China

The collapse of land-sale revenue and the LGFV debt trap

The real-estate downturn and local government debt form a tightly coupled constraint on China's fiscal space and growth trajectory. The property sector correction, which began in 2021, has directly reduced land sale revenues that local governments rely on to service debts accumulated through local government financing vehicles (LGFVs). Land sales typically accounted for 30 to 40 per cent of local government fiscal income before the downturn.

As property developers defaulted and new construction slowed, land auction revenues fell sharply, with national land sales revenue dropping by roughly 20 per cent in 2022 and a further 10 per cent in 2023. The interaction between property market weakness and LGFV debt is structural. LGFVs, which are off-budget entities used by local governments to fund infrastructure and urbanisation, issued bonds and borrowed from banks against future land sale proceeds.

By 2023, total LGFV debt was estimated at over 50 trillion yuan, roughly 40 per cent of China's GDP. With land sales declining, local governments face a funding gap that forces them to cut spending or seek central government transfers. GDP growth in the 2020s has averaged 4.88 per cent across the first five years of the decade, down from a mean of 7.66 per cent in the 2010s, indicating that the drag from the property sector and local debt is a significant factor in the deceleration.

Deflation, fiscal squeeze, and the drag on growth

The fiscal space available to local governments has narrowed. In 2024, China's GDP stood at 18.7 trillion US dollars, but the GDP deflator turned negative at -0.71 per cent, the first sustained deflation since the late 1990s. This deflationary environment exacerbates the real burden of local government debt, as nominal revenues grow more slowly than the stock of liabilities.

The GDP deflator averaged 3.13 per cent in the 2010s, but has fallen into negative territory in the 2020s, compressing the capacity to inflate away debt. Local governments have responded by delaying payments to contractors and suppliers, which in turn depresses private sector investment and consumption. The property sector itself has not stabilised. Real estate investment fell by approximately 10 per cent in 2023 and continued to decline in 2024.

Housing starts, a leading indicator, have dropped by more than 40 per cent from their 2020 peak, and total LGFV debt reached over 50 trillion yuan.

Housing starts, a leading indicator, have dropped by more than 40 per cent from their 2020 peak. This correction has reduced the value of collateral held by banks and LGFVs, increasing credit risk. The number of unsold homes in smaller cities has risen, while in tier-one cities prices have only partially adjusted. The overall effect is a drag on GDP growth, which decelerated from 8.6 per cent in 2020 to 4.99 per cent in 2024, a level still above the 2.34 per cent trough of 2020 but well below the 10.6 per cent average growth rate of 2010.

Debt restructuring limits and the feedback loop

Local government debt restructuring has been attempted through bond swaps and central government guarantees, but the scale of LGFV liabilities remains large. In 2024, local government special bonds, used partly to refinance existing debt, reached a quota of 3.9 trillion yuan, but this only covers a fraction of the maturing obligations. The central government has signalled a shift towards fiscal consolidation, yet the need to support growth limits the pace of deleveraging.

GDP per capita in 2024 stood at 13,309 US dollars, up from 10,661 dollars in 2020, a 24.8 per cent increase that masks the uneven distribution of income and the strain on local public services. The interaction between the property downturn and LGFV debt creates a feedback loop: lower land sales reduce local revenue, which forces spending cuts that weaken demand, which in turn depresses property prices further.

This loop constrains the effectiveness of monetary and fiscal stimulus. The People's Bank of China cut interest rates in 2023 and 2024, but credit transmission is impaired by the high level of existing debt and the reluctance of banks to lend to stressed local governments. The result is a growth environment that is structurally slower than in previous decades, with the 2020s GDP growth rate averaging 4.88 per cent compared to 9.75 per cent in the 1980s and 10.37 per cent in the 2000s.

The end of the labour-force bonus and decelerating growth

China’s demographic transition has entered a phase that fundamentally alters its economic trajectory. The working-age population peaked around 2015, and the total population began to decline in 2022. This structural shift directly reduces the labour-force bonus that powered growth for decades.

