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Is the Chinese economy well and truly broken? Will China be stuck in low growth for a decade or more? And what would that mean for the industries we cover on ChinaTalk, for China’s military power, and for policymakers around the world? To discuss, ChinaTalk interviewed Logan Wright, partner at Rhodium Group, my former boss, and, in my humble opinion, the person with the deepest understanding of China’s macroeconomic picture of anyone following the PRC in the West. His new book is Broken China: How the Economic Miracle Shattered and What It Means for the World. Co-hosting is the great Brad Setser of CFR. We discuss: - Why China’s “economic miracle” has broken down and how the financial system that powered China’s growth for two decades now constrains it. - How the world’s biggest credit expansion turned into a debt trap, with investment generating less and less growth. - Why China’s property collapse, weak domestic demand, and surging exports are actually all part of the same story. - How China’s push into EVs, AI, robotics, and other “new industrial sectors” can’t by itself replace the growth China used to get from property and investment. - The jobs crisis facing China’s 12-13 million graduates per year and the ideological, fiscal, and strategic constraints that make it difficult for Beijing to address. - What a “broken China” means for the US and the rest of the world and why Logan argues there is no longer systemic economic rivalry with China, but only a military and industrial-resilience one. Listen now on your favorite podcast app, or watch on YouTube! Why China is “Broken” Jordan Schneider: Logan, is China’s economy broken? Are we sure? Logan Wright: The title is not a prediction. It’s an explanation of how we got here. The basic argument is that it’s still underappreciated how central the financial system was to China’s growth over the past two decades, and how much the financial system’s problems now constrain that growth. Those are the parts that are broken. China does have choices. But those options involve much slower growth in the short term. They cannot maintain the pace of the past two decades. The options they have involve restructuring the fiscal and financial systems: the way they allocate capital, the way they provide countercyclical support, how they raise tax revenue and how they allocate it. It is not meant to be a dramatic, bearish title. It’s meant to say there’s no point in asking Beijing to fix this model, because they cannot fix this model. If they are truly constrained in their policy options and not willing to fix it, what should the rest of the world do about it? The other key takeaway is that if growth depends so much on the financial system, and the financial system now constrains growth, then a lot of China’s external messaging — that they’re economically successful and time is on their side — is simply wrong. It will become more obvious that it’s wrong. That raises different questions for Western governments, which I raised in the Foreign Affairs article previewing the book and discuss extensively in its later chapters. It expands our options, and it means we have the capacity to use time on our side as our policy tools become more salient while China’s become less so. Jordan Schneider: How did we get here? We had China growing at ten, eight, seven percent. Now what’s the latest Rhodium forecast — somewhere in the one to three range? Logan Wright: At the start of the year we expected growth of 1% to 2.5%. We would argue we’re trending well below that, and we’re likely seeing negative growth in Q2 and Q3, because investment in China is contracting. The question is by what margin. The official data points to it contracting. Jordan Schneider: That is a dramatic turnabout. We had the excuse of COVID, that things would come back. It’s the fall of 2026 ,and they haven’t. On one hand, it’s a developing economy that’s going to grow slower over time. But going from seven to maybe one and a half is a truly dramatic thing for the Chinese and global economy. Turn the page back to chapters one and two. What broke, such that an economy with so much latent potential is now totally stuck? Logan Wright: This is a story of contingent outcomes. It was not inevitable. It is the result of distinct policy choices about how the financial system operated. After the global financial crisis, China saw the largest single-country credit expansion the world has seen in at least the last century, possibly many centuries. China added a third of global GDP to its bank assets in just eight years. We’ve never seen anything remotely like it. First, there was a deliberate attempt to provide countercyclical support in response to the global financial crisis. The extension after that was essentially path dependence. Growth was strong, it was dependent on investment, and it became too difficult for authorities to shut down without imperiling the overall economy. That facilitated the growth of the shadow banking system, and credit growth became increasingly disconnected from the real economy. A lot of it went into the property sector and local government infrastructure. After the deleveraging campaign started in 2016 and