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

For decades, as its economy slowly developed into the world's factory, China has been exporting cheap goods to stores near you. But as the nation battles a real estate slump and a Gen Z youth unemployment crisis, it could soon be exporting something else: economic pain in the form of deflation and sluggish growth.

After years of strict lockdowns, China’s economy is floundering and many of its decades-old problems are coming to bear. Overdevelopment has left the property market in crisis; local governments are struggling to service their growing debt burden; and the official youth unemployment rate surged to a record 21.3% in July—or as high as 46% by some third-party estimates.

On top of that, rising tensions between China and the West risk forcing an economic “decoupling.” The two sides are trying to become less reliant on each other for trade and direct investment, which could hinder China's export-led economy even further.

With all these issues coming to the forefront, Brendan McKenna, an international economist at Wells Fargo, is worried about China’s economic disease spreading. Its recent problems with deflation—consumer prices in the country sank 0.3% in July from a year ago—could infect the rest of the world. “If you get a scenario where China is really in crisis and exporting deflation, I can see where that actually filters through the United States and we actually might get deflation here, which is probably a bigger problem than elevated inflation,” the economist told Fortune.

How will China export deflation? For one, the country’s role as a leading commodity consumer gives its domestic economy an outsized influence on the global price of everything from iron ore to steel. And secondly, with declining domestic sales, Chinese manufacturers are likely to cut prices, leading more cheap goods to be exported abroad.

McKenna fears that China’s domestic issues signal a new era for the nation—one in which the gross domestic product (GDP) is apt to grow much slower. And given that China currently accounts for roughly 35% of global GDP growth, that could mean a whole new era for the global economy, too.

From 1980 to today, McKenna noted, the global economy has grown about 3.5% annually on average. “I think five to 10 years down the line we're probably going to be looking at a new normal that's closer to 2.5%,” he argued, warning that the impact from China’s slowdown is “going to be relevant pretty quickly.”

China’s growth slowdown

At the start of 2023, many economists hoped that China’s economy would surge this year after it lifted strict COVID lockdowns, enabling consumers and businesses to return to normal. But the recovery has been muted at best, leading some experts to warn that China is facing a “lost decade” similar to the one Japan experienced in the ‘90s.

An aging population, rising debts, and the ongoing property crisis have sparked an economy-slowing balance sheet recession in which consumers and businesses focus on building savings and paying down debts instead of spending or investing, Nomura’s Research Institute’s chief economist Richard Koo explained earlier this year. To his point, China’s GDP grew just 0.8% quarter over quarter in the second quarter, compared to 2.2% in the first quarter, amid weakening consumer demand.

Alfredo Montufar-Helu, who runs the Conference Board’s China Center for Economics and Business, an organization that provides on the ground intelligence to international corporations about economic, policy, and regulatory developments in China, told Fortune that he is already seeing consumers and businesses in China become increasingly selective and price conscious when buying in what’s known as “consumption downgrading.”

In addition to China’s balance sheet recession and youth unemployment problem, local government debts reached $13 trillion in 2022, and property prices have plummeted due to years of overbuilding. The level of housing oversupply in the country has increased dramatically in recent years. A total of 4 million completed residential units are now unoccupied nationwide, leaving real estate developers in the lurch. Country Garden, one of China’s largest residential and commercial property developers, is facing default as its sales tank, and the company’s rival Evergrande was forced to file bankruptcy this month after defaulting on its debts in 2021.

As China’s economy shifts from its role as the world’s factory to a more developed, consumer-centric model, some of the country’s youth have also decided that “lying flat” or “letting it rot” is better than taking on thankless factory work—even as President Xi Jinping urges Gen Z to “eat bitterness” and accept basic employment.

All of these issues have led to a crisis of confidence in China that is wreaking havoc on the economy. “The real challenge is persisting weakness in consumer confidence,” Montufar-Helu told Fortune. “The scarring effect of the past three years of COVID disruptions and the downturn of the property sector have had a terrible effect on the balance sheets of Chinese households. And this has led to the softening of confidence and demand that we're seeing.”

Fading demand in China even helped spark deflation in July. Some economists have argued that China’s deflation could help to slow U.S. inflation in the near-term, enabling the Federal Reserve to pause its aggressive interest rate hiking campaign of the past 17 months. But deflation can be a terrible long-term economic disease. It often leads to a vicious cycle in economies where falling prices cause consumer spending to drop, which, in turn, leads businesses profits to sink, forcing them to lay off employees or cut back on investments. Put another way, deflating economies are typically contracting economies.

Wells Fargo’s McKenna clarified that ongoing deflation in China and an economic crisis is “not his base case outlook,” as Beijing will likely respond with stimulus to boost its economy in a worst-case scenario. But it remains a tail risk—an unlikely but threatening potential outcome.

The ‘new normal’ for China—and the global economy

In 1978, the leader of the Chinese Community Party (CCP), Deng Xiaoping, enacted a series of free market reforms that opened China to foreign investment and trade. It was the beginning of an era the World Bank has called “the fastest sustained expansion by a major economy in history.” China’s real annual GDP growth surged an average of 9.5% between 1978 and 2018 as the nation quickly became a world power and pulled more than 800 million of its citizens from poverty.

