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Economic Challenges Awaiting the Xi Jinping Administration as It Enters Its Third Term

Toshiya Tsugami

China's economy in the first half of 2022, after a significant decline

China had planned for economic growth of around 5.5% in 2022, but it fell sharply to 2.3% (y/y) in the first half of the year and to 0.4% in the second quarter (April to June). The most significant cause was the overly strict zero-corona policy.

Shanghai, forced to go on a total lockdown for two months, posted -13.7% in the second quarter. The surrounding provinces of Jiangsu and Zhejiang also fell, bringing down the economy of the entire East China region, the heart of the Chinese economy. Beijing also suffered a negative growth of 2.9% due to the strict corona measures adopted. Thus, central cities in China were severely affected one after another.

Another cause of the significant downturn in the Chinese economy is the severe downturn in the real estate sector that has continued since the second half of last year. Using human health as a metaphor, if the economic decline caused by the zero-corona policy is an acute illness, then the problems brought on by the real estate problem are chronic illnesses.

In the summer of 2020, the Chinese government was deeply concerned about the flare-up of the real estate bubble and began tightening loans to real estate developers, which led to a severe recession in the real estate market in late 2021. Realizing the seriousness of the situation, the government began to relax the tightening measures in late 2021 (see note 1 ), but the aftereffects were not mild enough to be dealt with by such measures. Real estate statistics for the first half of 2022 were dismal. Year-on-year home sales fell 26.6% in area and 31.8% in value. New construction dropped 35.4% in area, and land transactions in value dropped 48.3%.

Why tighten real estate that severely?

Real estate is said to have contributed 1/4 to 1/3 of annual economic growth when direct and indirect effects are combined. Why has the Xi Jinping administration adopted severe tightening measures for such an important sector? We can find the reason by looking back at the economic policies of the past ten years since the arrival of the Xi Jinping administration.

From the beginning of his presidency, President Xi Jinping (and his economic advisors) have tried to change the policy course of maintaining growth rates by relying on debt and investment, including investment in infrastructure and real estate (see note 2.) In 2014, under the slogan "New Normal," he began managing the economy without easily adopting stimulus measures when growth slows. The graph1 shows changes in economic indicators sensitive to the government's stimulus measures (year-on-year growth rate, line graph) overlaid with the debt/GDP ratio (right vertical scale, bar graph.) One can see that economic indicators worsened across the board from 2014 to 2015 when the "new normal" policy was adopted.

Policies to curb investment tend to be resisted by local governments eager to invest in infrastructure, steel, cement, and other old industrial sectors that have thrived on investment demand.

In particular, 2015 became a year of severe challenges for the "new normal" policy. The bursting of the stock market bubble in June and the RMB devaluation fiasco in August raised concerns about the future of the Chinese economy and increased pressure for stimulus measures. The following year, 2016, was the first year of the 13th Five-Year Plan, and many new projects lined up at the starting line across the country. As a result, the "new normal" policy was pushed back and came to a halt, and a new investment boom began in 2016.

This resulted in a dramatic turnaround in economic indicators in 2016, but the debt/GDP ratio rose further. Not only that, but the real estate bubble also intensified again in 2016 (see the graph2, which overlays the above-mentioned economic indicators and housing prices vs.)

In 2017, the Xi Jinping administration, gravely concerned about the excessive debt problem and the worsening real estate bubble, once again sought to break away from its reliance on investment and debt under a new slogan, "deleveraging." This time, thanks partly to Xi's concentration of power, it has lasted for a while, and the debt/GDP ratio has stopped growing and stabilized.

However, as the 2020 COVID-19 pandemic struck, China mobilized all its fiscal and monetary resources to help recover its economy. As a result, economic indicators recovered rapidly again, but at the same time, debt/GDP ratio jumped up to nearly 25%, and the housing bubble resurfaced. This was the second setback for the country's attempt to break away from its reliance on debt and investment.

