China's economy is at risk of a brutal 'debt-deflation spiral'

Experts say policymakers in Beijing must intervene to prop up the economy and stabilize markets, and a policy error could make things worse.

• Headwinds in China are well-documented, but more turmoil could come if policymakers don't act soon.
• Economists at the IIF say Beijing still has the capacity to provide stimulus in 2024.
• But a lack of policy support could lead to a "debt-deflation spiral."

China's economy has crawled out of the pandemic far below the pace of what most analysts expected, and if policymakers don't step in with sufficient support in 2024, a "debt-deflation spiral" could ensue.

Current headwinds include deflation, an aging population, real estate tumult, and an uber-bearish narrative around Chinese stocks. While some economists and Wall Street strategists have shared their skepticism with Business Insider on Beijing's chances of engineering a rebound, researchers at the Institute of International Finance maintain a more upbeat outlook.

Gene Ma and Phoebe Feng said in a Monday IIF report that they maintain a growth forecast of 5% for China this year, above the 4.6% consensus estimate, though that hinges on an adequate policy response from officials in Beijing. 

Deflation and falling stocks

The researchers said China's leadership has failed to address the lopsided supply and demand dynamics in particular. Housing supply and manufacturing capacity have outpaced domestic needs, and key consumer price and growth gauges all moved negative in the fourth quarter of 2023.

"The deflation means the PPI-adjusted real lending rate stayed elevated in 2023, tightening the credit condition despite the moderate monetary easing," Ma and Feng said. 

Meanwhile, deflation has crushed corporate earnings and stock prices in China, as well as wage growth and tax revenues. The CSI 300 Index was one of the world's worst-performing stock benchmarks last year, while China's export price index declined 9% in 2023 as export growth dragged. Nominal GDP grew at 4.6% in 2023, 0.6 points below real growth. 

However, Beijing has the flexibility to boost demand via monetary and fiscal policy adjustments. 

Banks, for example, could lower rates charged on new loans to spur more borrowing, and the People's Bank of China could ramp up its funding-for-lending schemes, according to the IIF. 

The housing recession

The real estate market in China now accounts for a smaller share of the economy, and Beijing appears to have resigned itself to the reality that it can't rely on property values to fuel growth like it once could. 

Since peaking in 2021, home sales and housing starts in China have plunged 45% and 59%, respectively. However the IIF anticipates policymakers to stem those declines this year, making the sector less of an economic drag.

"The y/y housing growths in 2024, even still negative, will be less bad than in the past two years and thus a relatively smaller drag to growth," Ma and Feng said. "A stabilization of housing and healing of the Covid scars should further lift household consumption in 2024. The expansionary fiscal and monetary stance will help investments."

The IIF maintains an optimistic growth forecast for China in the year ahead, but the team acknowledged plenty of risks remain, especially given Beijing's recent history of policy errors.

"The deep housing crisis may take longer than expected to recover," Ma and Feng said, adding that the housing and stock market downturns could hit household wealth and consumption potentially worse than feared in the coming months. 

Should policymakers fail to act, the researchers cautioned that deflation expectations could become entrenched, further weighing on domestic demand and foreign investment.

"Faced with perils, such as policy errors, deflation expectations, and trade tensions," the researchers said. "The economy could fall into a debt-deflation spiral without adequate policy support."