Nicholas R. Lardy
For over two decades, China’s phenomenal economic performance impressed and alarmed much of the world, including the United States, its top trading partner. But since 2019, China’s sluggish growth has led many observers to conclude that China has already peaked as an economic power. President Joe Biden said as much in his State of the Union address in March: “For years, I’ve heard many of my Republican and Democratic friends say that China is on the rise and America is falling behind. They’ve got it backwards.”
Those who doubt that China’s rise will continue point to the country’s weak household spending, its declining private investment, and its entrenched deflation. Sooner than overtake the United States, they argue, China would likely enter a long recession, perhaps even a lost decade.
But this dismissive view of the country underestimates the resilience of its economy. Yes, China faces several well documented headwinds, including a housing market slump, restrictions imposed by the United States on access to some advanced technologies, and a shrinking working-age population. But China overcame even greater challenges when it started on the path of economic reform in the late 1970s. While its growth has slowed in recent years, China is likely to expand at twice the rate of the United States in the years ahead.
MISREADING THE DATA
Several misconceptions undergird the pessimism about China’s economic potential. Take the widely held misconception that the Chinese economy’s progress in converging with the size of the U.S. economy has stalled. It is true that from 2021 to 2023, China’s GDP fell from 76 percent of U.S. GDP to 67 percent. Yet it is also true that by 2023, China’s GDP was 20 percent bigger than it had been in 2019, the eve of the global pandemic, while the United States’ was only 8 percent bigger.
This apparent paradox can be explained by two factors. First, over the last few years, inflation has been lower in China than it has been in the United States. Last year, China’s nominal GDP grew by 4.6 percent, less than the 5.2 percent that its GDP grew in real terms. In contrast, because of high inflation, U.S. nominal GDP in 2023 grew by 6.3 percent, while real GDP grew by only 2.5 percent.
Moreover, the U.S. Federal Reserve has raised interest rates by over five percentage points since March 2022, from 0.25 percent to 5.5 percent, making dollar-denominated assets more attractive to global investors and boosting the value of the dollar relative to alternative currencies. Meanwhile, China’s central bank cut its base interest rate from 3.70 percent to 3.45 percent. The growing gap between Chinese and U.S. interest rates reversed what had been a large inflow of foreign capital into China, ultimately depressing the value of the renminbi vis-à-vis the dollar by ten percent. Converting a smaller nominal GDP to dollars at a weakened exchange rate results in a decline in the value of China’s GDP when measured in dollars relative to U.S. GDP.
But these two factors are likely to be transitory. U.S. interest rates are now declining relative to rates in China, reducing the incentive of investors to convert renminbi into dollar-denominated assets. As a result, the depreciation of the Chinese currency has begun to reverse. The International Monetary Fund forecasts that Chinese prices will pick up this year, which would boost China’s GDP measured in renminbi. Its nominal GDP measured in U.S. dollars will almost certainly resume converging toward that of the United States this year and is likely to surpass it in about a decade.
A second misconception is that household income, spending, and consumer confidence in China is weak. The data do not support this view. Last year, real per capita income rose by 6 percent, more than double the growth rate in 2022, when the country was in lockdown, and per capita consumption climbed by nine percent. If consumer confidence were weak, households would curtail consumption, building up their savings instead. But Chinese households did just the opposite last year: consumption grew more than income, which is possible only if households reduced the share of their income going to savings.
China will likely continue to contribute about a third of the world’s economic growth while increasing its economic footprint.
A third misconception is that price deflation has become entrenched in China, putting the country on course toward recession. Yes, consumer prices rose only 0.2 percent last year, which gave rise to the fear that households would reduce consumption in anticipation of still lower prices—thereby reducing demand and slowing growth. This has not happened because core consumer prices (meaning those for goods and services besides food and energy) actually increased by 0.7 percent.
The prices of tools and raw materials used to produce other goods did fall in 2023, reflecting global declines in the price of energy and other internationally traded commodities as well as relatively weak demand in China for some industrial goods, potentially undermining the incentive for firms to invest in expanding their productive capacity. Rather than pump money into their businesses, the thinking went, companies would use their declining profits to pay down debt. But here, too, the very opposite came to pass: Chinese corporations ramped up borrowing, both in absolute terms and as a share of GDP. And investment in manufacturing, mining, utilities, and services increased. No recession appears on the horizon.
Another misconception concerns the potential for a collapse in property investment. These fears are not entirely misplaced; they are supported by data on housing starts, the number of new buildings on which construction has begun, which in 2023 was half what it was in 2021. But one has to look at the context. In that same two-year period, real estate investment fell by only 20 percent, as developers allocated a greater share of such outlays to completing housing projects they had started in earlier years. Completions expanded to 7.8 billion square feet in 2023, eclipsing housing starts for the first time. It helped that government policy encouraged banks to lend specifically to housing projects that were almost finished; a general easing of such constraints on bank loans to property developers would have compounded the property glut.
Finally, there is the misconception that Chinese entrepreneurs are discouraged and moving their money out of the country. Undoubtedly, the government crackdown that began in late 2020 on large private companies, notably Alibaba, did not help matters. From the beginning of economic reform in 1978 through the mid-2010s, private investment in China grew more rapidly than investment by state-owned firms. By 2014, private investment composed almost 60 percent of all investment—up from virtually zero percent in 1978. As private investment is generally more productive than that of state companies, its expanding share of total investment was critical to China’s rapid growth over this period. This trend went into reverse after 2014 when Xi Jinping, having just assumed the top leadership position, aggressively redirected resources to the state sector. The slowdown was modest at first, but by 2023, private investment accounted for only 50 percent of total investment. Xi had undermined investor confidence; entrepreneurs no longer saw the government as a dependable steward of the economy. So long as Xi is in power, runs a common argument, entrepreneurs will continue to hold back on investing in China, opting instead to funnel their wealth out of the country.
But here again, the pessimism is not supported by the data. First, almost all the decline in the private share of total investment after 2014 resulted from a correction in the property market, which is dominated by private companies. When real estate is excluded, private investment rose by almost ten percent in 2023. Although some prominent Chinese entrepreneurs have left the country, more than 30 million private companies remain and continue to invest. Moreover, the number of family businesses, which are not officially classified as companies, expanded by 23 million in 2023, reaching a total of 124 million enterprises employing about 300 million people.
REAL CHALLENGES AHEAD
Although China is beset by many problems, including those resulting from Xi’s efforts to exert greater control over the economy, exaggerating these problems serves no one. It could even lead to complacency in the face of the very real challenges that China presents to the West.
That is particularly true for the United States. China will likely continue to contribute about a third of the world’s economic growth while increasing its economic footprint, particularly in Asia. If U.S. policymakers underappreciate this, they are likely to overestimate their own ability to sustain the deepening of economic and security ties with Asian partners.
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