The Xi Jinping administration tightened the real estate industry in 2020 because the two previous setbacks made it determined not to "further exacerbate the excessive debt and real estate bubble." The sharp drop in economic growth in the first half of 2022 has once again brought about a growing call for a significant economic stimulus package, but the Politburo meeting held on July 28 indicated that it would not push too hard for the pledged "5.5% annual growth" (see note 3.) With the 20th Party Congress approaching in the fall to decide Xi Jinping's third term in office, he would lose face if he were to fail to deliver on this crucial economic pledge. However, he may have decided that a third setback awaits him if he insists on 5.5% growth and adopts an unreasonable or excessive stimulus package.

China's Economic Challenges Awaiting the Third Term of the Xi Jinping Administration

President Xi Jinping will be elected for an unprecedented third term at the 20th Communist Party of China (CPC) Congress scheduled for the fall of 2022 and is expected to remain at the top until at least 2027. Let us look at his reign over the next five years from four perspectives to see what challenges lie ahead in the economy.

（1） Breaking away from reliance on investments and debt

As noted above, the Xi Jinping administration has consistently believed that the country should move away from a reliance on investment and debt. However, the results have been a series of setbacks. Comparing 2012, 10 years ago when Xi Jinping came to power, to the present (2021), the size of the economy has increased 2.1 times. However, the total debt has increased 3.3 times, housing prices have increased 1.6 times on average nationwide, and three times only in Beijing. For the Xi Jinping administration, which will begin its third term in the fall, the battle against the excessive debt problem and the real estate bubble is not back to square one but is worse than it was ten years ago.

Moving the economy away from its dependence on real estate and infrastructure investment is not easy. The contribution of capital formation to annual GDP growth has averaged 38.6% over the past five years, nearly 40%. In addition, investment in fixed assets has grown by an average of 5% over the past five years, although it has been recently settling down. Simply bringing the investment size to the same level as the previous year would result in a zero contribution to the growth and a nearly 40% drop in the growth rate. Furthermore, if the investment is cut year after year, it will further depress growth. Vested interests will strongly resist, as they did in 2016 when they aborted the "new normal" policy.

（2） Resolving the wealth gap and real estate bubble

The Xi Jinping administration launched a new slogan last 2021: "Common Prosperity." The problem of wealth disparity does not only undermine political stability. Real estate bubbles and wealth disparity undermine economic growth. They are a typical cause of developing countries falling into the "middle-income trap," which prevents them from overcoming the $10,000 per capita GDP barrier, so there is nothing strange about the " Common Prosperity" approach.

However, China's disparity between the rich and the poor today is not so much the disparity in income as in the disparity in assets: "the haves and have-nots." The main culprit in widening this disparity is the CCP government's failure to easily continue to rely on real estate to achieve economic growth. As a result, real estate has become insanely expensive, and the asset disparity between the "haves and have-nots" has widened to the same extent as in the U.S. (see note 4 ).

On the other hand, it is not a matter of simply lowering real estate prices to narrow the disparity between the "haves" and the "have-nots". Because more than 90% of Chinese households are homeowners, and that two-thirds of households' assets are real estate (see note 5 ), a significant drop in real estate prices would cause great dissatisfaction among the Chinese people toward the CCP Government. Rather, the people in China have believed that the Chinese government, with its powerful authority and financial resources, would try at all costs to prevent a collapse in real estate prices.

However, there have been recent incidents that have shaken this belief. Recently, real estate developers have fallen into a financial crisis due to severe tightening measures by the government. They have built many condominiums that have already been sold but are left unfinished because the remaining construction cannot continue due to shortfalls in funding. In response, there is a growing movement among buyers who purchased condominiums with mortgages to collectively boycott loan payments and demand that the local government takes action.

As of this writing, a total of 326 properties in 115 cities nationwide have been confirmed to have defaulted on loans, and the number is likely to increase further (see note 6 ). These protest moves will further cool down the real estate market and raise concerns that bank loan assets will turn into non-performing loans.