Between 1980 and 2019, China’s real GDP grew at an average of 9.7% per year in the 1980s and 10.1% in the 1990s, but the growth rate has since decelerated sharply. In the 2020s, the mean annual growth rate has fallen to 4.9%, with the 2024 figure at 4.99%. The end of demographic dividends means that each percentage point of growth now requires greater productivity gains from a smaller pool of workers.

Rising dependency ratios and fiscal strain

The dependency ratio is rising as the population ages. The share of people aged 65 and over increased from 7.0% in 2000 to over 14% by 2023, crossing the threshold that demographers classify as an aged society. This shift strains the pension and healthcare systems, which were designed when the workforce was expanding.

In 2019, GDP per capita reached $10,339, but by 2024 it had risen only to $13,309, reflecting both slower growth and the fact that a smaller share of the population is of working age. The old-age dependency ratio is projected to exceed 30% by 2035, meaning that for every three workers, there will be one retiree. This will require either higher payroll taxes, lower benefits, or a combination of both.

The shrinking workforce also reduces potential output growth. Between 2000 and 2009, the economy expanded at an average of 10.4% per year, but the labour force grew by only about 0.5% annually. In the 2010s, growth averaged 7.7%, while labour force growth turned negative after 2015. By 2024, the labour force had contracted by approximately 2% from its peak.

The old-age dependency ratio is projected to exceed 30% by 2035, meaning that for every three workers, there will be one retiree.

With fewer new entrants, the economy must rely more on capital deepening and total factor productivity to sustain growth. The GDP deflator turned negative in 2024 at -0.7%, indicating deflationary pressure that can be exacerbated by weak domestic demand from an older population that saves more and consumes less.

Social security finances are under increasing strain. The number of contributors to the basic pension system has grown more slowly than the number of beneficiaries. In 2020, the surplus in the national pension fund turned into a deficit for the first time when excluding central government transfers. The dependency ratio in the pension system itself rose from 3.0 contributors per retiree in 2010 to about 2.5 in 2023.

With the retirement age still set at 60 for men and 55 for women (50 for female blue-collar workers), the system faces a growing imbalance. The government has announced plans to gradually raise the retirement age, but implementation is slow and politically sensitive.

Structural headwinds for housing, productivity, and potential growth

The demographic cliff also affects housing demand and local government finances. The number of new households formed each year has declined as the population ages and the marriage rate falls. Housing starts peaked at over 1.6 billion square metres in 2013 and had fallen to below 1.0 billion by 2023. Local governments, which rely heavily on land sales to fund expenditures, face a structural revenue shortfall. This reinforces the need for fiscal consolidation at a time when social spending is rising.

Productivity growth has slowed as the labour-force bonus fades. In the 2000s, GDP per capita grew at an average of 302.5% over the decade, but in the 2010s the growth rate fell to 124.6%, and in the 2020s it has been 24.8% so far. Without the tailwind of a growing workforce, China must shift from an investment-led growth model to one driven by consumption and innovation. The transition is proving difficult, as evidenced by the 2024 GDP growth rate of 4.99%, which is below the official target of around 5%. The demographic headwind is now a permanent feature of the economic landscape, not a cyclical fluctuation.

The implications for potential growth are sobering. Estimates suggest that the potential growth rate has fallen from around 10% in the 2000s to below 5% in the 2020s. With the labour force projected to shrink by an average of 0.5% per year through 2035, even maintaining 4% growth would require annual productivity gains of 4.5% or more. This is a high bar, given that productivity growth itself has decelerated. The demographic cliff is not a future risk; it is already embedded in the data. The 2020s mean GDP growth of 4.9% is less than half the average of the 2000s, and the trend is likely to continue downward as the population ages further.

The deceleration of factor-driven growth

China's economic trajectory has entered a phase where the question of the middle-income trap is no longer theoretical. With GDP per capita rising from $878 in 1999 to $13,309 in 2024, the economy has moved decisively beyond low-income status. However, the growth engine that powered this ascent is losing momentum.

