the “build it and it will sell” spirit haunt the economic landscape in the form of unfinished ghost towns and falling asset prices. Externally, China’s top customers are pushing to diversify the supply chains that link the ports of Shanghai, Ningbo, Shenzhen and Guangzhou to rich markets in the West.

Egged on by the United States, the advanced economies of Europe and East Asia seem to have changed their minds about China. Chinese exports are often viewed as Trojan horses, concealing everything from software hacks to fentanyl, that are being shoveled into foreign markets by job-busting subsidies.

That said, Chinese leaders show no loss of confidence in their ability to guide the transition – at least in public. At the latest meeting of the Communist Party of China Central Committee Political Bureau, the leadership dug in their heels on the need for “reform and opening” even as they acknowledged that the country faces problems at home and abroad. Promising to use familiar macroeconomic tools to ensure continued growth this year, the Politburo called for continued development of “new productive forces” while upgrading traditional industries.

Aspirations for a greater role in shaping global economics and geopolitics appear undiminished, but it’s understood they must be deferred while the economy transitions. The tensions implicit in Xi’s emphasis on “establishing the new before breaking the old” will necessarily slow progress toward renewal. And it’s hard to avoid the conclusion that a weakening economy in the near future will limit Beijing’s global ambitions, at least for the present.

The Old Is Breaking Under Its Own Weight

Nothing illustrated China’s old growth model like the spectacular pace of residential property development. Once a key economic driver that absorbed tens of millions of surplus workers from the countryside, real estate has been a drag on growth for more than two years now and will likely remain so for the indefinite future.

The deflating housing bubble affects virtually every corner of the Chinese economy. It undermines consumer and business confidence and threatens to submerge both local government finances and bank profitability in a sea of red ink. Moreover, the property crisis reverberates across China’s industrial sector, depressing demand (and prices) for steel, cement, furniture, appliances and other materials related to housing. Excess capacity in those sectors is finding its way to export markets, amplifying protests from trading partners.

Unlike in the West, where inflation has disrupted markets, prices in China have barely risen. The consumer price index rose only 0.2 percent in 2023. Core consumer prices (i.e., excluding food and energy) rose a mere 0.7 percent, far lower than the government’s target of 3 percent. Moreover, China’s GDP deflator, a measure of economy-wide price changes, was actually negative 0.6 percent last year – the lowest since the Asian Financial Crisis in the late 1990s. Perhaps most telling, prices of virtually all manufactured goods declined, with the producer price index falling by 3 percent. And data so far from this year suggest that, in some sectors, deflationary pressure is still increasing.

While the numbers in part reflect weak global commodity prices, Chinese deflationary pressures are reinforced by a combination of excess supply and weak demand at home. Risks of a deflationary spiral are well understood – lower production, falling wages and rising unemployment. More concerning for the long term, however, is the effect of deflation on current private investment. Expectations of future profitability plummet, even as falling nominal prices push up real (i.e., inflation-adjusted) interest rates. Indeed, borrowing costs in late 2023 reached their highest real levels since 2016.

Consumers are unlikely to rescue China’s business sector, even with a push from government incentives to purchase durable goods like cars and home appliances. Final consumption contributed more than 80 percent to China’s GDP growth in 2023. But this seemingly strong performance resulted from realization of pent-up demand and a low base of comparison in Covid-plagued 2022 – not from consumer confidence. As real estate prices continue to drop across China and household wealth shrinks accordingly, consumers are likely to cut back.

It is not only Chinese consumers and investors who have lost confidence in the economy. China’s own published data show that foreign capital is exiting China. Foreign firms are not only reluctant to make new investments, some are selling assets and remitting earnings that not so long ago would have routinely been plowed into more productive capacity. Note, though, this hardly amounts to a mass rush for the exits. Many foreign firms seem to be hedging, repatriating earnings or selling part of their investments in China while continuing to maintain a presence in the world’s largest economy.

So much for this week’s and this month’s challenges. While China’s working-age population has been on the decline for more than a decade, the long-term implications of a shrinking, aging workforce are becoming harder to ignore. Last year China’s total population fell by more than 2 million – a drop in the bucket in a country of 1.4 billion, but symbolically important since it was the first decline since the Mao-era Great Famine in 1961.

