Japan Institute for National Fundamentals

　
The Chinese economy has come under unprecedented deflationary pressure. This is because demand does not recover due to 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. This is because China's unique financial system, which relies on foreign capital, is severely constrained by foreign companies’ and investors’ exodus from China. The current situation represents a natural consequence from China investment risks, including Taiwan-related risks, that have been growing since Russia's invasion of Ukraine in February last year. The U.S. Biden administration should not take a conciliatory approach to China that could lead to the resumption of Western investment in China.

Chinese economic policy at a dead end

Real estate investment, which has driven the Chinese economy for 10 years under the Xi government, 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 this year, meaning that more than one of every 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 and fell to the 0.7% range in May this year. 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.

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 years after 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.

On the other hand, financial difficulties are serious for local governments, where land use income from real estate developers account 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.

Xi pretending to be strong

There is only one solution. It is 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 year-on-year at the end of 2022. The current account surplus of about $400 billion in 2022 cannot cover capital outflow.

President Xi took an arrogant attitude of sitting at the head table during his recent meeting with visiting U.S. Secretary of State Antony Blinken. But it is probably a bravado. Unless Xi tries to improve relations with the United States even by bowing his head, in fact, foreign capital cannot be expected to return to China.

Hideo Tamura is a Planning Committee member at the Japan Institute for National Fundamentals and a columnist for the Sankei Shimbun newspaper.