By Zhu Tian

Even before the pandemic, China's economy had slowed significantly, with GDP growth falling from 10.6% in 2010 to 6.1% in 2019. Nevertheless, over the previous 30 years, China has outpaced all other nations in terms of economic growth, with its GDP per capita growing by over 9% annually. This rate starkly contrasts with a global benchmark of less than 2%; the pace in countries across Asia, Africa, and Latin America, meanwhile, lagged even further behind that of developed Western nations.

In today’s new economic climate, can China continue to grow faster than other countries? How will geopolitics impact China’s economy? To unearth the answers, we must first address two other fundamental questions: what catalysed China’s rapid economic development after 1978, and what underpins this recent downturn? Unfortunately, in attempts to address these two questions we often bump up against significant misconceptions about the Chinese economy, which in turn have influenced macroeconomic and industry-level regulatory policies.

If China can dispel these misconceptions and promote reform and openness, while implementing stronger fiscal and monetary policies, the country’s economy has the potential to return to its upward trajectory.

Dispelling misconceptions about China’s economy

China’s extraordinary growth over the past four decades is often credited to a range of factors, including a low starting point, a demographic dividend, reform and opening-up policies, globalisation, WTO membership, foreign direct investment, export-oriented strategies, political stability, and industrial policies. From a global comparative perspective, however, these factors are not unique to China. Many developing countries share similar characteristics, yet they haven’t achieved robust growth. It is true that China’s impressive progress would not have been possible without reform, opening up, and political stability. These factors also explain why China’s post-1978 growth has outpaced its earlier performance. They do not, however, explain why China’s growth has been faster than that of other developing nations.

Likewise, while China’s economic slowdown is often attributed to factors such as an aging population, the middle-income trap, substantial corporate and local government debt, an unsustainable growth model heavily reliant on investment and exports with insufficient consumption, and the impact of geopolitics, these structural reasons alone do not provide a good explanation for the sharp decline in growth rate over a few short years, nor the robust recovery and widespread optimism observed in 2021. Geopolitics did not trigger the economic downturn prior to 2023; rather, its influence is just starting to emerge.

Misconceptions about China’s economy mostly stem from two sources. The first is the absence of a global comparative perspective. Often, comparisons are made between China’s economy and those of a few developed countries such as the United States and Japan, while overlooking comparisons with developing nations such as the Philippines, Nigeria, Pakistan, or Mexico. Such simple comparisons fail to identify the distinctive features of China’s economy.

A failure to distinguish between short-term fluctuations and long-term growth also leads to misconceptions. Long-term economic growth depends on productivity and supply-side factors, which are driven by investment, education, and technological progress. Conversely, consumption, investment, and exports are the demand-side factors that have a bearing on short-term GDP growth rate. Confusing these two concepts can lead to misunderstandings about China’s growth. For instance, some may believe that China relies too much on investment and exports and not enough on consumption, thereby advocating for policies to reduce investment and increase consumption. Such beliefs lead the country’s macro-economic policies in the wrong direction.

What are the distinctive features of China’s economy?

It is not surprising that China has grown faster than developed countries considering its low starting point, but it is hard to explain why China has grown much faster than almost all other developing countries. This is what I call the real Chinese growth puzzle. China differs from other developing countries not primarily because of a demographic dividend, unique industrial policies, political and economic regimes, or government effectiveness. Instead, its exceptional position is largely due to a high savings rate and a strong basic education. This distinction becomes clearer when viewed from a global comparative perspective.

To understand the essential role of savings and education, we need to clarify what drives economic growth. This involves distinguishing between long-term growth and short-term fluctuations. In standard textbooks, “economic growth” is defined as a sustained rise in productivity and output of a country or region. Therefore, investment, education, and technological progress are the real engines of a nation’s long-term economic development.

Economic fluctuation refers to the change (upward and downward movement) in annual or quarterly growth rate. The commonly-known three growth engines - consumption, investment, and exports - are the demand-side factors that have a bearing only on short-term GDP growth rate. Consumption and exports are not drivers of long-term growth. Therefore, there is no such thing as a consumption- or export-driven growth model in economic theory.

In times of economic slumps, boosting consumption can promote economic recovery. However, investment tends to also be weak at such times, and needs stimulation. In addition to consumption, the role of investment in boosting domestic demand should not be overlooked. Upgrading consumption cannot be separated from significant investment in the consumer goods and service industries. Weak demand is due to both insufficient consumption and tepid investment. Therefore, macroeconomic policies should aim at increasing overall demand, which includes both consumption and investment, rather than focusing on consumption alone.

In most developing countries, consumption and exports account for a larger share of the economy than they do in China, yet their growth remains sluggish. If consumption could spur economic growth, there would be no poor countries. On the other hand, in the 40 years since China’s reform and opening up, it has enjoyed the world’s fastest consumption growth, which is fully in line with GDP growth. The logic is quite simple: consumption growth is not the cause of economic growth, but rather a result of it.

What truly differentiates China’s economy is the fact that it boasts the highest investment rate in the world, which is because it also has one of the highest savings rates in the world. China also outperforms other developing countries in quality of basic education, which enables it to learn and imitate Western technologies faster than other developing players. This in turn drives China’s technological progress and builds its innovation capability. These three factors - investment, education, and technological progress - have been the key drivers of China’s rapid growth over the past 40 years.

