When the U.S. enters a recession, typically every few years, the public seldom questions whether the economy has peaked. Yet China’s recent sluggish growth has sparked widespread speculation about a potential long-term decline. Critics cite centralized power, a prioritization of national security over economic growth, and a retreat from market-oriented policies. But before declaring the Chinese economy is in permanent decline, we must examine the situation with nuance, precision and foresight — especially as we look toward what might unfold in 2025.

Just a few years ago, the Chinese economy was a roaring engine described as “easy to heat up, difficult to cool down.” Today, the dynamic has flipped to “too easily cooled, very difficult to heat up.” Years of monetary tightening since 2015, aimed at reining in the shadow banking system, have shifted sentiment from irrational exuberance to excessive pessimism. This doesn’t indicate that China has peaked, but that it needs a paradigm shift. The current model, brilliant at scaling up supply, falters in promoting demand.

China’s immediate economic woes stem largely from its real estate sector. Accounting for 20% of gross domestic product, 40% of fiscal revenue and 60% of household assets, property has long been more than just bricks and mortar. It’s been the lifeblood of the shadow finance and fiscal systems. As the sector slumps, two key drivers of the economy have been paralyzed.

Companies like Evergrande weren’t just developers: They functioned as shadow banks, providing off-the-books credit to businesses, local governments and investors. At their peak, real estate-linked shadow banking products accounted for nearly 50% of the shadow banking sector. As the property market crashed, liquidity dried up, choking off credit flows.

Local governments, heavily reliant on real estate, have been hit hard. Real estate made up over 50% of their revenue in many regions. With land sales plummeting, local government income has collapsed — from 8 trillion yuan (about $1 trillion) in 2020 to under 5 trillion yuan today. At the same time, real estate has been the backbone of government debt financing. Remarkably, 73% of broad government financing at the national level is tied to real estate, with an even more staggering 91% at the local level.

This has left local governments cash-strapped and unable to implement countercyclical policies during economic downturns. Instead, many localities have tightened their belts, freezing wages, reducing public spending, or increasing fees and taxes, thereby exacerbating the economic slowdown.

For decades, China’s rapid development hinged on what’s known as the “mayor economy.” Local officials competed fiercely to achieve GDP targets, driving infrastructure projects, building mini silicon valleys and nurturing private-sector champions. This focus yielded incredible results: massive industrial growth, dominance in emerging sectors like electric vehicles (EVs) and solar panels, and global manufacturing prowess.

But this supply-side success has come at a cost, leaving the mayor economy trapped in a Catch-22. Local governments are incentivized to prioritize GDP growth over social welfare spending, resulting in underdeveloped social protection systems and a glaring gap in China’s consumption potential. The rural population, including 300 million migrant workers, faces limited access to affordable housing, health care, and education. Rural pensions average a mere 188 yuan per month, just 5.26% of what urban residents receive. These underserved groups, with the highest propensity to consume, remain neglected, perpetuating China’s demand problem. As a result, consumption accounts for just 37% of GDP in China, compared with 68% in the U.S. and similar levels in Japan and South Korea.

This leads to the question of why the Chinese government has refrained from unleashing a massive stimulus package. The hesitation lies in a central dilemma: how to stimulate growth without triggering another debt explosion. Large-scale, supply-focused stimulus risk exacerbating overcapacity, driving prices further downward and failing to resolve the core issue of weak demand and low confidence.

Policymaking in China is thus a delicate interplay between choice and constraint. Writing off local government debt to increase local fiscal capacity is believed to create moral hazard, incentivizing reckless borrowing and fiscal mismanagement in the future. This balancing act highlights the complexity of China’s policy challenges and the careful navigation required to tackle a persistent imbalance: local governments currently bear 86% of expenditure responsibilities but control only about 54% of tax revenues. This misalignment has left local authorities deeply dependent on land sales and off-budget financing.

Recognizing this, policymakers are shifting their focus. The Central Economic Work Conference has recently placed a strong emphasis on boosting consumption, particularly targeting low- and middle- income groups, as well as families with children. But to break to low-confidence trap, China may need its own version of “whatever it takes,” signaling an unambiguous commitment to restoring growth and fostering long-term optimism. Deng Xiaoping reinvigorated market confidence with his landmark Southern Tour in 1992, and set the tone for the subsequent decades.

As we look ahead, the era of China’s reliance on real estate as a shortcut to GDP growth is drawing to a close. In its place, the emerging technology and green energy sectors are stepping into the spotlight. Although high-tech industries accounted for a more modest 14.3% of GDP in 2023, they are on track to rival the contribution of real estate by 2026.

As the property sector wanes, some advocate for a “one-sixth rule”: housing costs should equate to one-sixth of income, one-sixth of lifetime income to purchase a home, and one-sixth of local government GDP for property investment. But usually, such a transition is a decade-long affair. China’s attempt to achieve this in less than half the time is both ambitious and disruptive.

Setting aside cyclical challenges, some of China’s long-term structural issues may be less alarming than they are often portrayed. For instance, while many argue that China’s aging population heralds economic decline, this perspective oversimplifies the issue. The productivity of the workforce is ultimately more critical than its size, and advancements in technologies such as automation and AI have the potential to mitigate demographic pressures. Despite China’s vast workforce, tertiary education attainment is only 60% of U.S. levels, and total factor productivity (TFP) lags, at just 40%.

History has witnessed numerous cycles of population growth and decline. When birth rates fall, investments in each child’s education and development tend to rise, enhancing human capital over time. While China’s one-child policy has undoubtedly accelerated aging, it has also driven an unprecedented surge in educational attainment and helped close the gender gap. The challenge of low birth rates may not be China’s most pressing issue, particularly given the untapped potential of hundreds of millions of under-educated and under-employed rural workers who could strengthen the labor force and keep rising wages in check.

Unlocking this potential, however, requires significant reforms, which are the ultimate solution to stagnant growth. Much remains to be done: the restrictive hukou (residence registration) system can be eased to facilitate greater labor mobility. Granting rural workers more secure land-use rights is critical for generating rural wealth. Establishing a transparent rural land market to attract investment will foster widespread participation and integration, thereby closing the huge geographic income gap.

China’s economic challenges are real, but they are not insurmountable. To join the ranks of the world’s wealthiest nations, China must evolve from a manufacturing giant into a consumption- driven powerhouse, a transformation that countries like Japan have successfully navigated. This pivot toward demand-led growth, underpinned by comprehensive fiscal reforms and robust social welfare investments, is crucial. It will take time, which is why only a modest recovery is anticipated for 2025.

But China’s economic woes are less a sign of stagnation and more akin to growing pains — inevitable hurdles on the path of transformation.

Editor: huyueyue