“Xinomics” Defeated by Deflation: Can Keynesian Measures Prevent a Financial Panic?

Collapse of an Investment Bubble

Supertall buildings reflect the rise and fall of a nation’s economy. The imposing 102-story Empire State Building in Manhattan was once sarcastically called the “empty state building.” The Great Depression striking in 1929 during its construction meant that vacancies were unfilled for a long time. Thereafter, the Empire State Building remained the world’s tallest building for 42 years.

A structure known as the world’s tallest unfinished building is found in the Chinese city of Tianjin. This is the Goldin Finance 117, whose framework nearly 600 meters tall stands exposed to the wind and rain. In Shenzhen, the World Trade Shenyang International Center, which was to become the world’s second-tallest building after the Burj Khalifa (828 meters) in Dubai, remains suspended in the initial stage of construction due to the financial difficulties of the developer.

The term “deflationary spiral” indicates a vicious circle of falling prices and a contracting economy. Such foreign financial media as Bloomberg and the Wall Street Journal have warned that China’s economy may experience just such a spiral.

China’s GDP deflator, which expresses the movement of prices, was negative for a fifth straight quarter in April–June 2024, confirming that deflation has taken hold. Wage cuts and delayed deliveries are widespread, youth unemployment remains high, customers have vanished from shopping malls, and a restaurant chain offering a breakfast set for three yuan (about ¥60) has been in the news.

Deflation in China is likely explained by the collapse of a real estate bubble. Immediately after Kenneth Rogoff, a Harvard University professor, published a paper titled “Peak China Housing” in August 2020, the financial difficulties of the property developer Evergrande Group came to light. China’s economic bubble, however, is not limited to real estate.

A database of the International Monetary Fund reveals that from 2004 on, while the Hu Jintao administration called for annual economic growth of 8% or more, China’s ratio of public and private investment to GDP surpassed 40% and continued to outpace private consumption expenditures. None of the other countries in the IMF’s database comes close to China’s record. Take the case of public investment. China’s expressways, beginning in the Shanghai area in 1998, had been extended to a total length of 177,000 kilometers by 2022—a greater length than the expressways built by any other nation, and more than enough to circle the globe four times.

China’s high-speed rail network quickly grew to a combined length of more than 40,000 kilometers since it was launched in 2008, which is greater than the earth’s circumference. However, only the link between Beijing and Shanghai is profitable, and the debt of the China State Railway Group Company has surpassed 6 trillion yuan (more than ¥120 trillion in Japanese terms).

Local governments, serving as shadow banks through local government financing vehicles, lent funds to developers and competed to finance development projects. The combined debt of LGFVs is said to total more than 60 trillion yuan (¥1.3 quadrillion).

A consequence of the corporate sector’s robust capital spending is China’s excess production capacity. Supported by government subsidies, the market is flooded with Chinese electric vehicles, EV batteries, and solar panels, causing the EU and the United States to greatly increase tariffs on Chinese EVs and other products.

Despite investments being made one after another, the growth rate of China’s GDP fell below 8% in 2012, the final year of the Hu Jintao administration. Subsequently, China’s economy has mostly slowed.

The Reversal of “Reform and Opening-Up”

The mistake made by the Xi Jinping administration that followed was to merely observe the collapse of the investment bubble while reversing the reform and opening-up policies that were the growth strategy of Deng Xiaoping.

The economic policies of the Xi administration (Xinomics), which called for making state-owned enterprises bigger, better, and stronger, sought to promote SOEs while dealing harshly with foreign and local private enterprises. It compelled private enterprises to install Communist Party members within their organizations and found pretexts for fining leading high-tech companies like Alibaba and Tencent.

Fearing management interference and a strengthened Counter-Espionage Law, foreign affiliates pulled out of China. The number of wealthy Chinese moving abroad also increased. This is none other than capital flight.

In August 2022, former premier Li Keqiang, following the Beidaihe meeting of the Central Committee, where the third term of President Xi was decided and where Li’s retirement was informally confirmed, visited the special economic zone of Shenzhen, laid flowers before a statue of Deng Xiaoping, and stated that reform and opening-up policies must be continued—that “the Yellow River and Yangtze River do not reverse their courses.” This was severe criticism of Xinomics.

The Great Depression that emptied skyscrapers of tenants in the United States is estimated to have reduced its GDP by 35% at its worst. The deflationary spiral in China similarly has the potential of turning into a financial panic.

Despite concerns that the 5% growth target for 2024 would not be achieved, President Xi has baselessly proclaimed from the start of the year that China has a bright future. He repeatedly postponed the Third Plenum of the Central Committee, where the framework for managing the economy during his third term would be decided. While the plenum finally met in July, no serious stimulus measures were announced.

In September, the economic tide turned. Yi Gang, a former governor of the People’s Bank of China, China’s central bank, stated at a symposium that the focus should be on fighting deflationary pressure. As if acting on the words of its former governor, the People’s Bank of China lowered the short-term interest rate by 0.2 percentage points and reduced the reserve ratio by 0.5 points.

With regard to fiscal policies, the government appears to be considering issuing 2 trillion yuan in ultra-long-term special treasury bonds to stimulate the economy. Such funds would be used to boost consumption and to support the finances of local governments. No matter how tone deaf regarding the economy, President Xi appears to have realized that the present situation requires something more than the voodoo economics of simply proclaiming a bright future.

There has been no great depression in the years since World World II of a scale that empties skyscrapers of tenants. The global financial crisis that started in September 2008 did propagate to advanced economies and caused a global recession. Even so, the global economy merely shrank by 0.1% in 2009.

The spread of Keynesian economics, which can be called a product of the Great Depression, should not be overlooked at this juncture. Keynes argued that recessions can be overcome not by economizing but by increasing effective demand through fiscal measures and monetary easing.

China appears to have decided to address deflation with Keynesian measures. It will not be easy to fill the hole left by the collapse of an asset bubble inflated by 20 years of repeated investments, though. One wonders whether the reported fiscal and monetary stimulus is a magnitude too small.

Japan’s asset bubble lasted about four years from the end of 1986 to the start of 1991. This was followed by a long period of stagnation, which has come to be known as the “lost decades.” Japan’s GDP as a share of the global economy peaked at 17.6% in 1995 and has fallen most recently to just over 4%.

China’s nominal GDP as a share of the global economy (on a US dollar basis) peaked at 18.3% in 2021 and has declined to 16.9% in 2023. Considering the expected decrease of the productive population, it is highly probable that the historical rise of China’s economy has reached an end. President Xi bears a heavy responsibility for his economic mismanagement. If China was a democracy, a change in government would have already occurred.

(Originally published in Japanese. Banner photo: The Goldin Finance 117, reported to be the world’s tallest unfinished building, in Tianjin, China. © Kyōdō.)