China’s economic slowdown exposes the limits of the AI success story

Is all okay in the Middle Kingdom? Judging by the imagery China now exports – futuristic cities, dancing robots, world-beating open-source AI models, highways of near-silent electric vehicles – the answer would appear to be an emphatic “yes”.

Looking at numbers due out of Beijing this week, however, the answer seems rather more complicated. The gap between the two – the official narrative and economic reality – is fast becoming the defining economic question of the decade. Which one should we believe?

When the Chinese National Bureau of Statistics reports second quarter GDP this week, economists expect year-on-year growth of 4.5%, down from 5% in the first quarter and scraping the bottom of Beijing’s 2026 target range. While this may sound impressive, the critical element is how this all fits against expectations and context. Quarter on quarter, growth is forecast to slow to 0.9%, the weakest reading since 2023. The immediate question is whether these figures alarm Xi Jinping’s team enough to accelerate government spending, perhaps by bringing forward stimulus measures pencilled in for later this year. The deeper question is whether this would make any real difference.

The composition of the slowdown matters more than the headline number. Investment has always been the core driver of the post-Deng Xiaoping China economic growth machine, and it is seizing up. Fixed asset investment is expected to have fallen 5% in the first half from a year earlier; this is worse than the 4.1% decline recorded through May, and a new low since the pandemic year of 2020.

The drop in property investment is forecast to accelerate to a terrifying 16.8%. Outside of the favoured high tech manufacturing sectors, capital is simply not being deployed.

Even bleaker

Investment though is nothing without consumption, and here the news is even bleaker. Efforts to coax China’s perennially wary consumers into spending are coming to naught. Retail sales probably edged down 0.1% in June from a year earlier, after a 0.6% fall in May – the first decline since 2022.

Passenger vehicle sales tumbled 23% year-on-year last month, a seventh consecutive month of double-digit declines. Consumer confidence in May was at its second lowest reading of the year to date. Weak sentiment means manufacturers will struggle to pass on rising costs for oil, chips and metals, squeezing corporate profitability and threatening the economy’s fragile rebound from deflation.

There are some bright spots. Exports have proven resilient to both trade protectionism and the war in the Middle East, and AI is seen as the panacea. But this is dangerous. For all the anxiety around the US economy becoming one big bet on AI, a similar and arguably more alarming wager is unfolding quietly in its rival superpower. China’s vaunted AI prowess is concealing a deeper rot elsewhere in its economy.

Ruchir Sharma of Rockefeller International has argued that 2021 was peak China. Growth crested that year, and since then China’s share of global GDP has fallen in nominal terms from 18 to 16.5%, while the American share has risen to 26%. China’s real growth rate has dropped below that of the rest of the world, including the US. Independent estimates now put real growth closer to zero than to the official 4.5 to 5% target. The forecasters who once treated China’s overtaking of the US as a matter of fact have been conspicuous in their absence of late.

The forces behind this are structural, not cyclical. Demography is the most unforgiving of its headwinds. China’s population peaked in 2021, last year births hit a record low and deaths a record high. The working age population is on pace to shrink by 75 million every decade this century.

The arithmetic is brutal

Countries with declining populations rarely sustain growth above 2%, and given the sheer scale of China’s demographic bust, AI-powered humanoid robots are unlikely to replace human workers fast enough to cushion the blow, as much as Communist Party apparatchiks might be praying for them to. As impressive as the technology is, the arithmetic is brutal.

Debt is the second millstone. Over the past five years China’s augmented deficit – which includes off-budget local government borrowing – has run at nearly 15% of GDP, higher than in any other major country, pushing augmented government debt to 135% of GDP. This is a breakneck pace. And unlike the US, China also carries rapidly mounting private sector debt. Total debt to GDP now approaches 350%, which already exceeds the US.

Much of this is the hangover from the great property bubble, inflated after 2008 when Beijing responded to the global financial crisis by simply flooding the real estate sector with credit. That bubble burst in 2021. In inflation adjusted terms, property prices are at 20-year lows. As property wealth dwindles, so does consumer confidence and propensity to spend; hence those lousy consumption numbers and falling retail sales.

Markets have delivered their verdict. The Chinese stock market has gone sideways for years, with earnings strong for anyone supplying the AI sugar-rush but weak for anything consumer related. The government, having moved on from propping up the property bubble, is now pumping credit into manufacturing – in effect replacing one debt bubble with another. Multinationals have caught on; once seeing China as a massive prospect they are scaling back. Net foreign direct investment is negative.

Last year a record $425-billion of capital flowed out of Chinese markets. Investors have concluded that not only are they not welcome, but the opportunity is also simply not that compelling.

Looming demographic shipwreck

People are also taking the hint. The number of Western expatriates living in China has fallen markedly, and immigrants make up just 0.1% of the population – clearly immigration will not be how they avoid the looming demographic shipwreck. This is historically unusual; rising hegemons have tended to attract talent and capital, one only has to look at the US during the 19th century. China is repelling both.

None of this points to an imminent crisis. Yet, it heralds something that Beijing might find more difficult to negotiate; a slow, structural decline. Unable to prop up domestic consumption against worsening demographics and spiralling debt, central planners have reverted to their default setting; dumping cheap manufactured widgets on the rest of us.

The protectionist backlash is only beginning. Artificial intelligence, while ostensibly an attractive panacea, is completely unproven in solving any of these issues. It cannot conjure up workers, pay back debts, or reinflate a bubble that has long since burst.

Perhaps all AI is good for is as a distraction, a conjuring trick. Unfortunately for the planners, there is no easy fix. As the situation deteriorates, we must hope they do not turn to ever more desperate ways to deflect attention from the realities. DM