5/1/24, 18:51 Who Killed the Chinese Economy?

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RESPONSE

Who Killed the Chinese Economy?

The Contested Causes of Stagnation
By Zongyuan Zoe Liu; Michael Pettis; Adam S. Posen November/December 2023

Published on October 3, 2023

Walking under umbrellas in Beijing, July 2023

Thomas Peter / Reuters

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In response to The End of China’s Economic Miracle

By Adam S. Posen

Fall Guy
By Zongyuan Zoe Liu

Inherited Trauma
By Michael Pettis

Posen Replies
By Adam S. Posen

Fall Guy
Zongyuan Zoe Liu

In “The End of China’s Economic Miracle” (September/October 2023), Adam Posen describes
China’s recent economic challenges as a case of “economic long COVID.” Chinese President Xi
Jinping’s “extreme response to the pandemic,” he posits, triggered “the general public’s immune
response” and “produced a less dynamic economy.” Posen’s analogy is creative and insightful. But
his diagnosis misses the chronic diseases that afflicted China’s economy well before the COVID-
19 pandemic: an exhausted growth model, stunted population growth thanks to the “one-child
policy,” and, most notably, Xi’s failures of leadership.

Xi is not to blame for the Chinese economy’s deepest structural problems. He is, however,
responsible for the government’s failure to deal with them. In 1978, Deng Xiaoping initiated
sweeping economic reforms after the end of the Cultural Revolution. Standing apart from
previous Chinese Communist Party (CCP) leaders, particularly Mao Zedong, Deng took an open
and pragmatic approach toward economic development. He rebooted China’s relationship with the
United States, observing in 1979 that “all countries that fostered good relations with the United
States have become rich.” When China’s economy faltered after the government’s crackdown on
the 1989 Tiananmen Square protests, he headed off a downward spiral by clearly reiterating the
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party’s commitment to economic reforms, especially during an influential 1992 tour of southern
China.

Over the last 45 years, China has transformed from one of the world’s poorest and most isolated
countries into the heart of the global supply chain. That economic rise, however, was built on a
system of financial repression that prioritized investment and exports over domestic household
consumption, leading to harmful stagnation on the demand side of the economy. Posen identifies
the first quarter of 2020 as the “point of no return” for the Chinese economy, but it has faced
looming problems for at least a decade. The workhorses of its growth model were already tiring
years ago.

When Xi became president, in 2013, he had an opportunity to focus on domestic demand-side

economic reform by shifting government policy to promote consumption over investment and by
developing a more robust social welfare system. Instead, the cumulative policy shocks of Xi’s first
two terms worsened the structural challenges that were dragging down—but not yet crashing—
China’s economy. They also badly weakened the confidence that undergirded Deng’s opening-up
era.

Xi focused on projects that prioritized state-led investment and diverted resources from
supporting households, such as the 2013 Belt and Road Initiative and the 2015 “Made in China
2025” strategic plan, which aimed to reduce China’s dependence on foreign technology. He greatly
expanded the role of state-planned industrial policies and, by emphasizing the role of the CCP
and the government in commanding capital management, diminished the space consumer-
oriented private entrepreneurs need to flourish.

China’s economic rise was built on financial repression.

Posen is justified in warning that Xi’s mishandling of the pandemic will likely “plague the Chinese
economy for years.” But he is wrong to imply that historians will look back on the COVID-19 era
as a critical juncture for China’s economy rather than one step on a long path. Well before the
pandemic, Xi’s aggressive promotion of a military-civil fusion strategy prompted U.S. leaders to
enhance investment screening and export controls; these Western restrictions have raised the cost

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of his drive for technological supremacy, requiring the state to commandeer additional national
resources.

China’s stepped-up military activity around Taiwan, which also predated the pandemic, has stoked
a gloomy perception in China that armed conflict is inevitable. China’s one-child generation
would shoulder the weight of such a conflict, an immense threat that few families are prepared to
cope with. Many China watchers underestimate the degree to which the souring of Western
confidence in China has negatively affected Chinese people’s willingness to spend and to take
economic risks. Pessimism from abroad contributes to the Chinese population’s mass loss of
confidence, which James Kynge of The Financial Times has aptly characterized as a “psycho-
political funk.”

In essence, Xi did not assemble China’s economic time bomb, but he dramatically shortened its
fuse. Posen argues that for ordinary Chinese people, the CCP has now become “the ultimate
decision-maker about people’s ability to earn a living or access their assets.” To some degree, this
has always been the case in China; what has changed is the way the party reacts to economic
difficulties. In the past, it responded with reform and pragmatism. By contrast, Xi’s instinct has
been to meet every challenge with political and economic retrenchment.

Pessimism from abroad contributes to the Chinese population’s mass loss of

confidence.

