Growth, debt sustainability, and zero-Covid: why China’s policy trilemma has global implications

Our Chief China Economist takes a closer look at how the country could navigate the pursuit of three important – but conflicting – policies and the implications for growth in China and beyond.

How can China possibly strike the right balance and achieve everything it wants to? In our view, it can’t. We believe the only course of action available is to let one policy goal go in order to achieve the other two.

Challenges to growth

To explain why we think this, let’s take a step back and examine the problems facing the Chinese economy. 

According to China’s Government Work Report, which sets out all of the economic developments in the country over the past year, there are three main factors threatening economic growth: contracting demand, supply shocks, and weakening growth expectations. In fact, these headwinds look likely to drag down Gross Domestic Product (GDP) growth below the government’s 5.5% target this year, our analysis suggests.

The zero-Covid strategy

In response to those threats to growth, China’s government wants to introduce policies that will help it achieve stable growth. But achieving that is a tall order against a backdrop of a ‘zero-Covid’ strategy (strict lockdowns to contain the virus’ spread), and even more lofty considering the government also hopes to keep a lid on quantitative easing to avoid excessive debt building up. 


There is a very real chance its zero-tolerance approach to Covid-19 could hold back the economy’s momentum. In the first quarter of the year, China’s real GDP growth slowed to 4.8% year-on-year, and this relatively low level didn’t even reflect the full impact of lockdowns in Shanghai and elsewhere in the country. The economic recovery from the pandemic has been driven by increased investment, while consumption and net exports have slowed. Exports have remained resilient enough to contribute to economic growth, but they are losing momentum due to lockdowns and related production slowdowns.


China’s push to prevent any new Covid cases has also put considerable pressure on the services sector. Strict regional lockdowns designed to end local outbreaks disrupt supply chains and dampen consumer sentiment. This policy may also delay the reopening of China’s borders, even as other countries reopen for business, further weighing on the sector. 


The zero-Covid policy looks unlikely to be relaxed in the near term, to the detriment of economic growth. The vaccination rate among the elderly remains relatively low, preventing policymakers from safety relaxing covid polices further. For these reasons, our outlook for consumption and a recovery in the services sector is muted for the coming months, although we think there will be a rebalancing over the longer term as consumption picks up and investment growth stabilises.

The move towards Common Prosperity

China’s policy trilemma has emerged against a backdrop of other pro-growth policies in the country. The Common Prosperity policy, for example, aims to bridge the gulf between China’s richest and poorest by redistributing wealth. We think this policy will be a game-changer as it refocuses the government’s priorities away from market expansion at breakneck speed towards a long-term goal of reducing inequality.

What does this mean for investors in China?

For starters, investors will need to be aware that politics will remain an important driver of the Chinese stock market. The government will prioritise its policy targets and regulation above the stability of the financial markets, as its recent crackdowns on sectors including education, technology and education have shown. 


Abrupt regulatory changes have certainly dampened investor appetite for the Chinese market since mid-2021 in the absence of clear guidance and communication from policymakers. But while we expect the regulatory environment to remain tough, 2022 should prove a more predictable year, with fewer surprise rule changes.


There is another macro risk on the horizon this year: a property market slowdown. So far, while defaults in the property sector have weighed on consumer sentiment, they have been carefully managed to prevent contagion. But a more broad-based slump in the sector could lead to disorderly asset sales, resulting in systemic financial market risks.

Impact on global economy depends on China’s approach

Impacts may vary and depend on China’s policy direction. With zero-Covid looking likely to stay, policymakers could face a trade-off between using aggressive stimulus to boost domestic demand and maintaining moderate easing – but risk missing this year’s growth target of 5.5%.


If the government re-ignites the stimulus on infrastructure and property sector like in 2008-09, we think this could lead to a surge in demand global commodities. If the government remains prudent in the medium-term and prevents excessive growth, it may lead to lower growth – but it could also have a disinflationary impact to global economy due to the subdued Chinese demand.

A mix of caution and optimism

We see more risks to growth in the short term as there is no sign of rolling out aggressive stimulus despite mounting headwinds from lockdowns. While our economic outlook for China comes with a healthy dose of caution, we can see brighter spots emerging. We expect China to post year-on-year real GDP growth of 4.7% in 2022, and 5.2% in 2023. We expect a strong rebound in retail sales next year, up 7.9% – almost double the rate we expect in 2022. But to preserve this relatively fragile recovery, the Chinese authorities will need to tread carefully, especially when it comes to managing Covid outbreaks.

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