Average annual GDP growth fell from 10.4 per cent in the 2000s to 7.7 per cent in the 2010s and then to 4.9 per cent in the 2020s (based on the first five years of the decade). This deceleration reflects the exhaustion of factor-driven expansion, as the labour force shrinks and capital accumulation yields diminishing returns.

R&D intensity versus productivity outcomes

The transition to innovation-driven growth requires a sustained increase in total factor productivity (TFP). China's gross domestic expenditure on R&D has risen steadily, reaching 2.6 per cent of GDP in 2023, above the European Union average but below the United States (3.5 per cent). Yet the efficiency of this spending is debated.

Patent filings have surged, but the share of high-value patents, those granted in multiple jurisdictions, remains modest. A 2022 study by the OECD estimated that China's TFP growth averaged 1.2 per cent per year between 2010 and 2019, down from 3.5 per cent in the 2000s. This slowdown suggests that simply increasing R&D intensity does not guarantee productivity gains.

In 2023, China imported $349 billion worth of integrated circuits, more than its crude oil imports, highlighting continued dependence on foreign technology.

China's industrial policy has targeted strategic sectors such as semiconductors, artificial intelligence, and electric vehicles. The "Made in China 2025" initiative aimed to raise domestic content in core components to 70 per cent by 2025, a target that remains unmet for many advanced chips. In 2023, China imported $349 billion worth of integrated circuits, more than its crude oil imports, highlighting continued dependence on foreign technology.

The government's response has been to increase state-directed investment, with spending on semiconductor equipment alone rising to $30 billion in 2023. Yet the return on this capital is uncertain, as geopolitical restrictions limit access to advanced fabrication tools.

The demographic headwind complicates the innovation agenda. China's working-age population peaked in 2014 and has since declined by over 30 million. A shrinking labour force reduces the potential output growth rate, making productivity gains even more critical. The old-age dependency ratio rose from 12.6 per cent in 2010 to 21.1 per cent in 2023, straining public finances and reducing the share of investment available for R&D. Without a compensating rise in TFP, GDP growth could fall below 3 per cent by 2030, according to projections from the International Monetary Fund.

Pockets of leadership and institutional constraints

There are sectors where China has achieved genuine technological leadership. In electric vehicles, Chinese firms accounted for 60 per cent of global EV sales in 2023, and battery production capacity reached 1,200 gigawatt-hours, more than the rest of the world combined. In renewable energy, China installed 216 gigawatts of solar capacity in 2023, more than the entire European Union. These successes demonstrate that innovation policy can work when aligned with large domestic markets and scale economies. However, the spillover effects to the broader economy are limited if innovation remains concentrated in a few industries.

The middle-income trap is not inevitable. South Korea and Taiwan transitioned from factor-driven to innovation-driven growth in the 1990s and 2000s, achieving GDP per capita above $30,000. Their success required deep reforms in education, intellectual property protection, and competition policy. China's current R&D intensity of 2.6 per cent of GDP is comparable to South Korea's level in the early 2000s, but the institutional environment differs. State-owned enterprises still account for 30 per cent of industrial assets, and the financial system allocates capital based on policy priorities rather than market signals. A 2023 World Bank report noted that China's market entry barriers for private firms remain higher than in other upper-middle-income economies.

In summary, China's ability to escape the middle-income trap hinges on whether productivity growth can be revived. The data from the 2020s show that GDP growth averaged 4.9 per cent, down from 7.7 per cent in the 2010s, and the GDP deflator turned negative in 2024 at minus 0.7 per cent, indicating deflationary pressure. These numbers suggest that demand-side stimulus alone will not suffice. Without a structural shift toward innovation that improves TFP across the economy, the risk of stagnation remains material.

The Scale and Limits of State-Directed Growth

China's economic trajectory over the past four decades has been defined by a state-directed model that combines large-scale industrial policy with a dominant role for state-owned enterprises (SOEs). This approach has produced remarkable growth but also persistent distortions, most notably in the form of overcapacity. The scale of this transformation is evident in the GDP data: from 1980 to 2024, nominal GDP rose from $247.5 billion to $18.7 trillion, a compound expansion that relied heavily on state-led investment.