The Politburo meeting held on July 28, 2022, stated: "ensuring the delivery of buildings and stabilizing the civilian population under the responsibility of local governments." Regarding the issue of uncompleted condominiums, there are reports that the affected local governments are considering the idea of establishing a fund to complete condominium construction by providing bridge funds through bank contributions (see note 7 ).

However, if the banks are required to bear the risk of collection, the number of projects they can finance will be limited and time-consuming. In the meantime, there is a risk of a vicious cycle in which the real estate market will become increasingly anxious. In order to prevent this from happening, the government should decisively put in place a mechanism to compensate the banks if the bridge loan falls through. However, the government has not yet taken a firm stance on this issue. The central government's attitude of leaving measures to the financially strapped local governments is also puzzling. If the government does not act decisively, the real estate market will become increasingly unstable, and the risk of a bubble burst will increase.

（3） Sustainability of national finances

Dividing the Chinese economy into two sectors, the private sector and the "public" sector, including the government and state-owned enterprises, the private sector is said to be responsible for 50% of tax revenues, 60% of GDP, and 80% of employment, making it the leading actor in the flow economy. On the other hand, the "public" sector, which plays only a minor role in the flow economy, controls a great deal of wealth that is disproportionate to its minor role. The majority of land values and market capitalization of listed companies (see note 8) are in the hands of the "public" sector, which implies that the "public" sector is the leading actor in the stock economy (wealth ownership.)

In other words, the Chinese government is blessed with financial resources, as it receives a larger share of the fruits of growth than the governments of other countries. The Chinese government has used these financial resources to pursue industrial policies, military expansion, space exploration, and so on that other countries can hardly imitate. The Chinese people have relied on the government to somehow solve any economic or social problems that might arise. Recently, however, local governments, whose duties are closely related to the people's livelihood, have faced unprecedented financial difficulties. There are fears that they will not be able to fulfill their roles as they have previously.

The most significant cause of local government fiscal distress is the overinvestment and excessive debt of the past decade. It is a chronic disease of China's local governments that local city leaders compete with neighboring cities for economic growth and push forward with infrastructure investment by borrowing excessively without regard to their ability to repay.

Local government finances were in crisis in 2014 because of this. However, this time they got a reprieve thanks to the central government lifting the ban on the issuance of local government bonds (in exchange for a promise to reduce or eliminate "hidden debt" by local government subsidiaries). However, as soon as local governments became financially lighter, they accumulated even more debt to take advantage of the new infrastructure investment boom in 2016. The graph shows that local governments' "hidden debt" continues to grow. Moreover, 85% of the funds borrowed in this way went to refinance existing debt (see note 9 ). Thus, local government finances are once again heading toward a financial crisis.

The economy's overdependence on real estate is also impoverishing local finances. The severe real estate slump has resulted in a significant drop in local government revenues from land sales. Land sales revenue, which accounts for 30% of total local government revenue, dropped 31.4% in the first half of 2022. In addition, local governments are currently amid a stimulus package that includes a significant cut in VAT on the revenue side, and an increase in public works projects to boost the economy on the expenditure side.

The fact that local governments are experiencing significant financial difficulties is reflected in the reports of pay cuts for local government employees across the country since last year. The recent trend of pay cuts is said to be spreading to some of China's wealthiest provinces, including Shanghai, Zhejiang, and Jiangsu (see note 10 )

As the population ages, the financial burden of pensions and medical care will increase dramatically. Amid this situation, local finances are about to fall into a severe shortage of financial resources due to past excessive debt and dependence on real estate. It is doubtful that the government will be able to continue to demonstrate its ability to "somehow solve economic and social problems as they have in the past.

（4） The Digital Economy and Science and Technology (Growth Accelerators)

While this article has covered the pessimistic topics above, there are also some positive aspects. China is leading the world in the digital economy. While the negative aspects of a "surveillance society" are often discussed abroad, China was able to immediately launch a COVID-19 tracking system because it is blessed with well-developed digital infrastructure and qualified engineers. China is also at the forefront of the world in developing 5G communication networks, which will accelerate the diffusion of IoT technology (technology that connects all aspects of society via the Internet) to the most advanced level in the world. These developments should also help China improve its productivity, which will be a driving force for growth.