Beijing pumped money into its economy to feed the ballooning global demand for cheap goods during the era, usually via state-owned enterprises, and usually via debt. It spent billions on major infrastructure projects, from lavish skyscrapers to state-of-the art bullet trains. But the critics said it couldn’t last.

Ever since China’s “ghost cities” made western news headlines over a decade ago, naysayers have cast doubt about the debt-fueled, export-focused expansion of China into the world’s second-biggest economy.

Although China’s old economic model enabled rapid growth, it also created imbalances due to a focus on investing in the manufacturing and construction industries, without offering sufficient support for consumer demand. And COVID only helped to bring those imbalances to the surface.

“Unfortunately, I think they didn't pay too much attention to the demand side of the economy,” The Conference Board’s Montufar-Helu told Fortune of the CCP’s old regime. “If you want to have a sustainable increase in domestic consumption, one of the key aspects you need in your economy is a very robust social security system that China doesn't have. You need to have better access to quality health and education services across the country, but China only has some of that.”

Montufar-Helu said consumers’ fading confidence levels are underpinned by these old structural imbalances. In many industries, like housing, there is plenty of supply, but not enough demand.

“These are imbalances that were generated under China's old development model, the fast road model,” he said. “And the problem is that if they [the CCP] want to address them now, they need to enact reforms that, unfortunately, will take time to take effect.”

Although China's GDP grew quickly in the decades after Xiaoping’s 1978 economic reforms, Wells Fargo’s Mckenna said that the nation’s current economic problems will likely slow its GDP growth to an average between 3.5% and 4% over the coming decade.

Under this scenario, the U.S. would also experience a GDP growth slowdown to an annual average of around 1.5%, partly due to weakness in China, McKenna explained. But emerging countries in Southeast Asia may suffer more because their economies are more dependent on China for trade and foreign investment.

“I'm more worried about the kind of ripple effects across the emerging markets than the effect on the United States,” he said. “But I think we are looking at a picture where global growth is certainly not going to be as robust as it was over the last couple of decades.”

The challenges of forecasting China’s growth

Accurate economic forecasting is always difficult, but predicting China’s long-term prospects is especially challenging for a few key reasons.

First, Beijing stopped releasing its youth unemployment data, some key bond market data, and even figures on the amount of land sold for development, making it more difficult to get a read on the true health of the Chinese economy.

Second, the recent expansion of China’s anti-espionage law and promises by President Xi Jinping at a summer Politburo meeting to “better coordinate development and security” have led multiple international firms to be targeted by Chinese authorities this year. In April, Chinese officials, for example, questioned staff in the Shanghai office of U.S. consulting firm Bain & Co., and, in March, they detained staff during a raid on the Beijing office of U.S. due-diligence firm Mintz Group.

The crackdown underscores the risky environment for businesses in China and makes predicting the future of U.S.-China relations complicated, to say the least.

Third, some experts remain unconvinced about the long-term feasibility of the U.S. becoming far less reliant on decoupling from the Chinese economy, given the potential for the move to hinder global economic growth in such turbulent times.

“Going forward, we wonder whether this decoupling can continue,” Bank of America’s global economist Claudio Irigoyen wrote in a recent note. “Or eventually will the negative impact of a China slowdown on global growth contaminate sentiment to the point of triggering a correction in risk assets that could impact the U.S. outlook?”

The Conference Board’s Montufar-Helu noted that China remains a huge market for goods worldwide, which means many international firms must continue to operate in the country despite current economic challenges, or else they risk losing valuable market share to domestic competitors. That could help to prevent the growth slowdown due to the decoupling of China and the U.S., once again making forecasting a challenge.

Changes to CCP policies and moves to stimulate the economy are also currently underway, from interest rate cuts to easing home buying restrictions. For Montufar-Helu, that means it’s still “too soon to say” what China’s GDP growth rate will be next year.

Montufar-Helu believes that July’s weaker than expected economic data could be temporary, and in order to “be fair” about China’s future prospects, he argues we should wait for third quarter and fourth quarter figures to judge the situation.

And some experts, including Nobel laureate Paul Krugman, argue that even if China’s economy does experience a worst-case recession scenario, it’s unlikely to significantly affect the U.S. Krugman cited a few key reasons for his bullish take in a New York Times op-ed this week.

For one thing, most of China’s debt is held, not by foreign governments, but by the national government. That means the CCP should be able to “resolve the crisis through some combination of bailouts of debtors and haircuts for creditors,” Krugman explained.

The veteran economist also argued that although China is a major U.S. trading partner, the links between the two economies aren’t as strong as they once were. He noted that U.S. direct investment in China is now just $215 billion and the nation only buys around $150 billion a year in U.S. goods and services, a figure that makes up less than 1% of U.S. GDP. “In economic terms, we seem to be looking at a potential crisis within China, not a 2008-style global event,” Krugman concluded.

This story was originally featured on Fortune.com

More from Fortune:
5 side hustles where you may earn over $20,000 per year—all while working from home
Looking to make extra cash? This CD has a 5.15% APY right now
Buying a house? Here's how much to save
This is how much money you need to earn annually to comfortably buy a $600,000 home