Culture has played an important role here. Confucian culture values thrift and education. This emphasis is also present in Protestantism and Judaism and is shared not only by China but also by all the East Asian economies, including Japan, the “Four Asian Tigers” (Hong Kong, Singapore, South Korea, and Taiwan), and Vietnam. However, a culture that prioritises savings and education is not enough to foster economic growth. Market-oriented reforms and a peaceful international environment are also critical components.

Other East Asian economies have experienced similarly rapid development, with their GDP per capita growing at an average rate of over 6% per year until their nominal GDP per capita reached 40% of that of the United States. Currently, China’s nominal GDP per capita is about 16% of that of the United States, indicating substantial growth potential. Under the right policies, China is capable of growing at a rate of 5% to 6% over the next 10 to 20 years.

Why is China’s economy slowing down?

Statistics show that China’s economic downturn is mainly caused by a sharp decline in investment growth and is less affected by consumption and exports. Investment is a key driver of economic growth, both in the short term and in the long term. However, recent policy shifts seem to prioritise boosting consumption at the expense of investment, which has led to a noticeable slowdown in investment growth. As a result, the economy and consumption have also experienced a similar downward trend.

Abundant savings and robust investment have long been the strengths of China’s economy. Unfortunately, the prevailing narrative now interprets them as weaknesses, arguing that China’s economy has become overly dependent on investment and exports, leading to inadequate consumption. Critics assert that this growth model, underpinned by credit expansion and escalating corporate debt, inevitably results in overcapacity and inefficient investment. This, they warn, could eventually precipitate a debt crisis or even a financial crisis.

However, high savings and increased leverage are two sides of the same coin. A high savings rate naturally leads to a significant share of bank deposits relative to GDP, resulting in a high M2 (broad money supply, 96% of which is bank deposits) to GDP ratio, which translates to a high corporate debt to GDP ratio, also known as the macro leverage ratio. In other words, a high savings rate and macro leverage ratio drives China’s rapid economic growth, rather than hindering it.

The real indicator of corporate leverage is debt-to-asset ratio, not macro leverage ratio. When compared globally, the debt-to-asset ratios of Chinese companies tend to be at the lower end; the relevance of the macro leverage ratio only comes into play when it comes to government debt. But even in this context, government assets should be taken into account. Given the large number of state-owned enterprises in China, the government has an abundance of income-producing assets, which allows it to withstand a higher macro leverage ratio compared to other economies. From this perspective, the Chinese government’s debt is far from being high.

Most economists believe that markets and private enterprises should be the driving forces of economic development. However, there are economists who, opposed to government intervention, resist any expansionary fiscal and monetary policies aimed at stimulating investment. Ironically, the macroeconomic contractionary policies they support, such as reducing investment and limiting production capacity, often have the most significant adverse impact on private enterprises.

In fact, there is no inherent conflict between investment growth and its efficiency. Encouraging investment is not confined to the government and state-owned enterprises; private investment actually holds a larger share. The main issue in China in recent years hasn’t been so much a flood of money leading to rising prices and currency depreciation, but rather a credit shortage that threatens deflation. China’s high M2 to GDP ratio stems from a high savings rate, not excessive currency issuance. Macro-level policies aimed at reducing debt and risk have not only fallen short of their primary goals but have also triggered liquidity and debt crises in the real estate sector and local governments. Contrary to achieving their purpose of reducing debt, these policies have heightened the risk.

Stronger policies needed to boost economic growth

China’s economy is currently showing early signs of deflation. A more robust strategy is required to swiftly reverse this trend and tackle the economic downturn. Combining market-oriented reforms with macroeconomic easing can boost confidence and stimulate demand. First, substantive measures for further reform and openness should be adopted to send a positive signal to both domestic and foreign businesses that China’s economy will become more market-orientated and more open. Second, stronger fiscal and monetary policies should be promptly implemented (such as issuing more government bonds and implementing “quantitative easing” measures) to address the debt issues faced by local governments and real estate companies.

A high savings rate and ample state-owned assets have put the central government in a strong position to take on more debt to help the economy bounce back. The current debt issue is mainly a liquidity crisis that has been caused by a decline in income and asset values due to a faltering economy. Only by accelerating economic recovery can the debt crisis be addressed at root.

In a nutshell, China’s economy still has considerable potential for faster long-term growth, and a further downturn is not inevitable. Geopolitical factors may slightly impact the pace of its development, but won’t change the big picture. Since 2006, China has been relying less on exports and foreign investment, which are now both much lower as a share of the economy than in most countries. This is an outcome of China’s rapid economic development, rather than geopolitics. What really influences China’s growth is not foreign governments, but China itself.

If China continues to move towards more market-oriented reforms, leverages its true strengths in savings and education, improves investment incentives by all market players - especially its private enterprises - and implements more accommodative macroeconomic and regulatory policies, it can still achieve faster growth than most other countries. The outlook for China’s economy, therefore, would remain promising.

Zhu Tian is a Professor of Economics, Associate Dean and the Director of the EMBA Programme at CEIBS. He is an expert on the Chinese economy and the author of Catching Up to America: Culture, Institutions, and the Rise of China.