China's Shifting Risk Assessment

The Chinese government is now placing equal emphasis on a negative external shock and inadequate domestic foundations — a serious warning for an already sluggish economy.

As always, March is the best time of the year for a deep think on China. Coinciding with the annual “Two Sessions” meetings of national legislators and political representatives, the government releases a series of detailed “work reports” that offer considerable insight into risks and policy priorities. The tone of this year’s work reports was different. The balance has shifted from a standard recapitulation of notable accomplishments to an unusually candid assessment of the multiplicity of mounting problems that China faces.

This was especially evident in the work report prepared by the National Development and Reform Commission (NDRC), the modern-day incarnation of China’s State Planning Commission and long the most powerful policy group in the State Council of the government (not the Party). The NDRC report fleshes out the detail of the Premier’s work report, which is formally delivered at the outset of the National People’s Congress. This year, buried in the middle of a 76-page document (English version), there were several paragraphs that placed equal emphasis on “the negative impact of the external environment” and a recognition that the “domestic foundations are not strong enough” for sustained growth in the Chinese economy. This leaves little doubt that Chinese policymakers are finally facing up to a tough combination of external and internal pressures. That message needs to be taken seriously.

Conflict escalation with the United States is obviously at the top of China’s external concerns. The good news for China is that it has traveled this road before. The bad news is that it is now facing a new round of US tariff hikes and sanctions when its economy is considerably weaker than it was in 2018-19 during the first phase of the trade war. While there are rumors of an upcoming Xi-Trump summit in mid-2025, I wouldn’t count on a diplomatic resolution of this superpower conflict. I remember all too well a similar sense of optimism surrounding the two leader-to-leader summits that took place in 2017, only to be followed by the sharp increases of US tariffs in 2018-19. Those tariffs on Chinese products, with an effective rate of 19%, are still in place today, making the recently announced hikes of an additional 20% all the more onerous.

China has been hit hard by the bilateral trade conflict with the US. While United States is still China’s largest export market, its share of total Chinese exports fell to 12.8% by 2023, well below the 19.8% average in the five years prior to the first phase of the trade war (2014-18). At the same time, the multilateral impacts have been minimal … so far. The share of overall Chinese exports held at 19.7% of GDP through 2023 — little different from the 19.5% average in the preceding seven years. China was able to manage a significant loss of support from US demand through an impressive export diversification strategy — namely, by especially large increases in export exposure to Vietnam, Russia, and India, along with smaller gains to Germany, the UK, South Korea, Thailand, Indonesia, and Mexico.

Alas, that is yesterday’s news. With further weakness in US export demand likely from the heightened anti-China actions of Trump 2.0, Chinese export diversification will need to intensify in order to avoid a significant shortfall in overall GDP growth. That may be very difficult to achieve considering darkening prospects for the global trade cycle. According to the IMF’s latest baseline forecast, total trade in goods and services (exports and imports combined) is projected to slip to 56.2% of world GDP by 2029, well below the 61.5% peak of 2022. That trajectory masks the increasingly worrisome risks of a full-blown global trade war. That’s especially the case with Trump about to escalate the early, product-specific, phase of his 2025 tariff campaign to more broad-based multilateral “reciprocal” measures, which will undoubtedly spark widespread escalating rounds of tit-for-tat retaliation. China’s export diversification strategy could prove even more problematic if growth in the overall world economy tilts to the downside in response to such a tariff-escalation scenario, as I suspect (and will discuss next week). In short, the NDRC’s concerns about China’s increasingly treacherous external environment seem well justified.

The implications are clear: In the context of China’s unchanged GDP growth target of “around 5%,” a new external shock puts increased pressure on internal demand to provide an offset. Unsurprisingly, with lingering weakness in the property sector, “boosting consumption and investment returns” is listed as the number one priority by the government in the year ahead. This ranking, however, is no guarantee of success.

Consumer-led rebalancing has, of course, been long been discussed in Chinese policy circles, but with household consumption remaining below 40% of Chinese GDP, there is little to show for the effort. It has been the top of my own research agenda on China for over fifteen years. I have been encouraged by China’s successes in boosting personal incomes through increased job creation in services and pushing up real wages through rural-to-urban migration, but I have been disappointed in the failure to convert the resulting growth in labor incomes into incremental consumer demand. The main stumbling block: The mounting excesses of fear-driven precautionary saving have not been effectively addressed.

