Zhang Jun outlines Chinese policymakers' tasks as the country's growth model confronts new sources of uncertainty

The business model that underpinned Chinese economic growth for over two decades has collapsed in recent years, especially since the outbreak of the COVID-19 pandemic. Now, the combination of rising uncertainty and falling confidence is casting a dark shadow over the Chinese economy.

The immediate reasons for the decline of China’s prevailing business model are external. In particular, geopolitical developments – mainly deepening trade frictions, especially with the United States – have rattled China’s export sector. And US President-elect Donald Trump’s incoming administration is set to introduce even higher tariffs on Chinese goods and tighter restrictions on China’s access to foreign technologies.

These external factors alone would be enough to require a profound domestic adjustment in China, including an update of the prevailing business model. But internal developments are even more relevant. After years of excessive investment, infrastructure projects are yielding diminishing returns, and the once-frothy real-estate sector is plagued by large debts, falling prices, and a massive stock of unsold units. A more subdued internet economy is not helping matters.

Many of these developments have been a long time coming: as early as 2013, China’s economy was confronting high volatility and soaring financial risk. With too much credit having been pumped into physical infrastructure and real estate, the debt-to-GDP ratio soared, and overcapacity plagued a number of industries, including coal mining, steel, and cement.

China’s top leaders recognised the need to rein in investment growth and find new sources of productivity, and acknowledged that this might require the country to endure another period of significant structural transformation. In 2015, the government introduced a set of policies aimed at accelerating supply-side adjustments, promoting structural transformation (not least through the adoption of digital technologies), and encouraging investment in cutting-edge industries, such as microelectronics, artificial intelligence, biopharmaceuticals, solar panels, lithium batteries, and electric vehicles (EVs). Many sectors – including real estate, manufacturing, and services – have since undergone significant adjustments, resulting in a painful period of L-shaped growth.

But the necessary transformation is far from complete, and economic conditions are changing fast. As Chinese exporters confront high levels of uncertainty regarding the external environment, domestic policy adjustments have plunged the real-estate and construction sectors into debt distress.

To mitigate the risks, firms are increasingly embracing digital technologies, with a growing amount of capital flowing toward AI. More firms should follow this path. Digital penetration fuels dynamic competition, with startups rising quickly to challenge – and destroy – the incumbents who fail to keep up. But while new “tracks” continue to emerge – particularly in advanced industries – they will soon become overcrowded.

Chinese increasingly use the term “involution” to describe the unnecessary and excessive competition that now plagues some parts of its economy. Young people often invoke the concept when discussing intense labour-market competition: at a time when the supply of high-performing university graduates is growing, revamped business models and more flexible working arrangements have undermined the stability of job creation.

But involution can also be applied to overcrowding in dynamic or promising sectors, caused by an influx of financial resources and factors of production. China’s EV industry is a case in point. Thanks to massive investments by both established firms and new players, Chinese EV production has soared from 1.27 million in 2018 to ten million this year. Predictably, this rapid increase in supply has caused prices to fall.

This suggests that supply shocks, rather than a demand shortfall, are the main cause of Chinese deflation. And, in fact, there is good reason to think that the supply-side effects of ongoing structural adjustments are a leading driver of China’s economic slowdown. But China’s future growth curve need not be “L-shaped.” The country has all the tools – and resilience – it needs to adapt to its new geopolitical environment, accelerate domestic transformation, bolster economic dynamism, and enter a new stage of development.

This is not to say that China can achieve the growth rates of 20 years ago. On the contrary, it is past the stage of development where sustained double-digit growth is feasible. The imperative for China’s leaders in the coming years will not be to achieve growth at all costs, but rather to offset the social costs of accelerating structural transformation with efforts to reduce uncertainty and maintain stability. In particular, China’s government should strengthen the social safety net and direct more fiscal spending toward supporting household incomes and welfare. By boosting confidence and stability, such efforts would go a long way toward improving China’s consumption-to-GDP ratio.

Zhang Jun, Dean of the School of Economics at Fudan University, is Director of the China Center for Economic Studies, a Shanghai-based think tank. Copyright 2024 Project Syndicate, here with permission.