China’s $18 trillion economy has indigestion—and the factory of the world could export its deflation and growth problems globally

China has been sending out inexpensive products to local stores for many years as its economy has gradually grown to become the leading global manufacturer. However, with the country currently facing both a decline in real estate and a crisis of joblessness among the Generation Z population, it is possible that China might start exporting a different kind of problem: economic hardship through a decrease in prices and slow-paced development.

Following years of stringent lockdown measures, China's economy is faltering and a multitude of long-standing issues are becoming prominent. The excessive development has placed the property market in turmoil, while local authorities are grappling with the challenge of managing their mounting debt obligations. Additionally, the officially recorded youth unemployment rate skyrocketed to an unprecedented 21.3% in July, with some independent assessments even suggesting a staggering 46% rate.

Additionally, increasing conflicts between China and Western nations run the risk of triggering an economic "separation." Both parties are striving to reduce their dependence on each other for trade and direct financial contributions. This could further impede China's export-oriented economy.

Concerned about the potential spread of China's economic disease, Brendan McKenna, a global economist at Wells Fargo, expresses worry. China's recent struggles with deflation, as consumer prices in the nation decreased by 0.3% in July compared to the previous year, raise concerns of a potential global impact. McKenna believes that if China experiences a significant crisis and begins exporting deflation, the United States could also face deflation, which would be more problematic than high inflation.

In what way will China cause deflation in other countries? Firstly, China's significant position as a major consumer of commodities allows its domestic economy to have a substantial impact on the worldwide prices of various goods, such as iron ore and steel. Additionally, as Chinese manufacturers experience a decline in domestic sales, they are expected to reduce prices, resulting in a greater quantity of inexpensive goods being exported to other countries.

McKenna is concerned that the internal problems in China indicate a fresh period for the country, wherein the gross domestic product (GDP) is likely to expand at a much slower pace. Moreover, considering that China presently contributes to approximately 35% of the global GDP growth, this could imply an entirely new era for the global economy as well.

According to McKenna, the world economy has been expanding at an average rate of about 3.5% per year from 1980 to the present day. However, he predicts that in the next five to ten years, we can expect a new normal with a lower growth rate of around 2.5%. He cautions that China's economic slowdown will have a significant and immediate impact.

As 2023 began, numerous economic experts were optimistic about the possibility of China's economy growing significantly this year. This optimism was driven by China's easing of rigorous COVID restrictions, which allowed consumers and businesses to resume their regular activities. However, the recovery has been far from impressive, causing concerns among some specialists who now fear that China might be entering a "lost decade" akin to Japan's experience in the 1990s.

The economy is experiencing a balance sheet recession due to factors such as an increasing elderly population, growing debts, and the ongoing property crisis. As a result, people and businesses are prioritizing saving money and reducing debts instead of spending or investing. Richard Koo, the chief economist at Nomura's Research Institute, highlighted this phenomenon earlier this year. To support this claim, China's GDP only grew by 0.8% in the second quarter compared to 2.2% in the first quarter, reflecting a decline in consumer demand.

Alfredo Montufar-Helu, the individual in charge of the China Center for Economics and Business at the Conference Board, an establishment that offers valuable information to multinational companies regarding economic, policy, and regulatory advancements in China, mentioned to Fortune that he has already observed a rise in discerning consumers and cost-conscious businesses in China. This phenomenon is commonly referred to as "consumption downgrading."

In addition to China's economic downturn and high rate of unemployment among young people, debts accumulated by local governments have reached a staggering $13 trillion by 2022. Furthermore, the housing market has been severely impacted as property prices experience a sharp decline due to excessive construction efforts over the years. The surplus of available housing has dramatically risen in recent times, with a startling 4 million unoccupied residential units throughout the country, leaving real estate developers in a precarious situation. One of China's notable property developers, Country Garden, is currently facing the risk of default as their sales plummet. Additionally, Evergrande, a major competitor in the industry, recently filed for bankruptcy after failing to repay its debts in 2021.

As China's economy transitions from being the global manufacturing hub to a more advanced and consumer-oriented model, certain young individuals in the country have chosen to embrace the concept of "lying flat" or "letting it rot" instead of engaging in mundane factory jobs that offer little satisfaction. This decision is made despite President Xi Jinping's call for the younger generation to endure hardships and accept low-level jobs.

All these problems have caused a severe lack of trust in China, which is causing major damage to the economy. "The actual problem lies in the continued decline of consumer trust," Montufar-Helu informed Fortune. "The negative impact of the past three years of COVID-related disruptions and the decline in the real estate industry has profoundly affected the financial situation of Chinese households. As a result, confidence and demand have significantly weakened."

Declining interest from China has contributed to a decrease in prices in July. Certain economists have suggested that this deflation in China could actually help decrease inflation in the United States in the short-term, potentially allowing the Federal Reserve to pause its intense campaign to increase interest rates over the last year and a half. However, deflation can have negative long-term effects on an economy. It often triggers a harmful cycle where decreasing prices lead to a drop in consumer spending, which then causes businesses to experience lower profits. This, in turn, can lead companies to lay off employees or reduce their investments. In other words, economies that are experiencing deflation are usually contracting.

McKenna from Wells Fargo stated that a continuous decline in prices in China and a financial emergency is "not what he predicts will happen," since the government in Beijing would probably take measures to stimulate the economy if things took a turn for the worse. However, it is still a risk that should not be ignored—a possibility that is unlikely, but could have severe consequences.

