China’s economic divide is widening in era of protectionism

The fault lines within China’s seemingly on-track economy are swelling.

While the 5 per cent growth reported this week for the first half of this year was well within Beijing’s target range of 4.5 to 5 per cent, the 4.3 per cent growth rate in the June quarter was the country’s weakest since the pandemic.

Since the pandemic and the meltdown in its property market that overlapped it, China’s economic story has had two very different threads to it. Exports have boomed while the domestic economy has shrunk. It would appear that this year that divergence is increasing.

China’s exports in June totalled about $288 billion, a record and 27 per cent greater than a year earlier.

Despite a 36 per cent surge in imports – fuelled by the global demand for the electronic inputs to artificial intelligence – China is on track for another $US1 trillion-plus ($1.4 trillion-plus) trade surplus this year.

The weakness in the June quarter – the worst since the fourth quarter of 2022, when China was still experiencing Draconian COVID lockdowns – was driven by a continuing fall in fixed asset investment, an 8.5 per cent decline in private sector investment, flat-lining retail sales (including a 16 per cent slump in auto sales) and further falls in property investment and housing prices.

Whether it is the US with Donald Trump’s tariffs, or the European Union, which is considering raising the level of its trade barriers as well, there is pushback against the tide of cheap Chinese exports.

China might also have been affected by the flow-on effects of the war in the Middle East.

As the world’s biggest oil importer and Iran’s major customer, the closure of the Strait of Hormuz and the resulting spike in oil prices posed a threat to China’s energy security and economy.

President Xi Jinping has, however, made self-efficiency an economic priority, and China had massive oil and gas reserves to call on.

Beijing halted exports of oil products and put ceilings on prices at the pump for consumers, but higher fuel prices and energy conservation measures might well have been a factor in the June-quarter slowdown in domestic activity.

Weakening domestic demand has been a feature of China’s economy ever since the property development bubble was pricked in 2020, when Xi imposed his “three red lines” policy to restrict developers’ leverage.

That property market meltdown, and over-investment in infrastructure, have left Beijing without the two big levers it has been able to pull in the past to stimulate the domestic economy.

With much of China’s household wealth tied up in property, the wealth effects of the freefall in property prices have been devastating, leading to consumer caution and domestic over-capacity despite repeated efforts (albeit relatively conservative and piecemeal ones) by Beijing to stimulate spending.

It has also forced Chinese companies, private and state-owned, to look to markets offshore to absorb their excess capacity, which in turn has fuelled rising discontent in the major markets targeted.

Whether it is the US with Donald Trump’s tariffs, or the European Union, which is considering raising the level of its trade barriers as well, there is pushback against the tide of cheap Chinese exports – a tide being diverted by Trump’s tariffs to other, less protected, economies.

With China’s growth faltering again, the pressure on Beijing to do something substantial to increase domestic consumption will only intensify, although the fact that first-half growth overall rate was within its target range may mean that it holds off until later in the year.

In recent years, the government has waited until the fourth quarter to act to boost spending and meet its official growth targets – which it always does, despite some cynicism about the accuracy of its reported numbers.

China’s policymakers have generally treated the weakness of domestic demand as a secondary issue, prioritising exports, investment in high-tech manufacturing and, increasingly, in AI and its deployment throughout the economy.

On Monday, however, the policymakers made household spending a higher priority, outlining a five-year plan to boost it by nearly 20 per cent by 2030. It was the first time Beijing has set a multi-year plan for consumption.

Its policymakers didn’t say how they were going to do it, referring to “targeted, more proactive and effective policies,” but in the past the measures have focused on encouraging consumers to trade in old appliances and vehicles for new ones, providing concessional finance to try to increase mortgage sales and consumers’ purchases, and tinkering with the social welfare safety nets to increase confidence.

Most of those measures have been limited and fallen far short of the scale of measures that most Western economists have advocated, for years, to achieve a better balance between domestic and external activities. In most developed economies consumption accounts for about 60 per cent of GDP. In China, its share is about 40 per cent.

Adding to China’s challenge is its demography. Its population is ageing and shrinking, with some estimates that it will shrink by about 75 million people a decade for the next several decades, with the ratio of workers to retirees halving by 2050.

That dwindling workforce might explain why Xi has placed so much emphasis on, and has subsidised, investment and promotion of AI and advanced technologies. To continue to grow the economy and avoid social tensions and distress within the swelling population of retirees, China will need to do more with fewer workers.

For the moment, and for some time beyond – unless it can increase the consumption of its vast pool of consumers – China remains dependent on its export-led growth strategy, which some critics label a “dumping” strategy.

Some of the surge in exports in June might reflect a recognition that the strategy is vulnerable to backlash from export markets.

Apart from the Europeans, who last month discussed plans to broaden import quota and tariff coverage for products from China and accelerate processes to prevent dumping and unfair subsidies, China’s exporters would be very conscious of July 24.

That’s the date when Trump’s temporary 10 per cent tariff on all imports (an interim measure introduced after the US Supreme Court’s ruling that his “Liberation Day” tariffs were illegal) has to end.

Using different legislation – such as punishment for not having sufficient legislation preventing the manufacturing of goods made with forced labour, or for having policies that “burden or restrict” US commerce – the US will then impose individual tariffs on every economy.

Some might still attract the 10 per cent rate, others 12.5 per cent and some might be singled out for much higher tariffs. China isn’t expecting gentle treatment, so there may have been an element of “front-loading” exports to the US, whether directly or via third countries, to get in ahead of higher duty rates.

Whether that’s the case will become clearer when the September quarter data is available.

Still, Beijing’s belated attempt to develop a five-year plan to boost domestic consumption signals that it is increasingly conscious of the risks to its export-driven economic growth strategy in this era of protectionism.

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