The world’s second-largest economy is visibly struggling. While countries across the world are raising interest rates or looking at policy to temper inflation, China is having to cut rates to push spending.

Economic data shows that China’s economic activity has been missing forecasts and downgrades by brokerages indicate that its growth, which showed early signs of progress after the COVID-19 pandemic, has been very subdued.

Before we get into the reasons for the downturn, let us look at why it has the world anxiously watching and waiting.

Why is the Chinese economy important?

Firstly, China is a manufacturing hub and a major supply partner for global companies and nations. So, a decline in economic activity or instability in China could throw off the global demand-supply balance. Nowhere was this better exemplified than during China’s long COVID-19-led shutdowns—owing to its “zero COVID policies”— that made companies scamper for alternative supply chains to cut their dependence on China.

Secondly, a slump in Chinese demand means that countries that depend on exports to China are particularly susceptible.

Thirdly, China is crucial to the global growth narrative. According to the data from the International Monetary Fund, the nation is a key driver of Asia’s growth and contributes the most—nearly 19%—to the global gross domestic product at purchasing power parity. A 1 percentage point growth in China leads to a 0.3 percentage growth in other countries, IMF’s analysis shows. China is slated to be the top contributor—22.6%— to global growth over the next five years.

So, how will a slowdown in China affect India?

India and China are major trade partners.

China’s primary imports from India comprise iron ore, refined petroleum, metals, hydrocarbons and cotton, data from the Observatory of Economic Complexity shows. In 2021-22, China accounted for 11% of India’s goods trade, according to a Mint report. So, India’s export bill could be significantly impacted if consumption in China slows down.

China’s total trade from exports and imports for the first six months of this year has already fallen 5% from the year-ago period, of which, imports alone have declined 6.7% due to stuttering growth. Meanwhile, India’s exports to the communist nation for the period totalled nearly $9.5 billion, down 0.8% year-on-year—a gap that is threatening to widen.

On the plus side, this could be an opportunity for India to increase its share as a supplier and boost its Make in India initiative, making the nation an attractive destination for global companies. India is already being looked at as a complementary Asian manufacturing hub. However, it will have to iron out several process and policy kinks before it can actually cut reliance on China. India’s younger working demographic, as opposed to China’s ageing population also works in its favour.

What is behind the downturn in China?

Recent economic data shows that China is struggling to meet its growth target of 5% and stress in the property market, which constitutes a quarter of China’s economic activity, is resurfacing.

So, what is causing this stress? The key issues broadly stem from low consumption and high, debt-fuelled investment in the real estate sector. Let’s take up the second issue first. Real estate accounts for a majority of personal wealth in China. But this wasn’t always the case.

The Chinese government began leasing state-owned land to developers after policy reforms in 1998. The sector took off soon enough and saw a major boom amid high demand from its growing working population that saw property as a family asset and status symbol. Loans were made easily available to buyers and developers and housing prices soared as more people came forward to buy homes. It also resulted in purchases by speculators—who buy in the hope of selling at even higher prices in the future. It was a cyclical chain of excessive borrowing and overbuilding.

Soon, the risk posed by the copious amounts of debt by developers began worrying the government. In 2020, the state imposed massive lending curbs, capping how much developers could borrow from banks. This worsened the liquidity at hand with cash-strapped developers failing to complete projects and defaulting on loan and bond payments. In China, “pre-sales”—paying for unfinished projects—make up 70-80% of new home sales. With developers defaulting on loans and leaving projects unfinished, protesting and worried homebuyers began boycotting mortgages and rethinking their purchases in the sector. This was further exacerbated by the COVID-19 crisis.

A case in point is the default by China’s biggest developer, Evergrande, in 2021 with liabilities worth $300 billion. Recently, property developer Country Garden Holdings missed two coupon payments on its bonds while state-backed Zhongrong International Trust, the largest shadow bank, missed repayments on several investment products, fuelling contagion fears.

Now there’s the other issue ailing the economy: consumption. Pandemic-induced lockdowns resulted in loss of work for months at a stretch and a crackdown by the Chinese government across sectors resulted in major job cuts. The Chinese largely fended for themselves during the lockdowns and so, the nation did not witness “revenge spending” the way the rest of the world did. China’s “zero COVID policy” also worsened the situation. All compounded, consumers grew wary of what lay ahead and became more conservative in their spending.

July data showed that China’s consumer sector fell into deflation and economists believe that it is the slowdown in domestic consumption that is resulting in slower national growth, similar to what Japan witnessed during the “lost decades”. Youth unemployment, which China has now stopped publishing, is also at extremely high levels, dampening demand. (We have written about this in a previous edition of Yesterday).

What is deflation and why is it bad for China?

We said earlier that China’s consumer activity witnessed deflation in July, but what does this mean? Deflation is when the price levels of commodities and services decline and the value of money rises. While that sounds like a good thing, large-scale or economy-wide debt deflation can result in a major financial crisis and eventually, recession.

Some economists are of the view that China’s deflated economic activity is a result of “balance sheet recession” —when consumers and businesses use more of their money to pay debt or save instead of spending.

When people spend less to pay their debts or put the money in savings, consumption reduces. This means demand will decline. As a result, companies will be forced to produce less to trim losses, which means low production, low investment and paring costs—including job cuts. No jobs will result in even lesser spending, and the cycle goes on. Under these conditions, China’s economic slowdown will only get worse.

Will boosting consumption work?

For years, the Chinese government has largely relied on debt-driven investments and spending on domestic infrastructure to spur the economy but the imbalance between China’s household consumption and investments is stark.

According to a Reuters report citing World Bank data, the contribution of investment to China's GDP is almost 20 percentage points above the global average, while household consumption is almost 20 points lesser. China’s household consumption also contributes far less than most countries to its GDP.

With the property bubble peaking, the government’s debts rising and exports declining, economists believe that spurring household demand is likely the only way to deal with the current crisis.

What must the Chinese government focus on?

China’s central bank, unexpectedly, cut rates last week and there is pressure on the state to further ramp up monetary efforts to push spending. China’s policymakers also need to immediately address risks from the country's property sector to ensure an even recovery, the IMF has said.

In the past, China has been able to use fiscal stimulus to boost economic growth but that, as we explained above, has also led to oversupply in the property market and exacerbated municipal debt and a cycle on loans. A large fiscal stimulus then seems unlikely but Beijing has few options and limited time left if it must arrest the slowdown.