Note, moreover, that China has not adequately prepared its workforce to support rapid population aging. China faces a dangerous lack of human capital, especially among its rural population. Indeed, it is far behind where other successful East Asian modernizers – think Japan, Korea, Taiwan, Singapore – were in terms of human capital as they began to converge to high-income status.

The party’s answer to this imbalance is more of the old medicine – drive investment to the state sector and manipulate the way the money is spent to activities that fit the state’s development strategy. State-sector investment grew more quickly than private investment in both 2022 and 2023 as the private share of fixed-asset investment fell to lows not seen in more than a decade.

China’s 2024 budget plans total spending 7.8 percent higher than last year’s actual expenditure. More than half of the increase will be used for public investment, mostly led by local governments. Though it is still unclear where these investments will be directed, much of it will likely go to support “new productive forces.” What is unusual is that the central government is going to undertake some capital investment on its own, suggesting a gradual shift toward a larger investment role (and greater control of the direction of development) for Beijing.

But while the central government is boosting spending to drive growth, local governments across China face worsening fiscal distress. Once a main source of local revenue, land sales have declined along with taxes from property development. Many local governments are struggling to repay debt accumulated outside of the formal fiscal system, a reality evidenced by reports of missed payments to private contractors working on public projects.

Beijing’s New Playbook

Despite all these headwinds, China’s leaders say they have high hopes for significant development by 2035. They understand the risks of diminishing returns to investing more in public infrastructure, housing and traditional industries. But they insist they are targeting projects that will raise total factor productivity. That’s fine in theory. But there’s no getting around the reality that the optimists are swimming against the tide.

Productivity growth in China has slowed considerably in recent years. And while global productivity growth rates have also fallen, the contrast with the recent past in China is more pronounced than in most other economies.

Beijing’s plan to reverse this trend is anchored on stimulating indigenous innovation. The plan has three key components, including upgrading and digitizing traditional supply chains, fostering emerging industries, and, more generally, promoting the digital economy. A host of industries are in the spotlight – everything from commercial spaceflight to quantum computing to artificial intelligence. Among the priorities, three clean-energy-related ones have drawn worldwide attention (and concern) in recent months: EVs, lithium-ion batteries and solar cells. Dubbed the “new three,” the country already has a dominant role in their global supply chains.

As the state pushes investment toward favored sectors, old industries limp along. And while the “new three” are growing very fast, these favored activities will not be able to absorb the bulk of new labor force entrants along with those let go by declining sectors. Exports of the trio exceeded RMB 1 trillion (about $140 billion) for the first time in 2023, to much fanfare in China and handwringing in the West. But despite the hype, these sectors represent a small share of China’s goods exports – less than 5 percent overall. A key contradiction of the new playbook, then, is that despite the fanfare about emerging technology and indigenous innovation, China remains reliant on “old industries” and cannot revive growth without reviving them as well.

Left unresolved, moreover, is how the state will both direct new investment and renew the market dynamism that buoyed productivity in the two decades before the global financial crisis. The sharpest drop in productivity growth coincides with the first decade of Xi Jinping’s rule, during which an increasing amount of capital from the regulated financial sector was allocated to the less efficient state enterprises while the private sector had to rely on retained earnings and entrepreneur wealth (as well as informal “shadow banks” outside regulators’ control) to fund expansion.

Beijing’s suspicion of the private sector culminated in the regulatory crackdown of summer 2021, which wiped out hundreds of billions of dollars in market capitalization from the flagship private companies. Today, Chinese policymakers still struggle to overcome the resulting legacy of distrust on the part of investors.

A third contradiction in the new playbook is that Beijing plans to rebalance the economy toward consumption even as it maintains control of the planned industrial transformation. How can consumers reign supreme when bureaucrats determine which enterprises will receive bank financing?

Hostility to consumer sovereignty pre-dates the recent hype about new productive forces. Rather than providing direct assistance to households during the Covid-19 years, Beijing relied mostly on tax cuts (and mostly for corporations), arguing that doing so would provide indirect support to households by preventing layoffs. The rationale can be found in an article published by the party journal Qiushi in May 2022, in which President Xi rejected the idea of “welfarism,” arguing that it had led some Latin American countries to fall into the middle-income trap.