intensified by 2018, you had a sharp decline in credit growth. This coincides with Xi Jinping’s rise to power and how that changes financial risk, which we should discuss separately. You now have credit that cannot expand at the same rates because the financial system is already overextended. Rather than write down the malinvestment and the losses from the shadow banking system, you have a financial system that provides everlasting life to state-owned producers and local government financing vehicles, but cannot maintain the same pace of credit growth. Credit becomes less and less efficient, generating less growth at a lower quantum of credit. The result is a decline in overall investment. The number one cause of the rapid decline since 2021 was the collapse of the property sector. It’s critical to understand that as a proximate cause, not the ultimate cause. After the deleveraging campaign hit developers’ shadow financing channels, the property sector was reinflated by borrowing from households in the form of pre-construction sales. Developers put up showrooms and sold properties in advance, for which homebuyers borrowed. When the defaults happened, they happened largely against homebuyers waiting for their apartments. That collapse in confidence weakened construction across the economy. Property was 20% to 25% of China’s GDP at its peak. Construction has fallen almost 80%. Sales have fallen about 60%. Nothing has replaced property as a driver of growth. The other underappreciated part is how the slowdown in domestic demand is directly related to the rise in China’s external surplus and supposed competitiveness. It’s a byproduct of falling prices, but also of continued production across industrial sectors that used to find demand in residential construction in China. Now there’s none, so they need to find markets abroad, typically by cutting prices. This has produced persistent deflationary pressure and a weakening of the real exchange rate. The domestic slowdown and the external surplus are very closely linked, but people still treat them as distinct — they argue the economy is K-shaped — when in reality these are the same phenomenon. Brad Setser: Two questions. This massive credit expansion could be called unique not just because it was so big, but because it didn’t generate an external deficit financed by inflows from abroad, which is unusual given its size. It would be helpful to discuss why such a huge credit expansion, with such heavy investment in property, never spilled over into an external deficit. There’s also an argument that this credit expansion ended without a crisis. Nothing like the US in 2008, nothing like Spain’s banking sector. There’s never been a moment of catharsis when key parts of the financial sector lose access to financing. Why was it possible to have such a big credit expansion without it ending in something that approximates the financial crisis most countries experience? Logan Wright: On the crisis moment first. The story in the book is not one of crisis or collapse but of decay: the decay over time of policy tools, of an attempt to forestall immediate crises at the cost of longer-term adjustment. Decay is an easier political choice for China’s leaders — accepting slower growth and inefficient policy tools rather than risking crisis. The path to crisis is not an external shock in China, where everyone assumes the government will provide support. The path to crisis is reform. And I would argue China had that cathartic moment. It’s exactly what the book leads off with: the protests in the lobby of Evergrande’s headquarters on September 13, 2021. China’s largest firm in its most important industry could no longer meet its obligations to its own employees, who were basically lending money to the firm. They protested and were ultimately not repaid. When China’s largest firm in its most important industry effectively defaults — later on its external obligations, and later on homebuyers — it raises the question of what else is going to provide growth. If you told me an economy had a financial crisis at date X and asked what the consequences would be at X plus five years, which is where we are now, I’d say this is entirely consistent with the aftermath of a financial crisis. Highly impaired policy tools that cannot deliver the same countercyclical response. Persistent deflationary pressure. Continued default pressure, as credit risk has migrated from the periphery to the center: from peer-to-peer lending in 2018, to small banks in 2019, to trust companies in 2020, to property developers in 2021, to mortgages in 2022, to local government financing vehicles in 2023. Much slower growth and reliance on external markets because of the inability to generate domestic demand. Everything you’d expect from an impaired, zombified financial system is taking place. The consequences are the same. On external financing: China’s post-crisis credit expansion was essentially externally financed through steady inflows of deposits into the banking system from exchange rate intervention and reserve accumulation, until about 2013. The change in that pattern in late 2013 and 2014 is exactly what forced increasing reliance on non-core liabilities, with banks