The Chinese economy has come under unprecedented deflationary pressure. This is because demand has not recovered following the bursting of the real estate bubble. Nevertheless, the Xi Jinping government remains unable to take fiscal or monetary measures to fully leverage the economy. The reason behind this is that China's unique financial system, which relies on foreign capital, is severely constrained by the exodus of foreign companies and investors from China.
The current situation represents a natural consequence of risks associated with investing in China, including Taiwan-related risks, that have grown since Russia invaded Ukraine in February 2022. The Joe Biden administration of the United States should not take a conciliatory approach that could lead to the resumption of Western investment in China.
Real estate investment has driven the Chinese economy for 10 years under the Xi government. But it fell 10% year-on-year in 2022 in the wake of housing price falls. The unemployment rate for urban youth (aged between 16 and 24) was 20.8% in May 2023. This means that more than one in five were unemployed.
A year-on-year rise in the core consumer price index (excluding energy and food prices), an inflation indicator reflecting the supply-demand balance, remained in the 0.8% range in 2021 and 2022. It then fell to the 0.7% range in May 2023. In contrast, the core inflation rate in Japan under chronic deflation was 4.3% in May. China is now under greater deflationary pressure than Japan.
Chinese Economic Policy at a Dead End
Furthermore, monetary easing by the People's Bank of China is very limited in terms of both quantity and interest rates. This is attributable to a decrease in foreign exchange reserves and the Chinese yuan's depreciation against the dollar. China's foreign exchange reserves are underlying assets for yuan issued by the central bank.
The ratio of foreign exchange reserves to the dollar-equivalent value of yuan issued has plunged to 60% from more than 100% in the years following the 2008 global financial crisis. Any substantial interest rate cut would lead to a large-scale yuan sell-off and force the central bank to dip into foreign exchange reserves to buy up yuan, creating a vicious cycle.
Additionally, financial difficulties are serious for local governments. After all, land use income from real estate developers accounts for some 80% of total revenue. Local governments should be able to secure financial resources through local bond issuance, but quantitative easing by the People's Bank of China is essential. This is also constrained by foreign exchange reserves. The economic policy of the Xi government is at a dead end.
There is only one solution for China: to increase foreign exchange reserves. The only way to achieve this is to expand the current account surplus and external debt. But it is difficult for China to increase the trade surplus that accounts for most of the current account surplus. The remaining external debt, or direct investment from foreign companies and securities investment from institutional investors, decreased by a total of $475 billion USD year-on-year at the end of 2022. The current account surplus of about $400 billion USD in 2022 cannot cover capital outflow.
President Xi took an arrogant attitude of sitting at the seat of honor during his recent meeting with visiting US Secretary of State Antony Blinken. But it was probably a show of bravado. In reality, unless Xi tries to improve relations with the United States — even if it requires humbling himself — there is little hope for the return of foreign capital to China.
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Author: Hideo Tamura
Hideo Tamura is a Planning Committee member at the Japan Institute for National Fundamentals and a columnist for The Sankei Shimbun newspaper.