Still, it is premature to imagine that China’s economy has peaked. Xi abruptly reversed course on
his “zero COVID” policy when its costs became untenable; he should do so on his economic and
political strategies, as well—and he may. Historically, the Chinese people have tended not to look
back on political upheavals after moving past them.

Posen suggests that the West might benefit from a Chinese decline. But the West has a genuine
interest in preventing China’s economic downfall. Given the size and importance of the country’s
economy, a full-blown financial crisis in China would have far greater consequences than other
previous emerging-market crises. And a crisis would complicate the West’s transition to clean

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energy since China is the dominant producer of the technologies and minerals needed for that
transition.

Instead of looking for opportunities in China’s economic struggles, U.S. and European Union
leaders should communicate their interest in preventing a Chinese economic crisis. One necessary
first step is to create a shared entity list to coordinate investment screening and export controls on
potential dual-use technologies. This move could minimize the potential that strategically
motivated investors will access sensitive technologies. If Washington and Brussels fail to clarify the
intentions of their “de-risking” strategies, however—or if they meet Xi’s aggression with chest-
thumping—they may legitimize his claims that economic containment is to blame for China’s
economic woes and that further isolation is the only antidote.

ZONGYUAN ZOE LIU is Maurice R. Greenberg Fellow for China Studies at the Council on Foreign
Relations and the author of Sovereign Funds: How the Communist Party of China Finances Its Global
Ambitions.

Inherited Trauma
Michael Pettis

Posen correctly identifies the problems the Chinese economy faces, including weak consumption,
anemic business investment, surging debt, and rising financial uncertainty among Chinese
households. But his explanation of what has gone wrong misses the mark, neglecting the structural
sources of China’s economic malaise.

Posen writes that China’s economic troubles are the result of President Xi Jinping’s turn against
the private sector in recent years, especially in response to the COVID-19 crisis. Under Xi, he
argues, the Chinese Communist Party “has reverted toward the authoritarian mean.” He proposes
that in response to “the government’s intrusion into economic life” and the increasingly visible
“threat of state control in day-to-day commerce,” an anxious Chinese public is saving more and
spending less, yielding a “less dynamic economy.”

This account gets the causality backward. The problems facing the Chinese economy are not the
consequence of recent policy shifts; they are the almost inevitable result of deep imbalances that
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date back nearly two decades and were obvious to many economists well over a decade ago. They
are also the problems faced by every country that has followed a similar growth model.

In the 1970s, the economist Albert Hirschman argued that any successful growth model has
obsolescence built into it, because it is designed to address and resolve particular economic
imbalances. This is the case for the Chinese growth model. In the late 1970s, the Chinese economy
was stunted by decades of civil war, conflict with Japan, and Maoism. It was among the most
severely underinvested in the world for its level of social and institutional development. The high-
savings, high-investment model that the Chinese leader Deng Xiaoping implemented in the 1980s
and 1990s succeeded because it closed, faster than in any other country in history, the gap between
the existing level of investment and the level the country could productively absorb.

Investment in China has continued to rise, even as it has progressively generated less
value.

China closed this gap around 2006. Once it did so, however, it should have switched to a different
growth model, one that prioritized consumption over investment. This would have required
developing a new set of business, legal, financial, and political institutions to promote the higher
household income and stronger social safety net that undergirds a more consumption-driven
economy. But like similar countries that reached this pivot point, such as Brazil in the 1970s and
Japan in the 1980s, China did not reform its growth model. In fact, from 2006 through 2011, its
household consumption as a percentage of GDP fell even faster than it had in the 1980s and
1990s, to 34 percent, compared with over 50 percent, on average, in the rest of the world.

Hirschman would have predicted this. A successful growth model, he noted, develops its own set
of institutions, along with powerful constituencies that benefit disproportionately from these
institutions, making the model politically difficult to transform. As the elites who benefit from the
model expand their wealth and power, Hirschman argued, they become motivated to entrench it.

This is what happened in China. In the past two decades, investment in China has continued to
rise as rapidly as ever, even as it has progressively generated less and less value for each dollar
invested. Overall growth has increasingly been driven by asset bubbles, especially in real estate, and

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an unsustainable rise in debt. Worse, over this period, business investment has become constrained
by China’s extraordinarily low consumption rate, as shaky domestic demand discouraged private
businesses from expanding production.

At the same time, the locus of Chinese economic activity shifted away from sectors of the
economy constrained by hard budgets and a profit imperative, mainly the private sector, and
toward sectors that are not so constrained, such as the public sector and those parts of the private
sector with guaranteed access to liquidity—real estate, for example. The turn against the private
sector was not the result of Xi’s particular ideology. It may have been accommodated by his
rhetorical and policy shifts, but it was driven by something deeper: the growing imbalances in
China’s economy and Beijing’s need to maintain high GDP growth rates.

