Key Points
- China’s first deflationary shock flooded the global economy with cheap labor in the early 2000s and hollowed out low-tech manufacturing industry in developed economies.
- A credit-fueled boom followed, with huge investment in infrastructure and real estate to sustain economic growth.
- A massive speculative real estate bubble developed, forcing Beijing to intervene.
- The real estate bubble collapsed in a controlled implosion after banking regulators restricted credit to the sector.
- Plunging real estate prices destroyed household wealth, setting off a deflationary spiral in China’s domestic economy.
- The government channeled investment into high-tech manufacturing to offset collapsing demand.
- Weak local demand forced manufacturers to focus on export markets.
- Booming Chinese exports of electric vehicles and other high-tech products threaten to hollow out high-tech industries in developed economies.
- However, export markets aren’t large enough to absorb China’s demand shock, and pushback from trading partners will likely trigger a major contraction.
Last week we focused on the slowdown of China’s economy. This week, we examine the root cause of the problem. Credit.
China experienced a credit-fueled boom in the early 2000s. This went into overdrive with massive government stimulus during the 2008 global financial crisis.
Unrestrained lending led to a massive speculative bubble in the real estate sector. Alarmed by the rate of credit expansion, Beijing put the brakes on, restricting sector access to credit in 2022.
The collapsing real estate bubble has destroyed household wealth.
Consumer Confidence collapsed in 2022 and has not recovered.
Household Debt, which had grown rapidly as a percentage of GDP, plateaued until 2024, and has now started to decline.
Property Investment has contracted since 2022, and is now shrinking at an annual rate of 18%.
Loan growth from financial institutions has rapidly decelerated to a low of 5.2% in June 2026.
Credit is the lifeblood of an economy, and rapid deceleration in credit growth triggers a domino effect of demand contraction across the economy.
Manufacturers turned to export markets to offset declining domestic demand, with exports peaking at $412 billion in June 2026.
China’s trade surplus jumped to $126 billion in June, falling back to $113 billion in July.
The People’s Bank of China (PBOC) has steadily expanded its balance sheet, employing QE to suppress long-term interest rates and stimulate the economy.
The Chinese government is also running deficits to support the economy, with government debt rapidly expanding to 99.2% of GDP in 2025.
Overall debt in the economy shows a similarly steep growth path despite slowing household credit growth.
Developed economies are not much better off (below), with average total debt at 260% of GDP and government debt at 100% of GDP. However, the difference lies in the growth rate: developed economies are no higher than in 2010, while China has almost doubled.
Conclusion
China has enjoyed a debt-fueled boom for more than 20 years, but is now sliding into a deflationary contraction. The Chinese economy is addicted to credit, and regulators’ attempts to rein in the speculative real estate boom have triggered a deflationary spiral. Falling real estate prices have destroyed household wealth, leading to a contraction in domestic demand. Beijing boosted investment in high-tech industry to sustain economic growth, leading to a massive trade surplus as manufacturers turned to export markets to offset shrinking domestic demand.
However, export markets are not large enough to absorb China’s deflationary surge without themselves suffering a domestic contraction. We expect trade surpluses to fall as trading partners push back with tariffs, import quotas, and other trade barriers.
China will then face a stark choice between a collapsing economy and debasing the Yuan through high inflation. We believe that Beijing has chosen the latter option, as the lesser of two evils, and will rapidly expand credit in the economy to that end while the PBOC expands its balance sheet to suppress long-term interest rates.
China’s debasement of the Yuan has fueled a rapid growth in domestic demand for Gold as a store of value, leading to a close correlation between Gold and the PBOC’s balance sheet.
Acknowledgments
- Michael Howell, Capital Wars: China Restarts Her ‘Great Debasement‘
- Trading Economics: China Economic Charts
- Yardeni Research: Global Money & Credit
- Reuters & Logan Wright of Rhodium Group: The cause and effects of China’s slow-motion crash
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He founded PVT Capital (AFSL number 546090), which provides income and growth strategies to wholesale clients.
Colin also co-founded Incredible Charts and writes the popular Patient Investor newsletter.
Using a top-down approach, Colin identifies macro trends in the global economy and then combines fundamental and technical analysis to evaluate opportunities in sectors that stand to benefit.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