By the 2010s, the mean annual GDP growth rate had already decelerated to 7.7 per cent, down from 10.4 per cent in the 2000s, signalling the limits of a model that prioritises output volume over efficient resource allocation.

Overcapacity as a Structural Feature of Industrial Policy

Industrial policy has been a central tool, particularly in strategic sectors such as electric vehicles (EVs), solar panels, and steel. The government has used subsidies, preferential credit, and direct state ownership to rapidly scale production capacity. In the solar industry, China now manufactures over 80 per cent of the world's solar panels, a dominance achieved through aggressive capacity expansion. This has led to chronic overcapacity: global solar panel production capacity exceeded demand by roughly 100 per cent in 2023, with Chinese factories accounting for the vast majority of the surplus.

Global solar panel production capacity exceeded demand by roughly 100 per cent in 2023, with Chinese factories accounting for the vast majority of the surplus.

The result is downward pressure on prices, trade friction with the European Union and the United States, and thin margins for producers that rely on continued state support to remain solvent. The GDP deflator in 2024 stood at negative 0.7 per cent, reflecting the deflationary pressures that such overcapacity can generate across the broader economy.

State-owned enterprises remain a key transmission mechanism for industrial policy. SOEs account for an estimated 30 per cent of China's industrial output and control the commanding heights of the economy, including energy, telecommunications, and finance. Their access to cheap capital from state-owned banks allows them to invest in capacity without regard to market signals. In the steel sector, for example, China produced over 1.0 billion tonnes of crude steel in 2023, more than half of global output, despite domestic demand having peaked in 2020.

The result is a persistent surplus that depresses global steel prices and triggers anti-dumping measures from trading partners. The GDP-PPP data illustrate the scale of the resource misallocation: from 2000 to 2009, China's PPP-adjusted GDP grew by 200.5 per cent, but much of this investment was directed into state-favoured industries rather than areas of genuine comparative advantage.

The overcapacity problem is not limited to heavy industry. In the EV sector, the government's "New Energy Vehicle" industrial policy has spurred a proliferation of manufacturers. By 2024, China had over 100 EV brands, many operating well below capacity. Utilisation rates for EV factories have been estimated at around 50 per cent, far below the 80 per cent threshold typically considered efficient. This overinvestment has been financed by state-owned banks and local government investment vehicles, which have extended credit based on policy directives rather than project viability.

The GDP growth rate in 2024 was 5.0 per cent, a level that masks the inefficiencies embedded in the state-led investment model. During the 2010s, the average GDP growth rate fell from 10.4 per cent in the previous decade to 7.7 per cent, as diminishing returns to capital accumulation set in.

Distorted Resource Allocation and Declining Productivity

The distortion of resource allocation extends to labour and capital markets. SOEs and state-favoured industries absorb a disproportionate share of bank lending, crowding out private-sector firms that are often more productive. According to the World Bank, private firms in China generate roughly 60 per cent of GDP but receive less than 30 per cent of bank credit. This misallocation has contributed to a decline in total factor productivity growth, which averaged just 1.0 per cent per year in the 2010s, down from 3.5 per cent in the 2000s.

The GDP per capita data reflect the consequences: while per capita income rose from $251 in 1980 to $13,309 in 2024, the growth rate has slowed, with the 2020s showing a 24.8 per cent increase over five years compared to 124.6 per cent in the full decade of the 2010s.

In summary, China's state capitalism and industrial policy have delivered rapid expansion but at the cost of chronic overcapacity and distorted resource allocation. The model relies on continuous state intervention to sustain output, creating vulnerabilities in global markets and within the domestic economy. The deceleration in GDP growth from a mean of 10.4 per cent in the 2000s to 4.9 per cent in 2024, alongside deflationary pressures evident in the negative GDP deflator, suggests that the costs of this approach are becoming more pronounced.

The measurable drag of decoupling on growth and income

US-China trade tensions and technology restrictions have reshaped the pattern of Chinese economic engagement with the global economy, most notably since 2018. China's GDP in 2024 stood at $18.75 trillion, up from $14.57 trillion in 2019, reflecting a nominal growth of 28.7 per cent over five years, though the GDP deflator turned negative at -0.71 per cent in 2024.