This perspective guides policy design. Even as the government attempts to stimulate consumption with subsidies to households willing to replace durable goods, the state insists on directing the flow of funds to targeted sectors.

On a recent visit to Beijing, U.S. Treasury Secretary Janet Yellen voiced concerns over China’s excess capacity in clean energy products and urged Beijing to rethink its growth strategy. A Yale-trained PhD in economics, Yellen suggested policymakers in Beijing shift their focus from boosting the country’s already huge manufacturing capacity to reviving domestic demand through measures like raising retirement benefits and making education more affordable. As Yellen observed, structural imbalance – too much investment and too little consumption – has long been a major problem in China’s economy.

Farming the old-fashioned way in Hunan Province, China.

To be fair, China has made some progress in this direction. Household consumption has risen since 2010, accounting for 40 percent of GDP by 2019 before the Covid-19 pandemic struck. If in-kind social transfers, like government-subsidized public canteens for elderly residents, are included, the share of household consumption has reached 46 percent of GDP.

Yet China’s share of GDP going to consumption is still very low compared to other middle-income countries, and it has dropped somewhat since the pandemic. To put China’s economy on a more sustainable path of development, household consumption will need to go up. But that isn’t likely to happen unless the safety net is strengthened and households see their disposable income rising on a stable trajectory. By the same token, more income and housing support for the country’s vast migrant workforce would both boost domestic demand and go a long way toward eliminating the remaining deep poverty in this once very poor nation.

But Beijing can’t quite make up its mind. While boosting domestic demand was the first priority laid out in China’s government work report in 2023, it dropped to third in this year’s report, trailing the development of new productive forces and improving the country’s education system in its pursuit of technological self-sufficiency. With Xi doubling down on advanced manufacturing, consumption is bound to lag. And unless there is a sea change in thinking among the leadership, China will remain caught between state and market, with the familiar imbalances still spilling out into the global economy.

Alien Sand In The Wheels

Resistance to the new China playbook is growing – particularly in the United States, but increasingly in Europe and the advanced economies of East Asia. A good chunk of this hostility stems from the ongoing perception that China is following beggar-thy-neighbor policies by promoting export expansion unmatched by import growth. Unfairly or not, many of the Global North’s most intransigent problems, including the decline of manufacturing employment and political polarization, are routinely laid at China’s doorstep.

Moreover, new frictions are creating support for decoupling from China. Repulsed by reports of human rights abuses of ethnic minorities living in the Xinjiang Uygur Autonomous Region, the U.S. Congress passed legislation in 2021 that establishes a rebuttable presumption that goods made or mined in the region were produced with forced labor. And U.S. Customs has accordingly blocked some 4,000 suspect shipments.

Then there’s the issue of China’s own inclination to weaponize international commerce. Beijing has used trade sanctions to punish South Korea, Australia and Lithuania for what it perceived as hostile political acts, further catalyzing the global push to reduce economic dependence on the world’s largest manufacturing country.

While that was not his intent, then-President Donald Trump’s trade sanctions began the decoupling of American supply chains in 2018. One year earlier, the United States obtained 20.6 percent of its imported goods from mainland China. By 2024, the share had fallen below 14 percent, as importers responded to stiff tariffs on two-thirds of goods from China. The U.S. share in China’s total goods exports also dropped from nearly 20 percent before 2018 to less than 15 percent in 2023. And over the same period, retaliatory tariffs eroded U.S. exports to the mainland; in 2023, less than 7 percent of U.S. exports were sent to China.

American direct investment is undoubtedly being diverted from China by these shifts. The search for new locations for overseas sourcing and production is promoted by U.S. government initiatives, such as the Indo-Pacific Economic Framework. And though little of real substance has borne fruit from IPEF negotiations, multinational firms are taking the hint and shifting toward factories in Vietnam and Mexico (among others) as alternatives to China.

At the same time, China’s “new three” sectors face mounting risk of being shut out of advanced-economy markets as the European Union investigates subsidies to Chinese electric vehicle manufacturers and contemplates the imposition of countervailing duties. The U.S. market already appears to be largely closed to Chinese EVs since the Trump trade war resulted in a 27.5 percent tariff on such imports. And in May, President Biden imposed punishing tariffs against Chinese clean energy exports.