Government intrusion is not China’s biggest problem.

Some economists presume that any rapid growth is, by definition, a consequence of private-sector
initiatives and that any slowdown arises from excessive government intervention. But that was
certainly not the case in China. On the contrary, government intervention drove China’s ferocious
growth in its first decades of economic reform. Beijing enacted policies to force up the savings rate
and corral the resulting savings into a highly controlled financial system that heavily subsidized
infrastructure and the manufacturing sector with very low interest rates, preferential lending, an
undervalued currency, and other direct and indirect transfers. These subsidies made China’s
logistical and transportation infrastructure the best in the world and its manufacturers the most
competitive, albeit at the expense of Chinese households. Posen writes of “government intrusion”
as if it is something new and unwelcome, but it in fact created the conditions for China’s
spectacular growth through the middle of the first decade of this century.

Today, even as it raises costs for businesses, government intrusion is not China’s biggest problem.
Its biggest problem is that it has not substantially adjusted its growth model. Retaining its current
high-investment model distorts the distribution of income and keeps domestic demand too weak
to support domestic business investment. And because this weak demand constrains the growth of
private businesses, China has had to rely on an expanding public sector to deliver the level of
growth Beijing deems politically necessary.

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Government intrusion, in other words, is the consequence of weak private investment, not its
driver. This distinction matters enormously when thinking about how China can fix its economic
woes. It must address the demand side of the economy by strengthening the share of its GDP that
Chinese households retain. Until Beijing does so, or until it is willing to accept much lower growth
rates, the role of the government in the economy must necessarily expand relative to that of the
private sector. Even if Beijing decided to reduce government intrusion, growth would not pick up
except at the margin, and China’s overall growth rate would continue to decline, probably to below
two to three percent.

MICHAEL PETTIS is a Senior Fellow at the Carnegie Endowment for International Peace, Professor of
Finance at Peking University, and the author of Trade Wars Are Class Wars.

Posen Replies
Adam S. Posen

Two things can be true at once: China’s structural economic issues have reduced its growth rate
over time, and increased intrusion into everyday life by the Chinese government under President
Xi Jinping has changed the economic behavior of the country’s people, reducing the growth rate
even further. As any economy develops, its growth rate slows because of the accumulation of
capital (including infrastructure), a diminishing rate of urbanization, and, usually, a declining birth
rate. This slowdown is expected and inevitable over the long term, and it typically does not disrupt
normal commercial life. The emergence of “economic long COVID” in China, however, is a special
case. The abandonment of autocratic self-restraint by Xi and the leadership of the CCP was not
inevitable, and it drove a marked change in the behavior of Chinese households, as well as in their
responses to government policies.

My analysis is supported by data gathered since Xi took office—and especially since the beginning
of the COVID-19 pandemic—on Chinese savings, investment, capital outflows, and durable
goods consumption. In their responses to my article, Zongyuan Zoe Liu and Michael Pettis go

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doggedly narrow; they neglect the importance of Xi’s behavior in shaping outcomes and even seem
to deny that the economic regime has changed.

Pettis’s claim that “government intervention drove China’s ferocious growth in its first decades of
economic reform” sets the stage for his argument that increased and arbitrary government
intervention is merely a continuation of past practice. The important role of government
investment in Chinese development in the 1980s and 1990s is undeniable; China’s industrial
policies, which the CCP borrowed from Japan and Singapore, did help it up the value chain in
trade. Those actions alone, however, did not deliver the miraculously high Chinese growth rates
from 1980 to 2008.

Total investment, public and private, remains elevated, but it declined as a share of GDP from 47
percent in 2011 to below 43 percent in 2016, where it remained before declining further this year
after the collapse of China’s real estate sector. Pettis is thus incorrect when he claims that “in the
past two decades, investment in China has continued to rise as rapidly as ever.” And the evidence
does not support his claim that “China has had to rely on an expanding public sector to deliver the
level of growth Beijing deems politically necessary.” Nonprivate fixed asset investment—the best
available proxy for public investment—began to decline in 2016, when it was at 26 percent of
Chinese GDP. By 2021, it was down to 21 percent, rising only slightly in 2022, to 22 percent. And
it was government regulation that, in 2020, killed the long-running residential property boom,
steps the CCP took because the private sector was driving growth in ways the party did not like.

The abandonment of autocratic self-restraint by Xi and CCP leadership was not

inevitable.