competing for wealth management products on higher interest rates. You got huge maturity mismatches between higher-rate short-term financing and a rising pool of assets, because you no longer had steady deposit growth. So there was an external financing component, though I take the broader point that it never spilled over into an external deficit. Jordan Schneider: Let me spotlight some of Logan’s prose: “For years, long-term trends in China’s economy and financial system have appeared unstable. Everyone asks when the crisis is coming. But the more precise question is: how long can these trends continue before China faces the same economic outcomes as a financial crisis? The answers are clearer, as these consequences are already apparent in China’s economy and the decay of the financial and fiscal systems. China has already seen a sharp slowdown in economic growth, led by its vitally important property sector and local government infrastructure investment. Private sector credit remains weak, similar to the effects of a shock to aggregate demand. The downshift in economic growth is structural in nature, as the economy is unlikely to recover to previous growth rates.” Even though we didn’t get something as dramatic and nationwide as 2008, what you’re living with is a version of permanently suppressed growth like post-bubble Japan in the mid-1990s. Logan Wright: Japan is probably the closest analogy in recent history, with differences. Japan had zero-bound monetary policy and therefore had to rely on fiscal stimulus to solve the balance sheet recession. China probably still has more space with monetary policy. The constraint is the exchange rate and the stability of the financial system, not getting rates lower. They could get rates lower; it would just introduce different trade-offs. The constraint China faces is fiscal. You’re already running a fiscal deficit of nine and a half percent of GDP, about two trillion dollars last year. You can run that to 15% or 16% of GDP, but you’re not going to generate much more economic activity unless you fix the underlying system. It’s not that there are no choices to offset short-term pressures. It’s that without resolving the structural issues, you shouldn’t expect a fundamental improvement in the outlook. And the property crisis was nationwide. As I argue in the book, you had a bank run. It just wasn’t at a bank. You had homeowners wanting their money back in the form of “we want our properties built,” and developers unable to deliver because they had borrowed forward to keep buying land. Xi’s Rebuttal Jordan Schneider: All right, Logan — Western PhD who thinks he’s got all the answers. Let’s say I’m Xi Jinping. I’m here to stabilize party rule and make China a world power. I’m not defining national power by ghost cities and second homes for middle-class people in Hebei. I’m defining it by the ability to build everything the world needs, get the world dependent on my manufacturers, and capture the commanding heights of the twenty-first-century technology economy. If that means squeezing consumers so they have slightly worse healthcare and services, if it means stressing people out so they don’t have savings and can’t get a good return on the money in the bank, fine. I inherited an economy working toward goals that weren’t in line with national rejuvenation. Now it is. Look at all the world-leading, technologically vibrant manufacturing powerhouses built over the past fifteen years. What’s wrong with that? Logan Wright: It’s fair to say, Mr. General Secretary, that we’re not talking about the same things. The simplest response is that if the underlying economy is not growing, your ambitions to develop those industries will face pretty fundamental limits. They already face limits from your own capacity to fund them through the domestic fiscal and financial system. The limit is that for everything being developed in China, the marginal source of demand is outside China rather than inside. If China remains an investment-led economy — the largest source of investment in the world — it can only grow, and your national rejuvenation can only occur relative to the rest of the world, by displacing others’ export market share, by fighting over a shrinking pie. That pie shrinks further if China’s export prices keep declining and drive disinvestment in the rest of the world, which means your customers, who are largely outside China, are increasingly unable or unwilling to afford everything you’re producing. Those are the limits of the model. You’ve identified the worldview of He Lifeng and the industrial policy planners well. There’s a fair line of argument in response, which I’m happy to engage with: that I’m measuring the wrong things. That GDP growth doesn’t account for the ways China is developing industrial dependencies and unlocking future growth drivers through industrial clusters, and that there’s a path-dependent process to this industrial development that will be sticky even if external trade defenses go up. Look at minerals processing. How did China become the dominant force in global metals and minerals processing? It’s a combination of stories. One is cheap credit. Two, state-owned producers willing to keep committing resources to