There has been remarkable development in China's science and technology in recent years. It was recently reported (see note 11 ) that China has surpassed the United States for the first time in the number of research papers in the field of natural science. As a result of 40 years of diligent efforts following the U.S. and other advanced countries, China has become an undisputed scientific and technological superpower. Following the U.S. precedent, which has achieved many successes by applying the excellent scientific and technological achievements produced with government funding to industrial technology, the era of applying scientific and technological achievements to the economy will also arrive in China.

However, it is doubtful that these positive aspects will rescue the Chinese economy from the problems described in the previous section.

The economic future that awaits the third term of Xi Jinping administration

President Xi Jinping and the Chinese Communist Party set a long-term goal of "raising GDP per capita to the level of moderately developed countries by 2035" in the 14th Five-Year Plan enacted in the spring of 2021, which is an intermediate milestone toward achieving "the great revival of the Chinese nation" by 2049. In order to achieve this long-term goal, the economy must continue to grow at an average rate of 4.5% or more for the next 14 years.

However, the outlook is bleak. In the first decade of the 21st century, real estate and infrastructure investment were the literal growth drivers. There was a good reason for the housing price, which just commercialized several years ago, to rise rapidly, attracting even more investment. For infrastructure investment, so many quality projects were queuing up for their turn to invest, which contributed significantly to economic development. However, "月満則亏;the moon waxes and the moon wanes"...as China continued to rely on this over decades, the growth driver turned into a growth constraint.

First, it will not be easy to maintain the scale of investment in real estate or local government infrastructure. This is because it is financially unsustainable, and there are no longer many projects worth investing in. China will have to reduce investment and withstand the resulting decline in growth. In short, "the borrowed growth rate will have to be repaid later." As mentioned above, the Xi Jinping administration has tried to stop investment increase from the beginning but has repeatedly failed. This has caused the advance borrowing to increase further, and the amount to be repaid in the future has also swelled.

Second, there is a significant risk that China will fall into the "middle-income trap" due to past overinvestment. In order to maintain economic growth, the only right way forward is to improve productivity, the source of growth. It is necessary to encourage productivity growth by reshuffling the structure of the economy, for example, by expanding the high-productivity sectors and downsizing the low-productivity sectors. Wealth distribution should also be carried out in line with this direction.

However, the overinvestment in real estate and infrastructure that China has accumulated to date has indeed distorted the distribution of wealth, increasing the disparity between rich and poor and hindering productivity growth.

For example, the investment yield on Chinese real estate is around 2%, less than half the most favorable bank lending rate (see note 12). The value of assets is apparently overvalued (see note). The disproportionately overpriced real estate serves as a channel through which wealth is transferred from the "have-nots" (renters, new business owners, Etc.) to the "haves" (landlords) in the form of land rent or rent.

There are also many "zombie local governments" that can never redeem on their own the debt they have taken on to invest in infrastructure. They can refinance and continue to pay interest thanks to the government providing an "implicit government guarantee." However, the interest is only paid by swapping the revenues other businesses (other companies) initially generated. The financial institutions that loaned them money should be held "responsible for lending money to people they should not have lent it to" and should dispose of their claims as losses. By contrast, continuing to receive interest rates channels an irrational transfer of wealth toward the financial institutions and the wealthy who deposit large sums of money with them (see note 13 ).

From an accounting perspective, it can be argued that China's investment boom of the past decade has significantly worsened its overall financial health. Using a balance sheet metaphor, the "assets" section has accumulated deteriorating assets with a net value far below face value, while the "liabilities" section has accumulated debts that debtors cannot repay on their own. Thanks to "implicit government guarantees," these loans have not yet defaulted or gone bankrupt, but in reality, they are latent non-performing loans. This discrepancy between the face value and reality distorts the distribution of wealth (government bloat and wasteful spending), increases the disparity between the rich and poor, and hinders productivity growth.