Simply put, Chinese growth has not been largely, let alone entirely, driven by public and
government-directed investment. On the contrary, as the economist Nicholas Lardy established in
his 2014 book, Markets Over Mao, the market-oriented reforms led by Deng Xiaoping drove
growth and restrained the party. The clearest evidence is that between 1980 and 2013, the year Xi
took control, China’s private investment grew at 2.6 times the pace of state investment. And
during that same period, the share of state investment fell from 80 percent to roughly 33 percent
of total investment. Similarly, private urban firms employed only 150,000 Chinese workers in
1980, or 0.2 percent of urban workers; by 2012, that number had grown to over 252 million, or 68

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percent of urban workers. Put another way, between 1980 and 2012, private firms accounted for 95
percent of the growth in urban jobs in China.

More fundamentally, it makes little sense to lump together the state infrastructure investments in
the pre-Xi era and Xi’s draconian government intrusions, including the arbitrarily applied “zero
COVID” policy and its abrupt lifting, which induced economic and social whiplash. From 1978 to
2012, the Chinese leadership undertook a number of policies that were explicitly market-oriented
or supportive of private markets: China’s 2001 entry into the World Trade Organization, which
allowed the private sector the right to trade internationally; its 2002 “Three Represents”
amendment to the CCP charter, acknowledging the need to develop the private sector; a law
instituted in 2007 that codified private property rights; a program of state-owned enterprise
reform that took place between 1998 and 2002 and reduced state-sector employment in cities by
30 percent; and many moves over the decades that opened the country to foreign investment.

By contrast, the CCP’s policies under Xi have rapidly increased the investment going to state-
owned enterprises, and the share of credit going to the private sector peaked in 2015 and has
declined steadily since. The party has also intruded more and more into the operations of private
companies, including through a September 2020 directive to expand the CCP’s role in private
firms’ corporate governance. Between 2012 and 2019, cumulative growth in credit to private firms
was 10 percent, a huge slowdown that brought it in line with growth in state investment. And
between January 2022 and June 2023, growth in private investment declined to half the level of
growth in state investment, a change driven by the residential real estate collapse.

Liu makes an argument similar to Pettis’s—that the structures of the Chinese economy driving
growth have remained largely constant. But even she notes additional policy areas in which Xi has
increased government intervention at the expense of the private sector and raised barriers to
private international commerce, notably the “Made in China 2025” strategic plan and the Belt and
Road Initiative. These points support my argument that the present is a deviation from more than
three decades of the preceding Chinese leadership’s relative self-restraint on economic
intervention.

China developed economic long COVID thanks to Xi’s shift to more autocratic
economic management.

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When discussing political economy, it is always wise to cite Albert Hirschman, but Hirschman’s
logic does not support Pettis’s case. If, as Pettis’s paraphrase of Hirschman suggests, a successful
growth model “develops its own set of institutions, along with powerful constituencies that benefit
disproportionately from these institutions, making the model politically difficult to transform,”
then China’s enormously successful private-sector elites should have better entrenched their
economic position. But they cannot because the autocratic rulers of China have decided to take
away their property rights and livelihoods at will. The relevant Hirschman insight is from his
profound 1970 treatise, Exit, Voice, and Loyalty, which explains the three choices citizens have
when forming a relationship with their rulers. Voice, as in criticism of government policies that
could lead to civic political action, has always been severely limited by the CCP, and its use of
electronic surveillance and repression has only grown in recent years. Loyalty, essentially accepting
that what the party leadership does on policy is right, was and largely remains the default. But that
has been the case only as long as everyday commercial life was productive and undisturbed—
which it has not been in recent years. That leaves only exit, and people in China have increasingly
resorted to that option under Xi’s autocracy: Chinese households are building up their liquid
savings instead of consuming durable goods; small enterprises are remaining liquid and investing
less, to reduce the risk of expropriation; and, in many cases, better-off Chinese citizens are
physically exiting by moving their assets, some of their production, and their families abroad.

All the structural problems Liu and Pettis identify in China’s economy exist and have long existed.
But Xi’s deliberate and widening violation of his predecessors’ “no politics, no problem” compact,
particularly during the pandemic, changed the game. My critics’ structuralist approach to analyzing
China misrepresents the sources of the country’s astonishing past growth and fails to explain the
shifts unfolding today. A narrow, structuralist reading would predict that the Chinese economy
would react especially well to measures that stimulate consumption and private credit, since the
relative benefits to households of those measures versus government investment would be high. In
fact, Chinese consumers have been notably sluggish in responding to the stimulus measures
introduced since the end of 2022, even when they targeted subsidies for auto sales or mortgage
payments.

China developed economic long COVID thanks to Xi’s shift to a more autocratic approach to
managing the economy. This syndrome was not inevitable, and it was not foreseen. And it will be

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very difficult for the autocrat who caused it to cure it.

East Asia China Economics Business Economic Development Politics & Society Demography
More:
Xi Jinping Coronavirus World Order Belt and Road Initiative

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