China’s economic locomotive derailed as Xi consolidates power

Since China’s 20th Party Congress convened in mid-October, the assessment of most commentators has been overwhelmingly negative. As was widely anticipated, Xi Jinping was reelected as party general secretary for an unprecedented third five-year term. The main surprise was the extent to which Xi consolidated power by appointing loyalists to key positions while those retiring included individuals considered to be reformists. The most visible symbol of the changing of the guard occurred when Xi’s predecessor, Hu Jintao, was escorted off-stage.

The market response included a steep sell-off of Chinese stocks and currency. The Nasdaq Golden Dragon China Index of U.S.-listed Chinese companies plunged to the lowest level in nearly a decade, while the Chinese yuan fell to 7.25 per dollar, the lowest level since the 2008 Global Financial Crisis.

Chinese stocks subsequently rallied in November when the government announced some relaxation of its zero-COVID policy, such as reducing mass testing and quarantine requirements. 

However, hopes were dashed when China experienced a major outbreak of cases and the government responded by clamping down on social interactions, including those with family members. As videos have circulated of the extreme methods the authorities have used to enforce policies, protests have spread throughout the country, with some calling for Xi to resign.

It remains to be seen how the protests will play out and what the government’s response will be. One difference from the past, however, is that China’s leadership cannot count on strong economic growth to deflect attention from its problems. Prior to the latest COVID-19 outbreak, the International Monetary Fund (IMF) was projecting real GDP growth this year to be just over 3 percent, well below the government’s target of 5 percent. Now a 2 percent rate appears more likely.

According to a New York Times article, China’s business elite is despondent about what is happening in the wake of the 20th Party Congress. Previously, there was an unspoken contract whereby business leaders would not comment on politics as long as they were free to make money. Now they fear that the absolute power Xi has been granted will translate into a bigger role for state enterprises and a smaller role for private businesses.

A common view is the outcome signals that China has come full circle from the reforms that Deng Xiaoping implemented in the 1980s. As Richard C. Bush of the Brookings Institution observes that Xi, “has disregarded the conclusions that Deng Xiaoping reached about the reasons for the dysfunction of the CCP system under Mao: concentration of power under one man.” The Economist calls it the “Great Leap Backward.”

Several prominent Western economists now believe China’s economy will suffer diminishing returns on investment in real estate and public infrastructure. Kenneth Rogoff of Harvard sees excessive state control as “a tried and true recipe for becoming mired in the middle-income trap that Chinese leaders have long vowed to avoid.” 

Mickey Levy of Berenberg Capital Markets sees a similar fate in which President Xi’s policies of throttling back free enterprise undercut what created China’s prosperity.

While Chinese companies are feeling the brunt of the government’s policies, foreign entities are also impacted. For example, the U.S.-China Business Council’s 2022 Member Survey found that 96 percent of respondents have experienced negative impacts on their China business because of government control measures.

A New York Times story highlights how Apple’s operations are affected by tough COVID restrictions. The company recently announced that it would be unable to produce enough iPhone 14s to meet the demands of the holiday season due to a lockdown where its biggest plant was located. A further complication is that Apple was in talks with a Chinese chipmaker to supply components when the Commerce Department issued restrictions on U.S. companies selling equipment to the Chinese entity. 

The bottom line is that the era in which China had unlimited access to the U.S. marketplace and U.S. multinationals gained access to China is effectively over. As Earl Carr, a Forbes contributor, observes: “The end result is that businesses are slowing new investment in China as they are attempting to hedge their supply chains to avoid Covid lockdowns, U.S. sanctions, and other potential risk factors.”

One silver lining is that the Chinese government may feel less emboldened to escalate tensions with the United States due to the growing problems at home. While the meeting between President Xi and President Biden in Indonesia did not resolve outstanding issues, Biden indicated there were areas where compromise was possible and other places where they disagreed.

Overall, China’s economy will still play an important role in the global economy. But it will no longer be a locomotive for global growth as it was after the tech bubble burst in the early 2000s and the Global Financial Crisis unfolded at the end of the decade. In this respect, what is happening inside China will have ramifications for the rest of the world.

Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books, including “Global Shocks: An Investment Guide for Turbulent Markets.”