largely unprofitable lines of business, because there’s enough industrial clustering and proximity to downstream consumer electronics and manufacturing that it still makes sense on economies of scale, which makes it very difficult for others to compete. The other is cheap, subsidized power for energy-intensive enterprises like aluminum. Aluminum is basically congealed energy. There’s a reason copper and aluminum smelting have concentrated in China: the downstream consumer electronics and battery businesses benefit from it. Those are measures of comprehensive national power that my book doesn’t fully address. But from the macroeconomic perspective, those arguments can only go so far, because fundamentally this economy is not growing at nearly the same rates. My further response to Chairman Xi is: are you aware that the United States has outgrown China over the last five years? And has a pretty good chance of outgrowing China over your fourth term, and a near certainty of outgrowing China over your fifth term, if you wanted to be around that long. Western economists are going to point out that China is still number two in the world for a long period of time. You might not care about that. You might downplay those headlines. But it means people will think about China’s inevitable rise differently as long as your domestic economy isn’t expanding. The other problem is that if import growth in China isn’t rising, it’s harder and harder to maintain trade relations with everyone. And if the marginal demand for everything you produce is outside China, how your consumers are feeling and behaving really does matter for the industrial policy project you’ve embarked on. But it’s a fair argument that relative influence, national rejuvenation, and economic statecraft tools aren’t captured solely through a GDP lens or a policy-transmission-efficiency lens. I concede that. Jordan Schneider: Premier Setser, care to dogpile on Logan? Brad Setser: I wonder if President Xi sees the world a bit differently. He looks out and says: everybody talks about GDP growth. I care about supply chain dominance. My industrial sector is clearly the world’s number one, and it’s becoming ever bigger relative to the world economy. There’s an ever-expanding set of sectors where Chinese production is central to global supply chains. Everyone says there are limits to how much you can grow through external demand, but those limits have yet to manifest. I’m still getting 10% year-over-year export growth. My exports are growing at two times global trade, because of the incredible productivity and technological advances that have occurred inside China under my rule. Moreover, I’ve identified a way to make this seemingly unsustainable outcome sustainable. If you don’t want my exports, I’m going to cut off your supplies of the critical inputs you need for your remaining industry. Supply chain dominance allows China to sustain export growth way past what conventional theory would say. Arguably that’s what has played out. The US is still importing from China; we just import through Vietnam. Europe is reluctant to risk renewed supply chain warfare and is continuing to import more EVs. Perhaps we’ve underestimated how much even a large economy like China can grow without a strong internal growth engine. Logan Wright: Brad’s response is exactly where the threat from China’s growing export share is manifest today, and it’s a different threat than we were considering five years ago. It’s not that China is going to become the world’s largest economy and maintain these capabilities ad infinitum. It’s that they can use this pattern of export displacement and supply chain dominance to lock it in for a longer period, fighting over a shrinking pie of global demand, because it will be that much more difficult for countries to respond. The answer is that it’s a lot easier for other developed economies to reinvest and counter this disinvestment pressure with their own policy response than it is for China to maintain the same growth and demand, even if, as Brad says, there’s capacity to extend this model further than we would have expected. A Billion People Outside the Champions Jordan Schneider: I had a little Claude chart: percent of Chinese GDP on one axis, productivity growth as the bars, bar width as share of the economy. What it illustrated is that even in the scenario Brad laid out, where the export champions keep kicking ass, you’re still left with a billion Chinese people in industries that don’t seem to have any future. Continue the optimistic Xi case: the world doesn’t block us off, we keep exporting. What are the domestic downsides if, given the credit mess, you’re still stuck throwing money into LGFVs and central SOEs and propping up property, and you don’t have growth from anywhere besides this pretty small slice of economic activity? Logan Wright: The irony is that you’re saying the most optimistic case for China’s development is one in which they have no control over the pace of development. Domestic controls and policy levers don’t work, so they’re beholden to the global economic cycle and whether external demand rises or falls. They can capture an increasing share of it, but they can’t control the global business