China’s Economic Headwinds

Proponents of this consensus about China’s economic rise argue that the United States naively welcomed Beijing into the rules-based trading system to pad the profits of multinational corporations at the expense of average American workers—all on a Panglossian belief about the ability of freer markets to facilitate democracy and peace. This development, critics allege, allowed China to dramatically increase its wealth, which it is leveraging to strengthen its military and adopt a revisionist foreign policy.

This consensus is rife with problems. First, China’s rise has a lot more to do with its abandonment of central planning decades ago than it does with today’s re-embrace of protectionism, industrial policy, and Maoist socialism. Second, China faces several headwinds that will constrain future growth. Indeed, overestimating China’s economic strength and future growth prospects leads to overreaction and poor policymaking. To be clear, many of China’s commercial practices are legitimately concerning and do pose significant challenges to the United States and the rules-based trading system. To meet these challenges, however, policymakers need a sober assessment of China’s economy and prospects for future growth.

Between the establishment of the People’s Republic of China in 1949 and the early 1970s, China’s economy was centrally planned, and it had little foreign trade. Beginning in the late 1970s, China began to liberalize its economy and experiment with private markets under the leadership of Deng Xiaoping. Among the policies enacted, “agricultural collectives were phased out, and private farming was introduced; the state monopoly on foreign trade was abolished; foreign investment was gradually permitted; and trade barriers were reduced in stages,” says Douglas Irwin in Clashing over Commerce: A History of US Trade Policy. Indeed, as part of the process that granted China a spot in the World Trade Organization (WTO), Beijing cut tariffs substantially—from an average of 25 percent to 9 percent—phased out import quotas, eliminated several nontariff barriers, and made a commitment to respect and enforce intellectual property rights.

China’s economic liberalization dramatically improved the lives of average citizens. Between 1980 and 2016, China’s national poverty rate, as judged by the World Bank’s poverty line, fell from about 90 percent to 4 percent, which implies 800 million fewer Chinese living in poverty. Global trade played a critical role in this advancement. Even according to David Autor, David Dorn, and Gordon Hanson, authors of the famous China Shock papers, Beijing’s own domestic internal reforms—especially tariff liberalization (and thus access to imports)—were responsible for much of its gains in global export competitiveness in the late 1990s and 2000s.

Despite the rapid growth following China’s market-oriented economic reforms, the average Chinese citizen remains poor relative to the individuals in the developed world because its economic growth began from a very low, communism-induced baseline. Figure 1 shows per capita gross domestic product (GDP) based on purchasing power parity (PPP) among the major economies in the world. As the chart shows, per capita GDP adjusted for PPP in the United States was about $66,000 in 2021 compared to just over $19,000 in China.

China’s influence in the global economy thus comes more from its massive population than from Chinese individuals’ productivity and wealth.

Nevertheless, China is the second-largest economy in the world—trailing only the United States. In 2021, its GDP was about $17.7 trillion compared to about $23.3 trillion for the United States. In fact, both countries dwarf their closest competitors economically as Figure 2 demonstrates. Japan is the third-largest economy in the world, but its GDP in 2021 was only about $5 trillion, while Germany, the fourth-largest economy, was about $4.3 trillion.

And, with about 1.4 billion people (about 18 percent of the world’s total population), China has a massive consumer market that most multinational corporations want to access. On top of that, the country is a major trading nation and central to many supply chains, especially in Asia. Indeed, China’s share of world goods exports was negligible in 1980, but it rose to 14.68 percent in 2020.

Thus, even if several American-allied countries in the region share U.S. concerns about Beijing’s commercial practices, the reality is that China’s market size, trade relationships, and geographical positioning are such that many foreign governments and multinational corporations will desire to maintain ties to the Chinese market, even amid growing geopolitical risk.

Nevertheless, China’s influence and economic strength now and in the future should not be oversold—especially to justify radical shifts in Western governments’ domestic and international economic policy. Indeed, China faces both short-term problems and long-term headwinds that will at best diminish the country’s once-bullish economic and investment prospects and at worst severely weaken China’s economy and government in the decades ahead.

Despite some undeniable economic successes, policymakers in Beijing, particularly under the leadership of Xi Jinping, have moved in an illiberal direction. As a result, China faces several short-term concerns that will likely weigh on growth in the coming years.

The tech sector, once a dynamic and thriving industry, has been paralyzed by Xi’s re-embrace of Maoist socialism. Likewise, Beijing’s crackdown on education platforms and its general antipathy toward private-sector firms continues to fuel youth unemployment in China. The Economist recently noted that China’s urban youth unemployment rate is above 20 percent.

