China’s economic model is faltering – does it have the political will to fix it? | George Magnus

The extended daylight hours of summer are proving to be excessively lengthy for the governing body in Beijing. In an effort to bring stability to the struggling property market, the officials disclosed a minor decrease in interest rates earlier this week, but it fell short in terms of both magnitude and purpose.

Individuals who remember the previous difficult times when the western region experienced a series of crises like Northern Rock, Bear Stearns, and Lehman Brothers will comprehend the uselessness of reducing interest rates to address fundamental issues in the real estate and finance sectors when the problem is not caused by excessively high interest rates. The same situation can be observed in present-day China, where the government is striving to establish stability in an unsteady economy.

It is evident that the Chinese economy is struggling. The value of the yuan in relation to other currencies is strained, and the government may find it difficult to control the situation and prevent individuals and businesses from moving money out of China, even with strict rules on capital outflows. Although stock prices are not strongly connected to the economy, they have hit their lowest point since the conclusion of 2022, signifying a lack of trust from Chinese households, investors, and private companies during a period of deflation.

The immediate reason for this concerning situation is the housing market. The number of transactions has significantly decreased and there seems to be an increasing decline in home prices. In recent days, the main player in this crisis, Evergrande, has sought bankruptcy protection in New York, Hong Kong, and the Cayman Islands to protect itself from creditors. While Evergrande and other similar companies are facing financial difficulties, another prominent company, Country Garden, which was praised for its corporate responsibility last year, has failed to meet certain international bond payments and is now considered a risky investment, causing a loss of market trust.

China's current difficulties are not caused by its zero-Covid strategies, nor can they be brushed off as a temporary phase that will dissipate over time with further policy relaxations. The crux of the issue lies in a breakdown of the country's economic growth model, which is witnessing the initial collapse of its real estate sector since transitioning from a former housing-welfare system into the globe's largest and, at one point, the most influential property market.

The surge commenced far prior to the Covid outbreak, and for numerous years the government fostered it with lenient regulations on property and repeated instances of abundant funding for building and infrastructure whenever the economy required a boost. With banks, households, and property developers aware that the government consistently supported them, they acted financially as if property prices and speculative ventures were a guaranteed success.

However, as we discovered back in 2008, when the music ceases, all individuals act collectively, flocking towards the exit. This is precisely the situation China is currently confronting, albeit compounded by unfavorable demographics. Prior to the pandemic, China was experiencing a housing construction boom that exceeded the justified levels predicted by lower household formation and first-time buyers. The problem of excessive construction and high vacancy rates persists in numerous smaller towns and cities.

The area of the economy focused on buying and selling property is expected to significantly shrink from currently representing about 23% to 25% of the country's total economic output. The government can only attempt to manage this decline, if possible. With a sharp decrease in property transactions taking place, there may be a chance for a temporary rebound if confidence is restored, possibly through the government offering financial support for housing in the near future. However, the long-term outlook appears to be fixed, and if housing prices continue to decline, it may be difficult to prevent negative consequences such as disruptions in the property supply chain, impacts on industries like construction and commodities, financial strains on banks, and even potential social unrest.

With the approach of autumn, China may attempt to revive its economy and conduct an important five-yearly political gathering, known as the third plenum of the 20th party congress. This event is often recognized for outlining crucial economic priorities. However, it remains uncertain whether Xi's China possesses the determination to address a multitude of problems that necessitate liberal or market-based reforms. These issues encompass modifications to the tax system, social welfare, local government debts, political governance, productivity, and most importantly, redistributing income from the state to individuals and private companies to stimulate increased consumption. Implementing such measures clashes with the communist principles upheld by Xi's China, making it akin to crossing a river where the depths of the stones remain unknown.