China’s economy is floundering, but supreme leader Xi Jinping has given no significant new instructions on how to deal with it. His preoccupation with security and geopolitical goals has overshadowed his willingness to show personal leadership on the complicated issue of how to tackle a slowdown.

Indeed he is on his way to South Africa to attend the BRICS summit in person and bolster Beijing’s influence among developing and emerging nations. His last public appearance was a military ceremony on July 31. 

Xi's priority continues to be to double down on national security, at the expense of growth if necessary, in order to fend off the threat posed to the PRC by the US. 

His rigid adherence to his geopolitical and ideological aims, combined with filling his third-term administration with apparatchiks rather than technocrats, is yet another factor that bodes ill for China's ability to manage its slow-motion real economy crisis. 

Some fear this is Beijing's debt-driven Minsky moment; others muse that China is on the cusp of a "balance sheet recession" or "Japanification." At the risk of sounding pedantic , we prefer to call China's predicament a "slow-motion real economy crisis."

Over the past two years we have been warning that China's economy is facing its sternest test since it started its opening and reform more than 40 years ago. This is predicated on the fundamental change towards statist policies and the reinstatement of Marxism-Leninism under Xi. This alters the incentives of private entrepreneurs, consumers, local government officials and China's youth and undermines the key drivers behind its past success. 

Back in 2015-16 we were worried by the pace of increase in the ratio of China's non-financial non-government debt to GDP, but saw ample fiscal scope for Beijing to absorb the credit losses. This is no longer the case. 

Our assessment is that China's continuous build-up of debt, exacerbated by the Covid disaster, has now reached crisis proportions amid an extremely challenging external environment. 

In September 2022 we wrote "Alarming Level of Credit Losses Bodes Ill for Chinese Economy – Enodo Exclusive", arguing that "our estimate of credit losses for 2021 should be ringing alarm bells now." We will shortly have all the data to calculate the 2022 figure. That is, of course, if some of the numbers do not suddenly become unavailable -- as has happened many times before, most recently with youth unemployment numbers. 

We expect that credit losses, which we estimate at between 26% and 31% of GDP in 2021, rose further last year. 

Meanwhile, government debt rose to 78% in Q4 2022, up from 71% in Q3 2022 and just 42% at the end of 2015. 

The nature of China's debt workout

Understanding how China's bad debt mess will evolve and the nature of the workout is critical in figuring out the impact on the world economy and global markets. 

The first key point to make, is that the adjustment will show up as economic stagnation rather than as a financial sector meltdown. This is why we do not like to describe this as China's Minsky moment.

China did indeed take on excessive credit risk in the wake of the Global Financial Crisis, pumping money into its economy. It repeated that trick as the coronavirus pandemic hit. A Minsky moment defines the tipping point when speculative activity reaches an unsustainable extreme, leading to rapid price deflation and unpreventable market collapse. 

But it was Beijing itself that pulled the rug from underneath its real estate market, and there has been no corresponding runaway equity bull market since 2015. While it is unlikely that the Party will abandon its mantra of "houses are for living in, not for speculation" (despite dropping the phrase out of official communication recently), it is determined to smooth out the adjustment it has started. 

Banking crises are typically liquidity crises, with or without an underlying solvency problem. In China because the bulk of debt is domestic, the banking system is state-owned and capital flows are controlled, interbank liquidity crunches or traditional bank runs do not take hold. 

But China clearly has a solvency problem and can no longer rely on a strong economic expansion to help it outgrow its bad debt problem. Years of wasteful investment have come to haunt it, resulting in serious demand deflation. 

Xi Jinping's new economic team is at a loss for how to revive the sputtering economy and prevent China from plunging into Japan-style deflation. China is indeed on the route of becoming the next Japan when it comes to going through a protracted period of stagnation, but it's still too early to forecast peak China and the subsequent decades of deflation. 

The second key point to stress about the adjustment we should expect is that while economically there are similarities, between China now and Japan then, technologically and geostrategically China is far from 1990s Japan -- a US ally before the technology revolution opened up new avenues for success. 

True, China's demographics are dire.  Years of over-investment mean its potential growth rate will also be dragged down by the necessary decline in accumulated capital. But its long-term growth potential hinges on productivity growth and China has engaged in a comprehensive supply-side transformation since 2015, which -- if successful -- will boost efficiency and productivity. 

Beijing also sees data as a new factor of production, allowing it to supercharge China’s economic development without relinquishing the control the Communist Party craves. The party’s hope to deliver “the rejuvenation of the Chinese people” lies in harnessing the flow of its vast pool of data and fulfilling the promised efficiency and technological progress offered by the internet of things and the digitalisation of everyday life.  

If China is successful -- and the jury is out on a 5-to-10-year horizon -- it will present a formidable challenge for the US. But more worryingly, instead of its global significance fading away as Japan's did, an unsuccessful China is likely to become a hugely destabilising geopolitical force over the next few years.  

Which takes us back to the upcoming BRICS visit. For Xi Jinping, it is another chance to put forward his vision of the future. The bloc’s members – Brazil, Russia, India, China and South Africa – account for more than 40% of the global population. They also share the desire for a more multipolar world and the demand for a greater say in global affairs. But they don't all necessarily share in Xi's vision of creating a Sino-centric sphere of influence to counter America's. The key participant to watch will be India. 

Conclusion

Xi’s inaction on the economic front has led to subtle critiques of the paramount leader’s ability to lead and to come up with new ideas. Last week, the People’s Daily  reminded its readers that “if officials fail to lead, others will not follow [top-level edicts] and if leaders do not set examples, they can’t win the trust [of the people.]” 

While Xi’s status as “leader for life” remains unchallenged, his failure to offer solutions to the country’s pressing economic problems could dent his jealously guarded image and authority. Certainly, his Marxist-Leninist ideology and overarching emphasis on national security have assigned China to a "slow-motion real economy crisis".

Xi has repeatedly rallied China's people to prepare for as-yet-to-be-defined painful struggle. It remains to be seen how willing the population will be to endure it, and whether economic hardship and diminished individual prospects for development will spark popular discontent -- or whether that discontent will be enough to derail his policy platform.