Likewise, China’s open embrace of industrial policy in the late 2000s generated backlash in the global business community and developed country governments, heightening geopolitical tensions and fomenting trade conflicts (or, at the very least, giving Western politicians an excuse to favor their own national industries). Thus, for example, the United States imposed expansive export controls on semiconductors and semiconductor manufacturing equipment to China in late 2022, followed by Japan and the Netherlands, two major players in the semiconductor production supply chain, shortly thereafter. Given the ubiquity of semiconductors in virtually everything produced today, these efforts will hurt China’s technology and manufacturing capacities in the short and intermediate term.

The real estate sector is increasingly overinflated while property developers fail to deliver on promised residential units leading to a large middle-class boycott of mortgage payments in 2022. Evergrande, a major Chinese property developer, defaulted on its debt in late 2021. Investment in property development fell by nearly 6 percent in the first quarter of 2023. As a result of real estate struggles, local government coffers, largely reliant on land sales to fund public services, are drying up. A Wall Street Journal story about the Guizhou province is illustrative of this problem. For a while, the southwestern province was one of the fastest-growing regions in China owing to debt-fueled infrastructure development that was financed by local banks that lent heavily to local governments. As the Wall Street Journal notes, “Chinese authorities largely stood aside over the past two years as the country’s largest property developers slid into financial distress, causing losses for investors and many businesses and depressing the land sales that were a big source of revenue for many local governments,” including Guizhou. As Tianlei Huang, a research fellow at the Peterson Institute for International Economics told the newspaper, “It is challenging the problems in the real economy to the financial sector and eventually could pose a threat to financial stability.” Indeed, two-thirds of local governments in China are “now in danger of breaching unofficial debt thresholds set by Beijing to signify severe funding stress.”

It’s not just economic policies that increasingly make China a less desirable country in which to invest and with which to trade. Beijing’s handling of COVID-19 and its disastrous Zero-COVID strategy is giving multinational corporations second thoughts about investments in China. The country also recently began cracking down on economic consulting firms, which is drawing criticism. Moreover, China is increasingly relying on forced labor and repression toward Uyghur Muslims in the Xinjiang region. Likewise, Beijing has turned its back on the “One Country, Two Systems”—meaning a great deal of autonomy and self-governance—promise to Hong Kong, which was effectively annexed with the passage of the national security law in 2020. Beijing’s hostility to inquiries into the origins of COVID-19 has increasingly alienated countries in the Indo-Pacific region, such as Australia, which led to a simmering trade war between the two countries.

In other words, Beijing’s belligerence is adding to growing geopolitical risk and uncertainty. Foreign direct investment into China fell by nearly 50 percent in 2022 compared to 2021 as foreign firms are increasingly wary of China’s deteriorating relations with other countries and firms. All told, growth is suffering and will continue to suffer unless these policies are reversed or at least mitigated.

China’s short-term problems may be surmountable, but its long-term headwinds pose a much bigger challenge for Chinese economic growth and global influence.

First, China’s rapidly aging population and a shrinking workforce will weigh on economic output, suppress innovation, and stress government services. The United Nations recently announced that India will overtake China as the world’s largest population in 2023. An essay in Foreign Affairs noted, “In 1978, the median age of a Chinese citizen was 21.5 years. By 2021, it had risen to 38.4, surpassing that of the United States.” In the 30-year period between 1949 and 1979, China’s population grew from 540 million to nearly 970 million. Beginning in the 1970s, however, China began a series of policies aimed at curbing population growth, and fertility rates began to drop precipitously—“from 5.8 births per woman in 1970 to 2.7 in 1978.” Today, China’s fertility continues to fall; in 2020, for example, the fertility rate of 1.3 births per woman is below the replacement rate of 2.1 births per woman. Data from China’s National Bureau of Statistics in 2021 show that the birth rate in the country fell for the fifth consecutive year with a fertility rate of 1.15 births per woman, one of the lowest percentages in the world (Figure 3).

In 2016, Beijing reversed course and lifted its brutal One Child Policy. As of May 2021, the limit is three children. Despite this about-face, what explains China’s demographic headwinds? For starters, women have seen increased educational and employment opportunities, which has been linked to lower birth rates in other countries, including the United States. Likewise, China has a severe imbalance in the ratio of men to women owing to the One Child Policy that favored males. In most of the world, the sex at birth ratio is 1.06 males for every 1 girl, but in China, it is 1.2 males for every 1 female, and in some provinces, the ratio is 1.3 males for every 1 female. Other possible drivers include the fact that the population has gotten used to having smaller families, rising costs associated with having a child, and a decrease in marriage rates.