cycle. China can grow as fast as its customers grow. It can’t grow relative to the rest of the world. It can’t rise in economic influence over that timeframe as long as it isn’t generating domestic demand. Domestically, that’s really difficult, and here’s where demographics and employment come to the forefront. Many reporters coming back from China these days tell me: basically, we just want to write stories about the employment crisis. We just want to write stories about jobs, and our editors just want us to write stories about tech. It’s not surprising that’s where the demand function is, but it shows you the disconnect. There’s a structural problem with leaving the economy unbalanced when your labor force has completely changed. China graduates 12 to 13 million college graduates a year out of a new labor force cohort of 17 to 20 million. It’s an astonishing proportion, but the economy hasn’t readjusted to provide opportunities for them. As that increases, and because birth rates have fallen over the last two decades, the problem becomes more pronounced. The new development engine Xi is pursuing isn’t very large as a proportion of the economy. We added up all of China’s strategic industries, the new champions, using the 2023 input-output tables: NEVs, all investment in AI data centers and hyperscaler build-out, advanced robotics. We get something like 6.5% of GDP. We could be wrong, but not by a factor of two. There’s not a hidden ten trillion yuan of additional investment out there. Changes in domestic consumption would have a far greater impact on aggregate growth if you could shore up consumption. The closer you look at the demographic headwinds, the more acute they are, not only because of the decline in aggregate and working-age population, which hits consumption directly, but because of the structure. An economy that has not seen structural reform will have significant problems generating employment. All of these strategic industries are far more capital-intensive than labor-intensive. The China scholars engaged in this debate think the constraint on China’s growth model is domestic, and the trade folks think it’s external. Eventually there’ll be pushback. It may be a combination of the two. But one way or the other, none of this looks sustainable. There are far more forces of entropy than inertia here. Jordan Schneider: Hu Jintao comes to the US in 2006, and George W. Bush, he’s a China guy, asks: what keeps you up at night? I’m stressed about terrorist attacks. Hu Jintao says: creating 25 million new jobs every year. You recount the story of youth unemployment rising past 20% and the statistics disappearing in 2023. It doesn’t really matter if you have a BYD that costs ten grand if your kid can’t get a job. Remember how freaked out people were in America when unemployment was 6% in 2009 and 2010? The social malaise generated when big swaths of the economy can’t get a job at all, or a job that befits all the hard work of the gaokao, of being the first in your family to go to college — and then they’re stuck delivering packages or going back home — is an enormous social challenge. Xi must appreciate that at some level. How does it cash out in his head? Logan Wright: I co-taught with Michael Pettis for years at Beida in his shadow central bank seminar after the global financial crisis. I’ve interacted with a lot of Chinese students and had several as research assistants. The intensity of the social pressures in that hyper-competitive environment, relative to how an American educational environment is structured, is really difficult to describe. You’re exactly right. How they think about it is a different question. Fundamentally, this is a Marxist worldview of development: we’re building the industrial structure and industrial capacity, and from there, growth has always come from investment; employment has always come from investment. That’s how the model has worked, and you can’t demonstrate that it’s not working now. Yes, there’s a youth unemployment problem, but maybe that’s part of a transition; once these new industries are up and running, things get better. We had these problems when we joined the WTO in the late 1990s. So they downplay it. They don’t think it’s structural; they think it’s cyclical. I can see those arguments percolating within the system. But honestly, I’m not sure they are. The thing we know least about at this point in the Chinese policymaking process is how information flows from ground-truth economic reality into filtered argumentation at the top. We read Qiushi, the party journal, pretty carefully. These are not reassuring messages that they really get it, or that economists within the system who do get it are having success filtering messages into the party apparatus. Qiushi had an article in mid-August asking, essentially, why are people’s lived experiences of the economy different from our stated growth rates? I urge you to read it. The response basically comes back: well, they haven’t adopted new technologies yet, and if they use more AI in their daily lives it’s going to be better. Jordan Schneider: Biden tried that argument. It didn’t turn out super well for him. Logan Wright: The analogy is extremely overextended, but normal