China Should Embrace Yellen with Open Arms

China Should Embrace Yellen with Open Arms

When Yellen arrives in China, President Xi Jinping will find himself holding a weaker economic hand than before. Instead of experiencing a robust recovery following the end of the "Covid Zero" policy in December, the Chinese economy seems to be stuck in neutral. Growth in the second quarter is expected to fall significantly below expectations, with manufacturing activities declining in April and May, and exports, which sustained the economy during the pandemic, also dropping in May.

Moreover, urban youth unemployment has reached an alarming rate of almost 21%, a historic high. If current trends persist, China may struggle to meet its modest growth target of 5% for the year.

The underlying causes of China's economic stagnation are well-known. The real estate sector, a key driver of the economy, is undergoing a slow implosion. In June, sales of new homes by the 100 largest real estate companies dropped by 28% compared to the previous year. Furthermore, Beijing's options to respond are limited. With total debt to the non-financial sector reaching nearly $50 trillion as of September last year (equivalent to 280% of GDP), loosening monetary policy dramatically would only increase leverage and add to the risk of a financial crisis.

However, China's economic downturn is not solely attributable to poor fundamentals. Many recent government policies have needlessly exacerbated the situation.

Immediately after lifting Covid restrictions, China signaled its intent to prioritize economic revival. Top officials engaged in a charm offensive to attract foreign and domestic investors. Unfortunately, China's government failed to follow up its business-friendly rhetoric with action and instead intensified its preoccupation with security. In late March, Chinese police raided the offices of the Mintz Group, a US due diligence firm, and detained five employees. A month later, Chinese police questioned staff at the Shanghai office of Bain, another US consultancy. These investigations were part of a campaign targeting US companies suspected of engaging in espionage under the guise of normal commercial activities.

China's revised anti-espionage law, effective since July 1, is particularly concerning. Its vague and broad definition of espionage raises the possibility of innocent foreign businesspeople being ensnared by the law. In late May, Chinese regulators imposed restrictions on the use of products from Micron Technology Inc., a US semiconductor maker, citing security concerns.

The Micron ban, widely seen as retaliatory for US export controls on advanced semiconductors, highlights the persisting tensions that cloud the Sino-US economic relationship. While Blinken's visit slightly improved the atmosphere, it did not lead to any substantial thaw in relations. Chinese foreign policy rhetoric remains strident, scaring away investors and prompting manufacturers, including Chinese companies, to relocate their facilities to other locations.

Most disappointingly, China's government has failed to convince domestic entrepreneurs that it will cease favoring state-owned enterprises over the private sector. At the beginning of the year, local officials made grand pledges to support private businesses, but their promises have largely gone unfulfilled.

The silver lining for China is that the damage caused by these policies is largely self-inflicted. Chinese leaders have the opportunity to change investors' pessimistic outlook through policy corrections, which would incur no financial cost compared to addressing the real estate crisis and high levels of debt. To begin, China should suspend its campaign targeting US companies and postpone the implementation of the anti-espionage law. It should also capitalize on the temporary lull in Sino-US tensions to further improve the bilateral relationship. Chinese leaders should consider expanding people-to-people exchanges, increasing flights between the two countries, and cooperating on combating narcotics, as discussed during Blinken's visit. Adopting a less confrontational stance on Taiwan would also help alleviate investor concerns.

The struggling Chinese economy grants the US some leverage. When Yellen arrives in Beijing, she should seize this opportunity to encourage China to adopt a more moderate approach. Above all, she should advocate for stronger protection of US businesses operating in China. China might seek concessions, such as relief on technology sanctions, but it would be unwise to grant such requests. Chinese leaders must understand that an easing of tensions would likely benefit them even more than the US. They should demonstrate pragmatism and willingness to negotiate at this juncture.