David Mahon on how tough zero-COVID policies have hurt the Chinese economy and the entrepreneurs who drive it, pushing away international buyers. He also explains why Beijing has remained staunch - and how it might end

By David Mahon*

The Chinese economy contracted in July and August, primarily due to the tightening of zero-COVID policies; more than 30 major cities are presently restricted or locked down. Over the last three months, China’s GDP grew only 0.4% year-on-year, down from 4.8% in the previous quarter.

An unseasonably hot, dry summer added to China’s woes, reducing hydroelectric output in Sichuan Province, forcing the giant battery manufacturer, CATL, and iPhone maker, Foxconn, to scale back production. As Sichuan generates 30% of China’s hydroelectric power, industrial production in neighbouring provinces has also been reduced. Yunnan Province makes 13% of China’s primary aluminium but is cutting production by 10% due to the loss of hydroelectric capacity. A drought grips 80% of Hunan Province, and with little rain forecast in the coming weeks, may well reduce the region’s rice harvest by 50%. With the exception of wheat, China’s national harvest will nevertheless be good, after years of the government enforcing land use rules requiring a high percentage of flat, arable land be planted in grain. Chinese citizens may not go hungry this winter, but many will be poorer.

Dwindling demand

Due to a slump in domestic and international consumer demand, a significant number of manufacturers in coastal China have reduced capacity and some factories have closed. Concerned that future supply of goods from China would be truncated by zero-COVID policies, international retailers over-stocked consumer products in 2021, but as costs of living continue to rise and consumer confidence falls in the West, key players such as Amazon are forecasting much of its excess domestic inventory will take up to 12 to 18 months to clear.

‘We survived COVID well last year. I borrowed to increase our raw material inventories, anticipating that we would face similar demand this year, especially from the US. I did not count on Omicron lasting as it has. After 20 years we closed the factory last month.’ Former light manufacturer, Hangzhou

‘We are working at 25% capacity, compared to last year. Still, I struggle to find skilled workers. They tend to leave the moment they think a business is in trouble. People talk a lot about unemployment and the province losing industrial capacity, but good workers are finding jobs and vulnerable businesses are being replaced by better capitalised ones. China has always struggled with over-capacity as companies opportunistically pile into rising sectors. This crisis is reducing capacity in our sector which should be good for us in the medium term, if we survive.’ Ningbo auto parts factory owner

Cooked books

World Bank and IMF assessments of historical Chinese GDP growth, industrial production and export data confirm that economic reporting over the last 10 years has generally been accurate. City and county officials, however, are now under such intense pressure to balance zero-COVID management with economic performance that some are pushing both state-owned and private manufacturers to inflate the production numbers they report - a practice Xi Jinping had until recently reduced by imposing stiff penalties on miscreant officials. As hard as it is now to get a detailed picture, the trend is clear: the Chinese economy has shrunk, due largely to consumption falling in the face of the strict implementation of zero-COVID policies. The more developed provinces have been hit hard, some struggling to pass 2% GDP growth in the last three months. Resource-rich, more thinly populated provinces such as Ningxia, Inner Mongolia and Shaanxi, have meanwhile been growing at more than twice that rate.

‘This is just political. Xi wants to ensure that he can receive thousands of delegates from across China to confirm personnel changes at the 20th National Party Congress. He will tie the country down until the meeting is over, then perhaps the policies will ease. Most people expect that they will. Without loosening zero-COVID policies the economy will tank. I can’t imagine how the country will react if zero-COVID policies are kept as they are.’ Beijing economic analyst

No quarter

It would make sense for China to open its domestic economy as soon as possible. The government is aware many people have lost faith in local authorities for the fearful and arbitrary manner in which they have applied COVID restrictions. Asymptomatic children were separated from asymptomatic parents in Shanghai quarantine centres, there have been acute food shortages during lockdowns, and recently a bus plunged off a mountain road, normally closed to night-time traffic, after officials tried to rush citizens out of the city in the small hours of the morning, despite the fact the passengers had tested COVID-negative over the previous ten days. They just happened to live in the same building as a few people who had tested positive. Rage, contempt and sorrow flooded social media.

