China’s economy registered a respectable GDP growth rate of 5.3% in the first half of 2025.

Despite US President Donald Trump’s tariff war, China’s exports grew by 7.3% and contributed more than one-third of the first half of the year’s growth. But domestic demand remains weak and prices are still falling.

The conventional wisdom identifies weak consumption as the culprit. The Chinese authorities have prioritised boosting household consumption. A 200 billion RMB (US$28 billion) program was introduced to subsidise designated consumer purchases in 2024 and expanded by 300 billion RMB (US$42 billion) in 2025.

Consumption is a slow variable to move that is endogenous to the economy. Income and expectations are its two most important determinants. Low expectations are especially important. The Chinese economy still faces numerous downside risks that prompt many people rationally to choose to save more. Household deposits increased by 15 and 18 trillion RMB (US$2 and $2.5 trillion), equivalent to 11.6% and 13.3% of GDP, in 2023 and 2024, respectively. In the first half of 2025, another 10 trillion RMB (US$1.4 trillion) was added.

Many people believe that Chinese people save because China’s social security system is insufficient for its residents to insure against future risks. Yet the country’s urban social security system is, in fact, strong. The average pension replacement rate — the size of aggregate retirement earnings relative to pre-retirement earnings — is 60%. Before 2015, pensions were increasing by 7% to 10% every year. While growth has slowed, it is still about 70% of nominal GDP growth rates, as in the past. The system generally provides reasonable healthcare for urban residents.

The problem is in rural areas where 40% of the population lives. The healthcare system was rebuilt at the turn of the century and now provides reasonable services to rural residents. More problematic is the nascent pension system. Retirees in many places receive just 200 RMB (US$28) per month. But the rural pension system is fully funded by local governments. Increasing payments would require some kind of contribution system to be introduced.

But the inadequacy of the rural pension system does not explain high national savings rates because most savings are accumulated by urban residents. One must look beyond social security to find out why consumption and domestic demand are sluggish in China.

There are two elephants in the room that the Chinese authorities consciously avoid linking to weak domestic demand – the decline in the real estate sector and local governments’ fiscal deficits.

The real estate sector has been declining since 2021. Its sales and investment have been cut by half since their peaks that year. Real estate still accounts for more than 15 per cent of the Chinese economy and has extensive backward and forward linkages.

Buying a home entails large spending on consumer goods such as furniture and home appliances. Spending in the most economically developed cities can easily exceed 300,000 RMB (US$42,000) per apartment. Government subsidies don’t lift this kind of spending. As the old Chinese saying goes, the government is trying to pick up sesame seeds, but losing sight of the watermelon lying nearby.

The decline of the real estate sector has more negative effects on consumption, including via the wealth effect. Homeowners who are losing value in their homes choose to consume less if they pay mortgages. Another negative effect comes through the channel of falling confidence. For ordinary people, declining real estate prices and the stockpile of homes are clear signs of an economy headed downward. It is rational for them to save more.

Compared with the real estate sector, local governments’ fiscal deficits are a hidden problem that has not caught the attention of ordinary people. But it is more serious. There is no credible source of statistics on the size of the deficits, but most estimates put it around 10 trillion RMB (US$1.4 trillion, about 7.5% of 2024 GDP).

One cause of this daunting number is tax cuts that have been made over the past 10 years. The rate of the largest tax — on value added — was lowered from 17% to 13%. There have also been several rounds of temporary tax cuts in addition to the regular tax exemptions for qualified companies – mostly in high-tech industries.

A second cause is significant pandemic-induced government spending. While spending from 2020–23 was mainly the mandate of the central government in most other countries, local governments in China footed most of the bills.

Another cause is the decline of land sales revenue. In the peak year of 2021, local governments collected 8.9 trillion RMB (US$1.2 trillion) by selling land. In 2024, this figure declined to less than 3 trillion RMB (US$416 million). The final cause is the slow growth of the tax base due to a sluggish economy.

The central government has asked local governments to deliver on their guarantees to pay off-budget debts, which are often borrowed by state-owned entities. Local government spending has, in consequence, been constrained. This has inevitably put downward pressure on aggregate demand as local governments are big players in the economy.

Kickstarting China’s domestic demand requires the authorities to give much more attention to reversing the negative trends in the real estate and the local government sectors. The central government realises the problem. Income raised from special government bonds — initially designated for financing local projects — can be used to reduce local governments’ fiscal deficits and buy idle stock of apartments, but more funds have to be raised. Further, local governments do not have any incentive to purchase idle property. The central government will have to take the reins in rehabilitating both sectors.

Republished from East Asia Forum, 10 August, 2025

The views expressed in this article may or may not reflect those of Pearls and Irritations.