This deflationary pressure contrasts with the 2010s, when the mean GDP deflator was 3.13 per cent, suggesting that trade frictions and domestic demand weakness have compressed pricing power. The decoupling narrative has accelerated under the Biden administration's CHIPS Act and export controls on advanced semiconductors.

China's GDP per capita rose from $10,339 in 2019 to $13,309 in 2024, a gain of 28.7 per cent, but this masks a slowdown in the rate of catch-up. The 2010s saw per capita GDP grow by 124.6 per cent from $4,604 to $10,339; the 2020s so far have delivered only 24.8 per cent growth, partly due to capital outflows and reduced technology transfer.

Foreign direct investment inflows into China fell to an estimated $33 billion in 2023, down from a peak of $344 billion in 2021.

Foreign direct investment inflows into China fell to an estimated $33 billion in 2023, down from a peak of $344 billion in 2021, as multinational firms diversified supply chains to Vietnam, India, and Mexico.

Technology restrictions and the reshaping of trade flows

Technology restrictions have targeted China's semiconductor and artificial intelligence sectors. In October 2022, the US Bureau of Industry and Security imposed new controls on exports of advanced computing chips and semiconductor manufacturing equipment to China, effectively barring sales of Nvidia's A100 and H100 chips. China's response included a $47.5 billion state semiconductor fund and export controls on gallium and germanium, critical inputs for chip production.

Despite these measures, China's GDP growth averaged 4.88 per cent from 2020 to 2024, compared with 7.66 per cent in the 2010s, indicating that the decoupling process has imposed a measurable drag on potential output. Trade patterns have shifted markedly. China's share of US imports fell from 21.6 per cent in 2017 to 13.9 per cent in 2023, while Vietnam's share rose from 2.1 per cent to 3.9 per cent over the same period.

The rerouting of supply chains is visible in intermediate goods trade: China's exports of machinery and electrical equipment to ASEAN countries grew by 18 per cent annually from 2019 to 2023, as firms relocated final assembly to avoid tariffs. Meanwhile, China's imports of integrated circuits from Taiwan and South Korea increased by 12 per cent per year, reflecting continued dependence on foreign chip technology for domestic production.

Domestic policy responses and the structural deceleration

The investment landscape has also changed. China's gross fixed capital formation as a share of GDP declined from 43.1 per cent in 2010 to an estimated 38.2 per cent in 2024, as private sector confidence waned amid regulatory crackdowns and geopolitical uncertainty. Outbound direct investment from China fell from a peak of $196 billion in 2016 to $98 billion in 2023, with a notable shift away from US and European targets toward Belt and Road Initiative partners in Asia and Africa.

The Chinese renminbi depreciated by roughly 12 per cent against the US dollar from 2021 to 2024, partly reflecting capital outflows and a widening current account surplus that reached $420 billion in 2023. Domestic policy has attempted to offset external pressures. The People's Bank of China cut the reserve requirement ratio by 50 basis points in September 2024, following a series of rate reductions that brought the one-year loan prime rate to 3.35 per cent.

Fiscal stimulus included 1 trillion yuan in special government bonds issued in 2023 for infrastructure and disaster relief. Yet the impact on growth has been limited: China's GDP growth rate in 2024 was 4.99 per cent, below the 5.5 per cent target set by the State Council. The mean growth rate for the 2020s so far is 4.88 per cent, compared with 9.75 per cent in the 1980s and 10.10 per cent in the 1990s, underscoring the structural deceleration.

The long-term implications for China's economic model are significant. The shift from export-led growth to domestic consumption and high-tech self-sufficiency requires sustained investment in R&D, which reached 2.6 per cent of GDP in 2023, up from 1.9 per cent in 2010. However, the US-China technology decoupling has raised the cost of innovation, as Chinese firms face restricted access to global patent pools and advanced software.

The GDP per capita gap with advanced economies remains wide: at $13,309 in 2024, China's income level is roughly one-quarter of the US figure, and the rate of convergence has slowed from the rapid gains of the 2000s, when per capita GDP grew by 302.5 per cent.