It is not certain that Beijing can risk opening the country, for it cannot accept any sharp rise in COVID deaths, having already declared that it is controlling Omicron. Any easing of zero-COVID policies will be gradual, with restrictions probably remaining until at least March/April next year. Although it is wrong to allege, as some do, that the Party welcomes COVID restrictions as a tool of social control, given Beijing’s view that the world failed in managing COVID where China succeeded, there is probably both a humanitarian and a competitive motive behind the current strategy.

‘There is a view in the cities that Chinese Government COVID policy is unsustainable, and Beijing has no choice but to relax the rules. But the government is looking at some alarming data. Vaccination rates in the major cities may be over 90%, but of the 23% of people over 60 living in rural areas, 52 million have not been vaccinated. There would be an unsustainable death toll if they dropped the zero-COVID policy tomorrow. The rules won’t change till the virus weakens.’ Beijing public health analyst

The Chinese Government is doing all it can to support the economy with increased investment in public infrastructure, lower interest rates, rent relief, looser house purchasing policies and employment subsidies. The impact of this stimulus is nevertheless barely adequate, and the cost will be a drag on future growth. Banks will struggle with high levels of non-performing loans as businesses continue to fail. Consumption is the prime engine of the Chinese economy, but the exports that have masked the anaemic consumer demand of the last two years are unlikely to be able to do so in the next 12 months due to weak global demand.

The Chinese economy will endure, but at a cost that accrues daily. Once COVID restrictions ease, domestic consumption and foreign direct investment will rekindle economic growth. FDI increased over 17% over last year, with European, particularly German companies leading the way. The longer the Chinese Government pursues the present zero-COVID policies, the cost of restoring public and economic confidence with be higher and recovery will be slower.

A nation of entrepreneurs

The economies of China and the United States are more similar than their conflict would indicate. Both are driven by competitive domestic markets that foster entrepreneurship and technical innovation, affording them better chances of renewal and recovery from downturns and recessions than their less-dynamic competitors. The difference is that the US focuses on international causes (real and imagined) for its present domestic economic weaknesses and social disparities, while China looks more to itself.

One safeguard is that while the domestic economic downturn and steadily accruing debt will drag on the Chinese economy in the coming two years, the banks are generally managed efficiently by the state. With the exception of some rural and a few municipal banks, bank lending is well collateralised - which is why even the failure of property giant Evergrande has not triggered an unsustainable crisis among its institutional creditors. At 34%, Chinese household savings are among the highest in the world, and consumer debt commitments are modest and manageable by OECD standards. An economy with a different juxtaposition of liabilities would already have entered a protracted recession.

The Chinese middle class is becoming more self-indulgent, and shares many of the ills of the middle classes in the US and Europe, such as a false sense of entitlement and depression, while obesity and addiction are growing - but the good news is that new entrants to the middle class from the poorly paid masses are swelling their ranks at a relentless rate, amounting to scores of thousands a year. These newcomers bring energy and innovation that drive and revitalise Chinese society and economic life. Forty years of communism could not repress the entrepreneurial spirit of the Chinese people, nor will a three-and-half to four-year pandemic.

The Chinese Communist Party and Government may appear to singularly lead the country, but they also adapt to its powerful underlying forces. Even as many officials, intellectuals and business leaders worry that President Xi Jinping is consolidating too much power around himself, the masses of the people support his continuing leadership. Xi may not bring economic relief immediately after the upcoming National Party Congress, but he knows he will have to offer a path to normalcy soon afterwards. Xi will heed the economic and social pragmatists around him, for he too is a pragmatist. China will stumble into next year, but it will not fall.

*Mahon also spoke to interest.co.nz recently for an episode of the Of Interest podcast. You can listen to this here.

*David Mahon is the Executive Chairman of Beijing-based Mahon China Investment Management Limited, which was founded in 1985. This article is here with permission.