China & Global Economy: The New Normal

In 1978, Deng Xiaoping, the head of the Chinese Community Party (CCP), implemented a range of measures that promoted free trade in China, allowing for foreign investment and trade. This marked the start of a period that the World Bank has hailed as "the most rapid and continuous growth ever witnessed by a major economy". China's actual annual GDP growth skyrocketed at an average rate of 9.5% from 1978 to 2018, propelling the nation into a global powerhouse and lifting more than 800 million people out of poverty.

Beijing invested a significant amount of money into its economy in order to meet the growing worldwide demand for affordable products. This was primarily done through state-owned businesses and debt. Enormous sums were devoted to important infrastructure endeavors, including extravagant high-rise buildings and cutting-edge high-speed trains. Nonetheless, skeptics expressed doubts about the sustainability of these efforts.

Since the emergence of China's "ghost cities" over ten years ago, skeptics have questioned the debt-driven, export-oriented growth of China as it climbed to become the second-largest economy globally.

Even though China's previous economic system allowed for speedy expansion, it also resulted in inequalities due to a concentration on investments in manufacturing and construction sectors, neglecting the necessary backing for consumer requirements. The COVID pandemic merely exacerbated these disparities.

According to Montufar-Helu, the declining trust among consumers is primarily caused by long-standing structural disparities. In numerous sectors, such as the housing market, there is an abundance of available products or services, but a scarcity of customers or buyers.

"These disparities have emerged due to the previous development approach followed by China, commonly known as the rapid progression model," he stated. "The challenge lies in the fact that rectifying these imbalances would require the CCP to implement reforms which, regrettably, would take considerable time before yielding positive outcomes."

Despite experiencing rapid economic growth in the years following Xiaoping's economic reforms in 1978, Wells Fargo's Mckenna predicts that China's current economic challenges will possibly hinder its GDP expansion, leading to an average growth rate of 3.5% to 4% in the next ten years.

In this particular situation, the United States would also witness a deceleration in GDP growth, averaging around 1.5% per year. This can be attributed, in part, to the economic fragility in China, as explained by McKenna. However, the impact on Southeast Asian countries could be more severe as their economies heavily rely on China for both trade and foreign investments.

"I am particularly concerned about the potential consequences that could spread through developing economies rather than the impact on the United States," he expressed. "However, I believe we are witnessing a scenario where worldwide economic expansion will definitely not be as strong as it has been in the previous couple of decades."

Forecasting China’s Growth: The Challenges

Accurately predicting the future of China's economy is always a challenging task, with several unique factors making it even more complex.

Initially, Beijing ceased sharing its statistics on youth unemployment, significant bond market figures, and even data regarding the extent of land sold for advancement purposes. This approach has further complicated the task of accurately assessing the condition of the Chinese economy.

Furthermore, the latest amendment to China's legislation against espionage and the assurance made by President Xi Jinping during a meeting with the Politburo to enhance the synchronization of development and security have resulted in several international companies being singled out by Chinese authorities this year. For instance, in April, Chinese officials interrogated employees at the Shanghai branch of American consulting firm Bain & Co., and in March, they detained staff members during a surprise search at the Beijing office of American due-diligence firm Mintz Group.

The enforcement highlights the precarious situation for companies in China and introduces uncertainty when it comes to forecasting the future of relations between the United States and China, to put it mildly.

In addition, there are still experts who are not convinced that it is sustainable in the long run for the United States to significantly reduce its dependence on disengaging from the Chinese economy. This is because such a move has the potential to impede the growth of the global economy, especially during these uncertain times.

In the coming future, we ponder if this separation can persist," expressed Bank of America's worldwide economist Claudio Irigoyen in a recent message. "Alternatively, will the adverse consequences of a slowdown in China on worldwide expansion gradually influence sentiments to the extent of provoking a decline in high-risk investments that could affect the prospects of the United States?"

According to Montufar-Helu from The Conference Board, China continues to be a significant global market for products. This implies that numerous international companies have to keep doing business in China, despite the existing economic difficulties. If they do not, they may lose their valuable market position to local rivals. This situation could potentially safeguard against the economic growth decline resulting from the separation of China and the U.S., making predictions even more challenging once again.

The CCP is currently implementing policy changes and taking actions to boost the economy. These measures include reducing interest rates and loosening regulations on home purchases. Montufar-Helu believes that it is too early to determine China's GDP growth rate for the upcoming year.

Montufar-Helu is of the opinion that the recent economic data for July, which was not as strong as anticipated, might only be a temporary setback. In order to maintain objectivity regarding China's potential for the future, he advises that we should reserve our judgment until we have access to the data for the third and fourth quarters of the year.

And certain professionals, such as Nobel laureate Paul Krugman, contend that even in the event of a severe economic downturn in China, it is improbable that it will have a substantial impact on the United States. Krugman provided a few essential justifications for his optimistic perspective in a recent New York Times article.

To start with, a significant portion of China's financial obligation is owned by the domestic government, not by external governing bodies. This implies that the Chinese Communist Party (CCP) should have the capacity to address the predicament by employing a mix of debtor bailouts and creditor concessions, as elucidated by Krugman.

The experienced economist also made the point that even though China is a significant trading partner for the United States, the connections between the two economies are not as robust as they used to be. He pointed out that the United States' direct investment in China is currently only $215 billion, and China's annual purchases of US goods and services amount to around $150 billion, which is less than 1% of the United States' Gross Domestic Product (GDP). Krugman concluded that from an economic standpoint, it appears that there might be a potential crisis brewing within China, rather than a global event similar to the one in 2008.