Sound the alarm! China’s economy grew by 6% in the third quarter, the slowest annual rate in 30 years. This was down from 6.4% in the first quarter and 6.2% in the second. The main culprits include sputtering factory output and sagging infrastructure investments.
This is a big deal. Not because it’s bound to spook investors (it won’t help that it comes on the heels of the IMF’s
gloomy global growth forecast), but rather because letting the economy weaken is actually a good thing.
“China needs slower growth,” explains Andrew Polk, an economist at Trivium, a Beijing-based research firm. “Policymakers’ reluctance to stimulate the economy might disappoint investors in the short term, but it’s a huge long-term positive.”
This is because the “quality” of China’s growth is, to use a technical term, kinda lousy. The way China measures growth and sets GDP targets encourages investment in projects that will never be profitable enough to cover initial costs. Short-term GDP growth trumps long-term GDP growth.
To understand why, it helps to run through the backstory. In theory, GDP growth should beget more GDP growth. As investments creates new production, the profits generated by that production fund still more economic activity—hiring more workers, installing new equipment, and building more factories.
But if that initial capital is spent on things that aren’t profitable, the cash to fund new investments dwindles. The economy grows more slowly and perhaps even shrinks.
The Chinese government has long defied this economic logic. Since many of its investments aren’t profitable, the money to fund new economic activity comes instead via credit from state-run banks and, in the past, through shadow finance (loans made off bank balance sheets). It achieves this in part by controlling banks, though also through setting GDP targets that tell local government officials how much they must invest to earn promotions. (The 2019 target, by the way, is 6-6.5%, so it just barely made it last quarter.)
Greenlighting investments based on politics, and not the potential for profit, has kept GDP growing at an eye-popping rate. And so, too, debt. China’s outstanding debt hovers around $35 trillion—as a share of GDP, it’s among the highest in the world.
But you’ll note that the pace of accumulation has slowed markedly in the past few years. That’s in no small part because, since 2017, the Xi Jinping administration has been trying to snuff out shadow banking in order to “de-risk” the economy. As Gabriel Wildau, an analyst at Teneo Intelligence notes, that crackdown is partially responsible for the current slowdown. That leaders are holding the line suggests a resolve to clean up at least some of the source of China’s debt woes. After all, they’re willing to stomach the lowest growth in 30 years to do it.
That resolve will face some tough tests over the next year or so. The worst is yet to come, says Wildau, which could force China’s authorities to sacrifice de-risking for stabilizing the economy with stimulus.
Then again, at a certain point, it’s possible that stimulus simply won’t work anymore.
However much China’s leaders want to crimp new wasteful investments, the economy is still weighed down by existing ones. Take, for example, the main policy tool for stimulating demand: infrastructure. After nearly a decade of heavy infrastructure investment—when spending surged by around 20% or more each year—there simply aren’t a lot of worthwhile projects left. And that, says Trivium’s Polk, “makes it awfully hard to put a floor under economic growth.”
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