people aren’t reading Qiushi. This isn’t a form of campaigning. Can AI Save It? Jordan Schneider: The book makes a pretty compelling case that there are no easy outs. All the reforms are hard, and all have serious political downsides, from rearranging power structures to making people unhappy, such that we’re stuck. Take that as a premise: we’re in a low-growth universe, and it’s unclear where the jobs come from. Logan, is AGI going to give us the jobs? Can humanoid robots or DeepSeek V7 save China’s economy? Logan Wright: You’re asking rhetorical questions. The entire purpose would be to displace manufacturing labor. Jordan Schneider: Fewer jobs as robots take over, AI doing more work for fewer people. Logan Wright: Marginal labor productivity can increase while overall labor force participation collapses, which is a likely path. On AI: we’ve just done a deep dive on China’s AI financing. People assume the state can maintain AI financing indefinitely. It doesn’t really look that way. The frontier models collectively look like they’re generating single-digit billions of dollars in revenue — about $11 billion at this stage for all the frontier models. The hyperscaler build-out is in the range of 930 billion yuan, about $135 billion, this year, and looks like 1.2 trillion yuan, around $160 billion, next year. That’s about 15% to 20% of the US build-out as of now. The problem is that it depends largely not on the bond market but on the equity market, and on the equity market maintaining extreme valuations. Government guidance funds provide some portion of financing, but just for the hardware, the chip purchases. If China is compute-constrained and increasingly finance-constrained, you’re setting up a situation where the call on industrial policy to fund this new strategic industry keeps rising, for business models that do not look self-sustaining. So what is this for? That becomes the notion of embedding China’s tech stack in consumer electronics and using it for geopolitical leverage and supply chain dominance, which is a different argument. But it’s not for making money, it’s probably not for making jobs, and it’s probably not for making AGI either. Jordan Schneider: These are toy companies, and OpenAI and Anthropic are not. They’re making tens, hundreds of billions of dollars. Logan Wright: They’re not making money. Jordan Schneider: Right. But they have real revenue to point to, which DeepSeek and Kimi can’t. Alibaba can, but not from the model stuff. Logan Wright: Moonshot just posted a new number, but it’s all ARR based on four weeks of best performance. ByteDance has had the largest marginal expansion this year, and my understanding is they’re funding it through an offshore loan, so it’s not necessarily a domestic system. But they’re not generating a lot of revenue right now either, based on what we can see. From Shadow Banking to Finance as a Utility Brad Setser: Logan, one of the strengths of your book is how you highlight that the state financial system went through phases of evolution. It hasn’t been one constant set of five state banks providing a constant stream of financing to the same borrowers for twenty-plus years. Some of what we called shadow banking, some people in China thought of as the first steps toward a true market and more competitive banking, but that phased out. Now you’re arguing that weakness in the system has led it to center once again around the state and lenders with a state equity backstop. What’s the next phase? What does China need to do to have a more functioning financial system? Logan Wright: Their answer right now is that a more functioning equity and bond market will provide meaningful diversification from the state system. Th
Is the Chinese economy well and truly broken? Will China be stuck in low growth for a decade or more? And what would that mean for the industries we cover on ChinaTalk, for China’s military power, and for policymakers around the world? To discuss, ChinaTalk interviewed Logan Wright, partner at Rhodium Group, my former boss, and, in my humble opinion, the person with the deepest understanding of China’s macroeconomic picture of anyone following the PRC in the West. His new book is Broken China: How the Economic Miracle Shattered and What It Means for the World. Co-hosting is the great Brad Setser of CFR. We discuss: - Why China’s “economic miracle” has broken down and how the financial system that powered China’s growth for two decades now constrains it. - How the world’s biggest credit expansion turned into a debt trap, with investment generating less and less growth. - Why China’s property collapse, weak domestic demand, and surging exports are actually all part of the same story. - How China’s push into EVs, AI, robotics, and other “new industrial sectors” can’t by itself replace the growth China used to get from property and investment. - The jobs crisis facing China’s 12-13 million graduates per year and the ideological, fiscal, and strategic constraints that make it difficult for Beijing to address. - What a “broken China” means for the US and the rest of the world and why Logan argues there is no longer systemic economic rivalry with China, but only a military and industrial-resilience one. Listen