China Faces a Familiar Economic Downturn. But Its Crisis Is Worsened by the War in Ukraine

Throughout the 1980s, Japan’s economy was the envy of the world. But by 1989 a real estate and stock market bubble spooked policymakers, who hiked interest rates to tame inflation. Japan’s bourse tanked, the value of assets plummeted, and several big banks either failed or required government bailouts. As businesses folded and joblessness rose, Japan became mired in a decade-long recession.

There are distinct parallels for China’s economic downturn today, which in many ways is typical of any credit-driven boom and bust cycle. China’s housing market—which contributes some 30% of GDP—is the chief villain. Despite a shrinking population, Chinese developers gorged on debt to build more new homes every year than the U.S. and Europe combined. Today, China has more than 23 million unsold apartments—enough to house the entire population of the U.K.

A regulatory crackdown on bad developer debt has pushed several to the brink of insolvency while threatening the broader economy by undermining the confidence of consumers, businesses, and investors. In July, new-home sales at China’s 100 biggest developers fell 33% year-on-year, according to data from the China Real Estate Information Corp.

The crisis is compounded by rocketing youth unemployment figures, which breached 21% before the government last month tellingly decided to stop publishing the figures. Understandably fearful for the future, Chinese consumers—like Japan’s before them—are now sitting on their savings instead of spending them.

Chinese President Xi Jinping has "his hands full right now," U.S. President Joe Biden told a news conference in Hanoi on Sunday, after Xi skipped out on the G20 summit in India last week. "He has overwhelming unemployment with his youth. One of the major economic tenets of his plan isn’t working at all right now. I’m not happy for that. But it’s not working."

Ultimately, whenever there’s a credit expansion it follows that asset values get inflated and can't be sustained by people’s incomes, sparking a massive correction. It was a similar story behind the 2008 financial crisis and stock market crash of 2015. But one factor above all else sets China’s current experience apart and renders any course correction more difficult to engineer: Xi’s support for Russian President Vladimir Putin’s war of choice in Ukraine.

“It’s China’s worst economic crisis since the Cultural Revolution,” says James H. Nolt, an adjunct professor at New York University and senior fellow at the World Policy Institute. “One of the biggest mistakes in Chinese foreign policy in the last half-century has been lining up with Russia.”

On the face of it, China has so far avoided the rampant inflation that has blighted many parts of the world. However, what China does import with relish is food, fuel, fertilizer, and non-ferrous metals—all of which have been severely impacted by the war in Ukraine. A lot of the Ukrainian grain that Putin is blocking from being transported across the Black Sea is actually bound for China. And at the same time, China’s exports have been hit by sanctions and slowdowns across the world, not least given the 20-member Eurozone is now in recession.

Another crucial aspect is Xi’s signature $1 trillion Belt and Road Initiative (BRI). Around one-third of Chinese loans for the BRI went to Persian Gulf states and are arguably more secure today due to high oil prices. But another third went to developing nations like Pakistan and Egypt that are suffering from catastrophic inflation and price hikes directly stemming from the war in Ukraine. And the final third goes to Russia itself.

According to financial data firm Refinitiv, Russia ranks top for BRI ventures with the country hosting 113 projects valued at $291 billion in 2019. Today, however, crippling sanctions mean nearly all these loans are non-performing. Given China’s voracious appetite for energy, some will likely be serviced by Russian oil and gas exports. But the projects themselves—and the future prosperity they promised—are largely stalled.

Nearly 60% of China’s foreign loans are now to countries in debt crises, compared to just 5% in 2010, according to a report by researchers from the World Bank, Harvard Kennedy School, AidData, and the Kiel Institute for the World Economy. In addition, a total of $76.8 billion in debt was renegotiated—and in some cases written off entirely—from 2020 to 2022, according to the Rhodium Group.

“Much of that trillion dollars in BRI capital has been thrown away,” says Nolt. “Many of those projects will never be completed and will never return anything.”

This is especially important since China’s local governments are still bearing the scars from the pandemic, when they ran up huge debts to satisfy the uncompromising testing and lockdowns demanded by Beijing. Local government debt reached 92 trillion yuan ($12.8 trillion), or 76% of economic output in 2022. Already, civil servant pay has been slashed in many provinces while cuts in benefits have prompted rare public protests. “This phenomenon is quite worrying for China because as long as the economy is going well people are less inclined to speak politics,” says Dominique Turpin, president of the Shanghai-based China Europe International Business School.

Compounding matters, a key avenue for local governments to raise money is selling land to real estate developers­—but the housing slump has decimated that revenue stream. Instead, the central government last month promised a “basket of measures” to alleviate the problem, including special bond issuance, loan rollovers, debt swaps, and dipping into the central budget. But with half of all Chinese cities struggling to pay back debts, there will be no quick fix. Already, China’s foreign exchange reserves had fallen to $3.16 trillion at the end of August—its lowest level in six months—as the government attempts to prop up a falling renminbi.

“The government needs a stronger policy response to the economic slowdown in order to stimulate growth,” says Xiaolan Fu, a professor of technology and international development at the University of Oxford.

Of course, it would be wrong to write off China completely. Fu notes that the economic picture varies a great deal depending on region and industry. In addition, China retains many advantages: unrivaled manufacturing supply chains, innovation centers, plus a huge domestic market.

“If you look at the current trend of geopolitical tension, one thing that’s very clear: the world’s going to get more expensive,” Yibing Wu, head of China for Singapore’s Temasek investment fund, told the Milken Institute’s 2023 Asia Summit this week. “Enterprises and [economies] ultimately win by efficiency … That’s what the Chinese market ecosystem provides.”

But domestically, Xi’s regulatory crackdown on private enterprises has clipped the wings of China’s biggest drivers of growth. In mid-2023, private companies accounted for just 39% of the collective value of China’s 100 largest publicly traded firms, according to the Peterson Institute for International Economics, down from 55% two years ago.

“Economic reforms are still very much needed,” says Fu. “The private sector is key to the commercialization and restoring confidence, incentivizing entrepreneurs to make greater efforts in terms of innovation.”

And overseas, Xi’s support for Putin has galvanized the impression in the West that the world is coalescing into divergent blocks, with bipartisan support for U.S. export controls on transformative technologies like semiconductors, AI, and Quantum Computing.

In response, Xi has attempted to grow his own counter bloc. At last month’s BRICS summit in South Africa, the forum of developing countries—Brazil, Russia, India, China, and South Africa—agreed to add six more: Argentina, Egypt, Ethiopia, Iran, Saudi Arabia, and the UAE. Still, the new additions collectively boast just 11% of the group’s collective GDP and hardly offer China much in the way of economic salvation.

“It’s a very, very bad situation,” says Nolt. “Once this thing implodes, there’s going to be a lot of hurt all around.”