Given the significant downturn in the Chinese economy in 2022, early indications are that the birth rate will drop again. Indeed, marriages in 2021 were down to their lowest levels since the mid-1980s, when Beijing began keeping records of annual registrations, and initial data suggest a further decline in 2022. Yi Fuxian, a scientist in obstetrics and gynecology at the University of Wisconsin-Madison and author of Big Country with an Empty Nest, a book on China’s demographic troubles, projected that China’s Zero-COVID policies would lead to a significant drop in marriages in 2020 and 2021 and would lead to a drop of about a million births in 2021 and 2022. Though there are legitimate questions about the veracity of Chinese demographic data, government officials are now acknowledging publicly that the country faces serious challenges. In August 2022, China’s National Health Commission wrote in an essay for the Communist Party’s journal, “Low births and aging amid negative population will become the norm.”

Low birth rates, a rapidly aging population, and a shrinking workforce will almost certainly inhibit China’s future GDP growth, but it will also inhibit productivity, dynamism, innovation and risk-taking, all leading to a weaker social safety net. Yet China’s long-term structural problems do not end there.

In theory, China should be leading the way in the high growth sectors of the global economy. Yet on top of low birth rates and a rapidly aging population, China also faces a serious exodus of young, talented, highly educated citizens.

The Organisation for Economic Co-operation and Development’s (OECD’s) Programme for International Student Assessment (PISA) measures international educational outcomes by administering a cross-national exam every three years to 15-year-old students in about 80 high- and middle-income countries. Each participating country selects a representative sample of between 4,000 and 8,000 students and administers the exam. Due to the outbreak of COVID-19, 2018 was the last time the OECD administered the PISA exam. Based on those results, China ranked first in reading, science, and mathematics. Meanwhile, the United States ranked 13th in reading, 37th in mathematics, and 18th in science.

China’s success extends to undergraduate education as well. The country awards “more science and engineering undergraduate degrees than the U.S., Britain, France, Germany, Japan and South Korea combined.” Between 2000 and 2015, “the number of science and engineering undergraduate degrees granted per year in China more than quadrupled”—from about 360,000 annually to more than 1.7 million.

These smart, talented individuals, however, aren’t staying in China. Take artificial intelligence (AI). Of the top-tier AI researchers globally, nearly one-third received their undergraduate degree from a university in China, yet the overwhelming majority do not stay in China. In fact, 56 percent come to the United States, and about one-third stay in China. As Macropolo, a project of the Paulson Institute at the University of Chicago, notes, “After completing graduate studies in the United States, a full 88% of those Chinese researchers chose to stay and work in the country, while only 10% headed back to China. (This sample includes a combination of recent graduates, mid-career researchers, and veteran researchers to reflect average stay-rates across all these groups.)”

Generally, about 70 percent of international science, technology, engineering, and math (STEM) graduates from U.S. Ph.D. programs stay in the country, but among Chinese graduates, the rate is significantly higher—about 85 percent stay here.

Not only is China failing to keep a large quantity of its highly talented AI researchers, but it also struggles to attract foreign advanced STEM talent. An October 2021 study from the Center on Strategic and International Studies notes, “Only about 10 percent of international scientists and engineers seemed open to moving to China, compared to nearly 60 percent for the United States.” This is despite China’s decades-long global recruitment efforts.

So why does China struggle to retain and attract talent? As a February 2022 report from Peking University Institute of International and Strategic Studies argues, this is largely due to the “relatively relaxed and innovative scientific research environment” in the United States compared to China. Other reasons include China’s “authoritarian political system and restricted freedom” and “language barriers, pervasive internet censorship, and environmental quality.”

Yet instead of capitalizing on China’s woes in attracting and retaining top scientists, Washington’s hostility toward Beijing is driving some top talent out of the United States. Recent research found that nearly 1,500 U.S.-trained Chinese engineers and scientists dropped their U.S. academic or corporate affiliations for Chinese affiliations in 2021, which represents a more than 20 percent increase from the prior year. This trend accelerated due to the Trump administration’s so-called China Initiative, which the U.S. Justice Department intended to use to counter espionage and national security threats from China. Yet it became apparent that many of the cases were weak and were quickly dismissed, and there were charges of racial profiling, which led the Biden administration to drop the program in 2022. Indeed, there is recent evidence that if the trend of Washington pushing scientists away from the United States and toward China continues, it risks undermining the asymmetrical advantage the United States has over China: the ability to attract and retain talented foreigners.

A nation’s economic growth and global influence generally stems from two things: the size of its population and the productivity of its workforce. China could thus increase global power by, theoretically, offsetting a declining population with strong productivity growth. In reality, however, productivity is a significant challenge for China’s economy that will increasingly hamper growth unless policies are radically transformed.