The Deflation–Debt Spiral and Local Government Strain

China's fiscal sustainability faces mounting pressure from the interaction of local government debt, corporate leverage, and deflation risks. The GDP deflator, a broad measure of price changes in the economy, turned negative in 2024 at -0.71%, marking the first year of outright deflation since 2009 when the deflator was -0.08%. This deflationary environment complicates debt servicing, as nominal GDP growth slows and real debt burdens increase.

Local government financing vehicles (LGFVs) and state-owned enterprises have accumulated liabilities that, while not fully captured in official statistics, are estimated to exceed 50% of GDP by some analysts, adding to the fiscal strain.

With the GDP deflator falling 0.71% in 2024, real interest rates are positive even as nominal rates decline, discouraging investment and consumption.

Decades of Rapid Expansion and the Corporate Leverage Hangover

The debt overhang is rooted in decades of rapid expansion. China's nominal GDP grew from $247.5 billion in 1980 to $18.7 trillion in 2024, a factor of 75.7, but the growth rate has decelerated sharply. Real GDP growth averaged 9.7% in the 1980s and 10.1% in the 1990s, but fell to a mean of 4.9% in the 2020s (2020-2024). Slower growth reduces tax revenues and increases the difficulty of rolling over debt, particularly for local governments that rely on land sales for income. Land sales revenues have declined by roughly one-third from their 2021 peak, squeezing subnational fiscal capacity.

Corporate leverage remains elevated. Non-financial corporate debt as a share of GDP has been around 160% in recent years, among the highest in the G20. This leverage was built during the credit-driven stimulus after the 2008 global financial crisis, when China's GDP grew from $6.2 trillion in 2010 to $14.6 trillion in 2019, a 136.2% increase. The rapid expansion was fuelled by bank lending, much of it directed to real estate and infrastructure. As property prices have fallen and defaults have risen, banks face rising non-performing loans. The People's Bank of China has cut policy rates, but the transmission to borrowing costs has been weak, partly because deflation raises real interest rates.

The Fiscal Trap and the Path to Resolution

Local government debt is the most immediate fiscal risk. Official data show that local government debt reached approximately 40 trillion yuan by 2023, but off-balance-sheet liabilities through LGFVs may double that figure. Debt servicing costs consume an increasing share of local budgets, reducing spending on public services. In 2023, interest payments on local government debt accounted for roughly 6% of total fiscal expenditure, up from 3% in 2019. The central government has attempted to restructure some liabilities, converting high-interest LGFV debt into lower-cost special bonds, but the scale of the problem is vast. Total social financing, a broad measure of credit, stood at around 300% of GDP in 2023, leaving little room for further leverage without triggering a crisis.

Deflation exacerbates the debt overhang by increasing the real value of debt. With nominal GDP growth slowing to an average of 4.9% in the 2020s, and the GDP deflator negative in 2024, real GDP growth of 5.0% in 2024 was achieved only through volume increases, not price gains. This contrasts with the 2000s, when the GDP deflator averaged 3.8% and nominal growth was consistently above 10%. The shift to deflation means that debt-to-GDP ratios are rising even as the economy expands in real terms. For example, if nominal GDP grows by 4% and debt grows by 6%, the debt ratio increases. This dynamic is particularly acute for local governments, whose revenues are tied to economic activity and property transactions, both of which have slowed.

Fiscal consolidation is constrained by the need to support growth. The central government has run budget deficits above 3% of GDP since 2020, and general government debt has risen to around 85% of GDP in 2024, up from 50% in 2015. While this is low by G20 standards, the hidden liabilities of local governments and state-owned enterprises push the total public sector debt burden much higher. The interaction of these factors creates a trap: austerity to reduce debt would slow growth further, while continued stimulus risks inflating the debt bubble. The resolution may require a combination of debt restructuring, higher inflation to erode real liabilities, and structural reforms to boost productivity. Without such measures, fiscal sustainability will remain under pressure, with deflation acting as a silent amplifier of debt distress.