now on your favorite podcast app, or watch on YouTube! Why China is “Broken” Jordan Schneider: Logan, is China’s economy broken? Are we sure? Logan Wright: The title is not a prediction. It’s an explanation of how we got here. The basic argument is that it’s still underappreciated how central the financial system was to China’s growth over the past two decades, and how much the financial system’s problems now constrain that growth. Those are the parts that are broken. China does have choices. But those options involve much slower growth in the short term. They cannot maintain the pace of the past two decades. The options they have involve restructuring the fiscal and financial systems: the way they allocate capital, the way they provide countercyclical support, how they raise tax revenue and how they allocate it. It is not meant to be a dramatic, bearish title. It’s meant to say there’s no point in asking Beijing to fix this model, because they cannot fix this model. If they are truly constrained in their policy options and not willing to fix it, what should the rest of the world do about it? The other key takeaway is that if growth depends so much on the financial system, and the financial system now constrains growth, then a lot of China’s external messaging — that they’re economically successful and time is on their side — is simply wrong. It will become more obvious that it’s wrong. That raises different questions for Western governments, which I raised in the Foreign Affairs article previewing the book and discuss extensively in its later chapters. It expands our options, and it means we have the capacity to use time on our side as our policy tools become more salient while China’s become less so. Jordan Schneider: How did we get here? We had China growing at ten, eight, seven percent. Now what’s the latest Rhodium forecast — somewhere in the one to three range? Logan Wright: At the start of the year we expected growth of 1% to 2.5%. We would argue we’re trending well below that, and we’re likely seeing negative growth in Q2 and Q3, because investment in China is contracting. The question is by what margin. The official data points to it contracting. Jordan Schneider: That is a dramatic turnabout. We had the excuse of COVID, that things would come back. It’s the fall of 2026 ,and they haven’t. On one hand, it’s a developing economy that’s going to grow slower over time. But going from seven to maybe one and a half is a truly dramatic thing for the Chinese and global economy. Turn the page back to chapters one and two. What broke, such that an economy with so much latent potential is now totally stuck? Logan Wright: This is a story of contingent outcomes. It was not inevitable. It is the result of distinct policy choices about how the financial system operated. After the global financial crisis, China saw the largest single-country credit expansion the world has seen in at least the last century, possibly many centuries. China added a third of global GDP to its bank assets in just eight years. We’ve never seen anything remotely like it. First, there was a deliberate attempt to provide countercyclical support in response to the global financial crisis. The extension after that was essentially path dependence. Growth was strong, it was dependent on investment, and it became too difficult for authorities to shut down without imperiling the overall economy. That facilitated the growth of the shadow banking system, and credit growth became increasingly disconnected from the real economy. A lot of it went into the property sector and local government infrastructure. After the deleveraging campaign started in 2016 and intensified by 2018, you had a sharp decline in credit growth. This coincides with Xi Jinping’s rise to power and how that changes financial risk, which we should discuss separately. You now have credit that cannot expand at the same rates because the financial system is already overextended. Rather than write down the malinvestment and the losses from the shadow banking system, you have a financial system that provides everlasting life to state-owned producers and local government financing vehicles, but cannot maintain the same pace of credit growth. Credit becomes less and less efficient, generating less growth at a lower quantum of credit. The result is a decline in overall investment. The number one cause of the rapid decline since 2021 was the collapse of the property sector. It’s critical to understand that as a proximate cause, not the ultimate cause. After the deleveraging campaign hit developers’ shadow financing channels, the property sector was reinflated by borrowing from households in the form of pre-construction sales. Developers put up showrooms and sold properties in advance, for which homebuyers borrowed. When the defaults happened, they happened largely against homebuyers waiting for their apartments. That collapse in confidence weakened construction across the economy. Property was 20% to 25% of China’s GDP at its peak. Construction has fallen almost 80%. Sales have fallen about 60%. Nothing has replaced property as a driver of growth. The other underappreciated part is how the slowdown in domestic demand is directly related to the