Beginning in the late 1970s and early 1980s—shortly after Deng’s market-oriented reforms—China experienced a rapid increase in productivity growth, but much of this was due to catch-up growth given that the country had a very low starting point. Indeed, China’s annual productivity growth averaged about 4 percent during this period. Today, however, there is mounting evidence that productivity growth is slowing in China—an even sharper decline than worldwide productivity trends (Figure 4).

What are the primary causes of China’s productivity slowdown? Demographic challenges and brain drain as documented above are certainly contributors. In addition, China’s increasing reliance on top-down economic planning (industrial policy) and state-owned enterprises (SOEs) is a major contributing factor. It is estimated that China’s SOEs are about 20 percent less productive than private firms operating in the same sector.

This is a relatively new phenomenon. Between 1998 and 2005, the International Monetary Fund (IMF) estimates that the share of SOEs in industrial output fell from about 50 percent to about 30 percent and that this “transition coincided with rapid aggregate productivity growth, which came in part from the growth of the private sector at the expense of less productive SOEs.” Yet the role of SOEs in China’s economy is growing. As the IMF noted in early 2023 in its review of China’s economy in 2022, “SOEs are being tasked to make advances in strategically important sectors and technologies affected by growing geoeconomic fragmentation, further burdening them with responsibilities.” Indeed, the IMF noted in 2022 that “the decline in business dynamism is particularly pronounced in sectors and regions with large SOE presence.”

China’s shift from economic liberalization toward central planning has also taken a toll on Chinese innovation and productivity. It is estimated that about 70 percent of China’s subsidies flow to less productive SOEs, and the government increasingly subsidizes non-SOEs—to their detriment. A December 2022 paper found, for example, that between 2007 and 2018, direct government subsidies to companies listed on China’s stock exchange increased by about seven-fold—from about $4 billion to $29 billion. Examining firm-level data about the relationship between firm productivity and government subsidies, authors of the study found that the latter tended to undermine the former:

Likewise, a November 2022 National Bureau of Economic Research (NBER) paper found “little statistical evidence of productivity improvement or increases in R&D expenditure, patenting and profitability” of China’s major industrial policy program known as “Made in China 2025,” which is the crown jewel for Beijing’s goal of indigenous innovation and technological supremacy as a bulwark for future economic and military strength. Finally, another NBER paper found that beginning in 2008, China’s industrial policy began heavily subsidizing local firms with many patents. As a result, more patents were awarded, but the quality declined and led to less innovative firms buying patents to receive subsidies. In total, it was a large welfare loss once accounting for the subsidy cost.

Debt continues to plague both the corporate and government sectors, which hurts growth. As the IMF noted, “Government and household debt‐​to‐​GDP ratios are estimated to have increased to new highs of 108 and 62 percent in the second quarter of 2022, respectively, while corporate debt is hovering around a very elevated 125 percent.” The Wall Street Journal reported that by June 2022, debt in China reached about $52 trillion, “dwarfing outstanding debt in all other emerging markets combined.” The same story reported that between 2012 and 2022, debt in China grew by $37 trillion—nearly one and a half times the amount in the United States, a larger economy. Much of this debt is the result of the massive subsidies China provides on industrial policy projects, the overwhelming majority of which did not create leading‐​edge companies. In short, Chinese “state capitalism” may have generated a few notable successes in industries like electric vehicles. But as long as Beijing pursues its economic goals through government‐​influenced SOEs and costly industrial policy, surging debt and sagging productivity will combine with demographic decline to severely hamstring the country’s economic growth—and its global influence.

China’s experiment with market-oriented reforms between about 1980 and 2012 propelled the country to increasing wealth and rising living standards for average citizens. In recent years, Chinese leaders have unfortunately turned back toward illiberalism through heavy-handed state intervention in the economy and repressive human rights practices. These policies are starting to show signs in the data. Since 2011—the last year before Xi Jinping became president—China has seen foreign direct investment drop precipitously as tensions mount between Beijing and the West. In 2011, foreign direct investment was about 4 percent of China’s GDP; today, it’s 1 percent. As economist Noah Smith recently noted, foreign direct investment in China from G7 countries declined from $35.4 billion in 2014 to $16.3 billion in 2020.

Policies emanating from Beijing are the primary culprit for this decline and will generate more of it in the future—an outcome that would be tremendously unfortunate for not only the hundreds of millions of Chinese people who have yet to escape relative poverty but also for the global economy overall.

But China’s future is not yet written, and Beijing should reverse course again in the years ahead and re-embrace the types of reforms that drove the country’s rapid economic growth in the past. This might not be the most likely future, but it’s the one we should all hope for.