The optimistic view is that China’s stimulus actions of last September, along with modest fiscal initiatives just announced, will re-energize consumer confidence, encouraging households to draw down excess saving. While the latest IMF assessment of China points to some reduction in household saving following the end of the Covid lockdown, the saving rate is still above pre-pandemic levels. With bourgeoning household bank deposits now 13% larger than nominal GDP, there is hope that the recent stimuli will unlock excess saving and spur pent-up personal spending. I have my doubts. Survey data from the People’s Bank of China indicate that over 60% of China’s urban residents still want to increase their personal saving — dramatically higher than the roughly 40% share prevailing in the pre-Trump trade war period of early 2018.

I have long stressed the need to focus on a more robust social safety net — namely healthcare, pensions, and hukou reforms aimed at benefit portability — as the necessary antidote to China’s excess saving problem. Unfortunately, as underscored by the limited safety net proposals in the just-released “Two Sessions policy package” — only about RMB50 million out of a total fiscal stimulus of RMB2 trillion — Chinese policymakers continue to lack resolve in embracing this approach. More than anything, Chinese households need to convert fear of an uncertain future into a greater sense of security and confidence that only a more robust safety net can provide — a transition that is undoubtedly complicated by the CCP’s “social engineering” fixation on the politics of discipline and control.

Instead, Chinese authorities continue to place much greater emphasis on trade-in campaigns to bring forward demand for aging and obsolete big-ticket durable products such as motor vehicles, appliances, and some consumer electronics. This is likely to have a short-term impact, at best. A one-off boost to replacement demand does not address the lingering excesses of precautionary household saving, underscoring a still problematic outlook for sustained growth in discretionary consumption.

In recent years, Beijing has opted for a different approach to China’s structural problems — focusing more on the supply side than on the demand side of the economy. This year, the government has been careful to stress that both household consumption and investment returns have top priority in its 2025 growth agenda. As such, in addition to the emphasis on consumption noted above, there continues to be considerable focus on “new quality productive forces” and related emerging industry clusters — especially AI-enabled indigenous innovation, modernized transportation (vehicular and rail), advanced computing, and alternative energy (generation and storage). This is aimed at boosting total factor productivity — the Holy Grail of economic growth for any nation that takes on added importance for China as an important counterweight to a declining working age population that has arisen from the draconian one-child family planning policy.

The Japanese precedent is especially noteworthy in that regard. Japan has long been struggling against serious demographic headwinds, unable to overcome enormous political inertia in addressing deeply entrenched resistance to productivity-enhancing measures in its labor market, immigration system, and corporate governance. For nearly nine years, China has actively debated the need for supply-side structural reforms as the most effective strategy to avoid the Japanese disease. Repackaging this emphasis into support for new quality productive forces doesn't change the basis thrust of China’s supply-side strategy. While there are certainly grounds for encouragement — especially reflecting recent breakthroughs in artificial intelligence, green technology, digitization, electric vehicles, and new-found focus on private sector “animal spirits” — the jury is still out on what that means for overall TFP growth as a potential offset to China’s increasingly stiff demographic headwinds.

Alas, there is an important catch to this strategy. Notwithstanding the importance of TFP as a key driver of long-term Chinese economic growth, without a commensurate increase on the demand side of the equation — especially household consumption — the heightened impetus to the supply side could be self-limiting. As a demand-short economy, China would then have to export production from the resulting excess capacity of its new quality products to the rest of the world — exacerbating the serious protectionist pressures it is already facing.

That’s what links the twin top priorities of its growth agenda. China’s focus on household consumption is critical if it is to absorb the increased high-return output of new quality productive forces. A failure to do so underscores the potential for a key strategic imbalance that could play an important role in China’s battle against mounting deflationary pressures. With China now in its third year of deflation — the longest episode of declining aggregate prices (as measured by the GDP deflator) during the modern post-1978 reform period — a resolution of this supply-demand imbalance looms as one of China’s major strategic challenges.

Beijing’s March policy debates have been a key aspect of my own professional journey as a China watcher for over a quarter of a century. Over that period, I have been privy to the inside debate in Beijing as China has faced several key external challenges — especially the Asian Financial Crisis of the late 1990s, the dotcom recession of the early 2000s, the Global Financial Crisis of 2008-09, and the Trump 1.0 trade war of 2018-19. In those earlier instances, China responded forcefully and did not fall into crisis, or wēijī (危机), as many in the West feared. In keeping with the dual Chinese meaning of this word, China avoided danger by seizing on the opportunity dimension of wēijī. This strategy was effective in large part because China had the backstop of strong underlying momentum of its real economy. That luxury is not available today.

Today, China is under more pressure than ever at this key juncture in its modernization journey. How it ultimately responds to that pressure remains to be seen. Last year, it was quite difficult for China to hit its 5% growth target. In a more treacherous external climate, I suspect that it will be even tougher to pull it off in 2025.