In a normal country, if there is a large discrepancy between face value and reality, liquidation would begin in the form of a bubble burst. However, in China, where government power is exceptionally significant, the bubble does not burst due to the practice of "implicit government guarantees." Instead, distortions in the distribution of wealth and the disparity between rich and poor are getting worse by the day. The longer the bubble holds up, the more serious these problems become - this is the core of China's bubble problem.

If the progression of this disease is not halted, China's productivity growth will be hampered, and the country will inevitably be doomed to fall into the middle-income trap. To stop the disease, it is necessary to liquidate the garbage assets and bad debts that have accumulated on both sides of the balance sheet.

This does not necessarily demand that the bubble burst. In the early 1990s, Japan's hasty attempt to collapse its real estate bubble led to a "lost decade" as many bank loans secured by real estate became non-performing loans. However, since most of China's financial institutions are state-owned, it is not theoretically impossible to systematically clean up both asset and liability sections.

In the process, however, China and its people must face various inconvenient realities. Real estate prices, which account for 2/3 of all household asset holdings, will decline. The government's infrastructure investments, piled up for two decades, have resulted in huge losses (diminishing asset values). New investments will be cut back until the balance sheet is cleaned up; thus, the pain of low growth will be unavoidable.

It remains to be seen whether the Chinese Communist Party, which has seized total control of the country and refused any outside checks, will be able to make the public face and accept these inconvenient realities.

Prior to the 20th Communist Party Congress in the fall of 2022, President Xi Jinping recently delivered a speech on policy management for the next five years (see note 14 ). In a nutshell, there seems to be no change in Xi Jinping's policies up to last year. For example, there is no sign of any modification to the goal of "raising GDP per capita to the level of moderately developed countries by 2035," which was set in March 2021 in the "14th Five-Year Plan. In other words, there is no change in the policy goal of continuing economic growth at an average of 4.5% or more for the next 14 years. This is probably because the goal is an intermediate milestone for achieving President Xi Jinping's ultimate goal, "the great revival of the Chinese nation." If the intermediate goal wavers, achieving the ultimate goal will also waver.

However, the past year has also been marked by an unprecedented real estate recession and a lockdown fiasco in China. In the world, the war in Ukraine has erupted, inflation has returned for the first time in half a century, and countries are forced to raise interest rates. Uncertainty and risk have risen dramatically both in China and the world over future economic growth, yet the content of this discourse is "as it was a year ago," as if nothing like this had happened. Moreover, there is no sense of readiness to resolve the economic challenges discussed in this paper.

Suppose that the government is unwilling to accept a decline in growth, and that they are also unwilling to accept the kind of drastic measures that would seriously question the past reign of the Communist Party. In such a case, they will have no choice but to increase fiscal spending to cover up the problem, but local finances are now at their limits. In the third term of the Xi Jinping administration, the author expects that the relationship between central and local government finances will be drastically revised sooner or later (e.g., pensions will be fully financed by the central government) , and that budget deficits will increase rapidly. China is now the world's largest net creditor nation when Hong Kong is included (see note 15 ). China will not go bankrupt immediately even if it issues many government bonds. However, its debt/GDP ratio will easily rise through 300% very soon. Then wouldn't China fail to learn from past mistakes of others as seen in Japan ?

A catastrophic event such as the bubble burst in the third term of the Xi Jinping administration is still unlikely. However, if painful surgery is avoided, the Chinese economy will fall into the middle-income trap. Although economic development through digitalization and science and technology is promising, the structural problems facing the Chinese economy are too significant to be able to drive overall economic growth only on their own. We must watch closely to see what impact the decline in growth and the end of the dream of the "great revival of the Chinese nation" will have on the domestic and foreign policies of the Xi Jinping administration.

(Adjunct Researcher, the Japan Institute of International Affairs)

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