rise in China’s external surplus and supposed competitiveness. It’s a byproduct of falling prices, but also of continued production across industrial sectors that used to find demand in residential construction in China. Now there’s none, so they need to find markets abroad, typically by cutting prices. This has produced persistent deflationary pressure and a weakening of the real exchange rate. The domestic slowdown and the external surplus are very closely linked, but people still treat them as distinct — they argue the economy is K-shaped — when in reality these are the same phenomenon. Brad Setser: Two questions. This massive credit expansion could be called unique not just because it was so big, but because it didn’t generate an external deficit financed by inflows from abroad, which is unusual given its size. It would be helpful to discuss why such a huge credit expansion, with such heavy investment in property, never spilled over into an external deficit. There’s also an argument that this credit expansion ended without a crisis. Nothing like the US in 2008, nothing like Spain’s banking sector. There’s never been a moment of catharsis when key parts of the financial sector lose access to financing. Why was it possible to have such a big credit expansion without it ending in something that approximates the financial crisis most countries experience? Logan Wright: On the crisis moment first. The story in the book is not one of crisis or collapse but of decay: the decay over time of policy tools, of an attempt to forestall immediate crises at the cost of longer-term adjustment. Decay is an easier political choice for China’s leaders — accepting slower growth and inefficient policy tools rather than risking crisis. The path to crisis is not an external shock in China, where everyone assumes the government will provide support. The path to crisis is reform. And I would argue China had that cathartic moment. It’s exactly what the book leads off with: the protests in the lobby of Evergrande’s headquarters on September 13, 2021. China’s largest firm in its most important industry could no longer meet its obligations to its own employees, who were basically lending money to the firm. They protested and were ultimately not repaid. When China’s largest firm in its most important industry effectively defaults — later on its external obligations, and later on homebuyers — it raises the question of what else is going to provide growth. If you told me an economy had a financial crisis at date X and asked what the consequences would be at X plus five years, which is where we are now, I’d say this is entirely consistent with the aftermath of a financial crisis. Highly impaired policy tools that cannot deliver the same countercyclical response. Persistent deflationary pressure. Continued default pressure, as credit risk has migrated from the periphery to the center: from peer-to-peer lending in 2018, to small banks in 2019, to trust companies in 2020, to property developers in 2021, to mortgages in 2022, to local government financing vehicles in 2023. Much slower growth and reliance on external markets because of the inability to generate domestic demand. Everything you’d expect from an impaired, zombified financial system is taking place. The consequences are the same. On external financing: China’s post-crisis credit expansion was essentially externally financed through steady inflows of deposits into the banking system from exchange rate intervention and reserve accumulation, until about 2013. The change in that pattern in late 2013 and 2014 is exactly what forced increasing reliance on non-core liabilities, with banks competing for wealth management products on higher interest rates. You got huge maturity mismatches between higher-rate short-term financing and a rising pool of assets, because you no longer had steady deposit growth. So there was an external financing component, though I take the broader point that it never spilled over into an external deficit. Jordan Schneider: Let me spotlight some of Logan’s prose: “For years, long-term trends in China’s economy and financial system have appeared unstable. Everyone asks when the crisis is coming. But the more precise question is: how long can these trends continue before China faces the same economic outcomes as a financial crisis? The answers are clearer, as these consequences are already apparent in China’s economy and the decay of the financial and fiscal systems. China has already seen a sharp slowdown in economic growth, led by its vitally important property sector and local government infrastructure investment. Private sector credit remains weak, similar to the effects of a shock to aggregate demand. The downshift in economic growth is structural in nature, as the economy is unlikely to recover to previous growth rates.” Even though we didn’t get something as dramatic and nationwide as 2008, what you’re living with is a version of permanently suppressed growth like post-bubble Japan in the mid-1990s. Logan Wright: Japan is probably the closest analogy in recent history, with differences. Japan had zero-bound monetary policy and therefore had to rely on fiscal s
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