China's Involution: How Deteriorated Labor Market Hollows Out Domestic Demand

China's deflationary process has received growing attention. The best-known consequence is the squeeze in corporate profits but there is a second one that might end up being as important, if not more. Chinese firms are also slashing labor costs in a desperate battle for market survival. The country's "flexible" labor market basically makes it possible for corporates to reduce labor costs as needed, which is behind the dramatic deceleration in wage growth.This trend is very clear in the data. Average wage growth for urban private-sector workers has collapsed from a healthy 8% before the pandemic to less than 1% projected for the end of 2025. This alarming trend is further underlined by the youth unemployment rate soaring to 16.7%, painting a bleak picture of China’s labor market. The subdued wage growth is probably behind the stagnant household spending. The data does show a very high correlation between wage growth and that of retail sales, the best proxy of consumption in Chinese statistics. The situation is further exacerbated by a powerful negative wealth effect, from still plummeting real estate prices.This downward spiral: weak consumer demand forces firms to cut prices, which leads to fewer profits, forcing companies to cut wages, which further diminishes demand. This vicious cycle cements a pessimistic business outlook for the Chinese economy, stifling new hiring and investment and trapping the economy in an increasingly weaker economic momentum.Reversing this trend requires more decisive policy action, including monetary easing, large-scale fiscal stimulus, and debt restructuring so that loss-making companies do not get resources from more productive companies. But all these measures are currently hampered by competing government objectives, such as maintaining exchange rate stability and favoring strategic industries, together with a major innovation push. Still, the latest Two Sessions continued with a cautious tone from the Chinese government. The outbreak of the Iran war adds another layer of uncertainty to an already fragile economic equilibrium. Rising geopolitical tensions are pushing up global energy prices and increasing volatility in external demand, both likely to further weigh on China’s labor market momentum. The PBoC will face a more challenging policy trade-off, as higher cost pressures and weakened household purchasing power coincide with a potentially widening yield differential that could exert additional pressure on the exchange rate. Taken together, these factors further justify a lower GDP growth target for China in 2026.