Perhaps the greatest concern to the Chinese are controls on their imports of advanced semiconductors along with the IP and equipment used to make them. These controls reflect the United States’ goal of slowing the maturation of China’s high-tech capabilities – a goal policymakers justify by invoking national security concerns. Given the emphasis China has placed on digitization of its economy and the promotion of productivity growth through diffusion of new technologies such as artificial intelligence, the controls represent a major roadblock to Xi’s economic transition.

President Biden has left the Trump trade-war tariffs in place and added some of his own, but attempted to focus attention on home-shoring of the advanced semiconductor industry and domestic development of EVs and new energy technologies. Biden has expressed his distaste for the alleged need for additional tariffs, and key officials in his administration have repeatedly traveled to Beijing to attempt to smooth U.S.-China relations.

But with a U.S. election just a few months away, the Chinese must assess the likelihood of a second Trump presidency. In recent months, Trump has talked up some extreme foreign economic policy proposals, including a 60 percent tariff on all imports from China – and, sometimes, the revocation of the basic agreement giving China default access (what used to be called “most favored nation” status) to U.S. markets.

China Looks Beyond The West

China has, in many ways, been preparing for the trade and investment backlash. Reduced reliance on the West has been on the menu at least since the global financial crisis. China has spent uncounted billions building physical and financial connections to about 150 countries (mostly in the Global South) through its Belt and Road Initiative. It now buys more corn from Brazil than from the United States. And its exports to Russia have grown rapidly during the Ukraine war despite increasingly stern disapproval from Brussels and Washington.

China has also steadily diversified its import sources and, more recently, its export destinations. The share of imports that China buys in the U.S. now comprise less than 10 percent of the total, while imports from Western-riented Japan and South Korea have also fallen. Meanwhile, China’s exports are increasingly going to middle- and low-income countries. This latter shift explains how China has maintained its global leadership in manufactured goods markets – shipping 28 percent of total manufactures exports in 2022 even as it lost market share in America.

These adaptations are not without cost to the Chinese economy, however. Some of the adjustment takes the form of redirecting Chinese investment to neighboring countries, which effectively exports jobs formerly performed on the mainland. A less obvious cost is the loss of learning-by-doing that selling into high-income, high-standard markets has afforded Chinese companies for the past quarter century. China has long benefited from the continuous diffusion of technology and management techniques that exporting to rich markets necessitates.

Lastly, shifting to poorer consumers limits the profits that Chinese companies can extract from their foreign sales. A recent Rhodium Group study estimates that, at current pricing levels, BYD (the world’s fourth largest maker of EVs) makes around €14,300 in profit on each SEAL U SUV sold in Europe, compared to €1,300 on units sold in the more competitive market in China.

As they survey the globe, China’s leaders are focusing on countries less inclined to follow the lead of Washington and Brussels. While rebutting American claims of Chinese overcapacity in EVs, wind turbines and solar cells, China has forcefully defended its industrial strategy as beneficial to decarbonizing the developing world. Nor has persistent criticism and warnings from the West diminished China’s embrace of Russia despite the risk of additional sanctions.

Meanwhile, even though weak domestic earnings have reduced Chinese lending to Africa – now at the lowest level in almost two decades – President Xi chose the 2023 BRICS emerging markets summit in South Africa for his second trip abroad since the pandemic. There, he promised more Chinese support for African industrialization and economic diversification.

These shifts in where China puts its money and support reflect an acknowledgment of new domestic and international realities. Aspirations for a greater role in shaping global economics appear, for now, to be eclipsed by the struggle to create a new economy better suited to global competition. No matter how long China delays reforms at home, its economy has reached a stage where it can no longer rely on exports alone to drive economic growth. Tensions implicit in Xi’s emphasis on “establishing the new before breaking the old” are by necessity shifting Beijing’s gaze inward and to the south and east. One challenge for the U.S. and its allies is to look there, too, even as the political focus is on protecting home markets.

In the 1840s, the struggle between the British and Russian empires in central Asia was dubbed “the great game.” Almost 200 years later, the rules governing clashing empires have changed – as have the stakes. China’s success in adapting to both growing internal tensions and to a global order no longer willing to give its motives the benefit of a doubt will drive geopolitics for decades to come.

The great game of the 21st century, it seems, has begun.