China’s third plenum is unlikely to significantly correct an ailing economy

China’s third plenum, taking place in Beijing from 15 to 18 July, is a once-in-every-five-years conclave of the Central Committee of the Chinese Communist Party, where a range of policies to address long-standing issues are unveiled. Historically, this event has seen announcements of major policy shifts and economic reforms. This time around, markets and China watchers hope the third plenum can answer a specific question: will sufficient growth-enhancing measures be announced to revive the Chinese economy after years of underwhelming performance?

The party’s official channels have been previewing the third plenum as a platform for “comprehensive” reforms, but foreign observers and some academics are not convinced. Increasingly serious problems have been piling up for China during the last few years, including the demise of the real-estate market, the difficult financial situation of local governments, rapidly declining returns on assets because of over-investment and the deflationary pressures in the economy.

The response to all these woes, as aired by China’s leadership during the past few months, will be the further strengthening of China’s manufacturing capacity under the mantra of ‘new productive forces’. Chinese manufacturing capacity is already nearly a third of global capacity, while its consumption is less than half that amount. Given such a huge imbalance, one might expect that measures to foster private consumption would be the main takeaways from the third plenum, but this does not seem to be the direction China’s leadership is taking.

At most, more consumption vouchers (targeted cash offered by the government to entice citizens to buy certain goods) are expected. In the past, these have not had much success in lifting consumption. What does seem clear is that China will not announce the introduction of a full-fledged welfare state at this plenum, judging from Xi Jinping’s dismissive comments on the consequences of “welfarism” on people’s behaviour, namely laziness.

Given the above, the plenum’s outcome will probably be an even larger imbalance: more supply without increasing domestic demand. This should lead to an even greater wave of Chinese exports and thereby an even bigger trade surplus. But things are changing. Western economies and some major emerging economies have started imposing barriers on Chinese imports, meaning that Chinese products might remain at home, unsold, piling up more overcapacity. The consequence will be more deflationary pressure, with the risk it will become entrenched, as happened in Japan in the 1990s. 

The same gradual approach to the solving of China’s key imbalance – stubbornly low domestic consumption – will probably be applied to other pressing issues, such as the deterioration in fiscal accounts, particularly local governments. Local government has long financed itself by land sales, which have plummeted since 2020. Now, the financial woes of local governments, compounded by rising interest rates, are forcing cuts to civil servants’ salaries and public services. The most likely response will be the transfer of consumption taxes to local governments, while also increasing transfers and having central government issue the bulk of debt, thus reducing interest payments.

Managing government spending will also be key. The government must balance carefully the increase in pension and medical costs given China’s shrinking working-age population. The government already announced last year that it would increase the retirement age, without giving a deadline for doing so. Ageing will also lead to a rapid reduction in the labour force.

Controlled urbanisation, rather than immigration from overseas, has so far been the Chinese government’s answer to this problem, but urbanisation would need to accelerate as ageing deepens. This could be done by relaxing restrictions on domestic migration. Reform in the shape of changes to the household registration system (hukou) has been floated many times but there is opposition from the largest cities, likely to be reinforced as job opportunities are increasingly scarce, even in the largest cities.

Finally, on the immediate issue of the policy mix, China would benefit from laxer monetary and fiscal policies, but the reality is China no longer has the room it once had. Public debt is at 100% of GDP and interest rates are already very low, especially when compared to the US, pushing the renminbi to record weak levels. Consequently, no radical change can be expected from the third plenum, not even on the mix of demand policies.

The announcements will likely look more like Chinese medicine than shock therapy, even if China’s economic health issues are increasingly serious. This has important ramifications for the global economy. China’s demand for foreign products will remain subdued and Chinese companies will continue to rely on foreign markets to survive. This points to continued trade wars, perhaps even moving beyond that to investment controls and currency wars.

This is an output of China Horizons, Bruegel's contribution in the project Dealing with a resurgent China (DWARC). This project has received funding from the European Union’s HORIZON Research and Innovation Actions under grant agreement No. 101061700.