China’s Moment of Weakness
Economic Decay and America’s Strategic Opening
The China challenge facing the United States is often presented as so large and so existential that it encompasses topics as varied as military planning, technology policy, and student visa applications. But while policymakers in Washington and technologists in Silicon Valley alike have been debating what to do about the challenge, economic conditions in China itself have changed dramatically. Indeed, the strategic challenge from China today is an entirely different threat from the one the United States and its allies faced only four years ago. And, crucially, this change represents an urgent but potentially definitive opportunity for the United States.
In the current strategic balance, many analysts fail to appreciate the fact that Beijing’s policy tools for generating economic growth are fundamentally broken. China is not facing an economic crisis or a collapse, but a steady decay of its capacity to influence its economy through its fiscal and financial systems. After years of unproductive investments and amassing trillions of dollars of bad debt, the country has no way to generate sustained domestic demand from households or corporations and is entirely dependent on exports for its growth. Last year, despite the Trump administration’s trade war, China achieved its largest-ever global trade surplus, $1.2 trillion, by exporting some $3.8 trillion worth of goods, a 5.5 percent increase from the year before. The rest of the Chinese economy, meanwhile, has cooled significantly since 2022 amid the collapse of the property sector and Beijing’s overly aggressive COVID-19 restrictions.
These are symptoms of the same phenomenon: China’s domestic economic slowdown is the primary driver of its export strength, because weak domestic demand in China means that excess production is exported at lower prices. Even using Beijing’s official data, which underreports the slowdown, China peaked as a proportion of the global economy in 2021 at 18.5 percent of global GDP and has declined since then. (Beijing’s latest figures imply that the country would account for 16.7 percent of the global economy, though the actual proportion is probably closer to 15 percent.) The United States, by contrast, accounts for around 26 percent of global GDP, up from 24 percent since 2021. Not only is there virtually no chance of China overtaking the United States as the world’s largest economy, but it is also likely that the U.S. advantage in economic strength will expand further in the next decade.
As a result, the United States no longer faces a long-term systemic economic rivalry with China, and Beijing’s strategic position is significantly weaker. To maintain any growth, Beijing must remain fully preoccupied with keeping markets for its exports open, which explains much of China’s diplomacy over the past two years, both with the Trump administration and with European leaders. The consequences of weakening export growth are now much larger for Beijing than only four years ago and include domestic deflation and rising corporate debt burdens, a weaker exchange rate, capital outflows and financial instability, and the potential for a lost economic decade similar to Japan’s struggles in the 1990s. The pressure on China’s economy means it will struggle to continue modernizing its military and maintain technological innovation. Although budgets can always prioritize these efforts, China’s overall fiscal resources are trending lower.
Herein lies both the urgency and the opportunity for the United States. China’s impressive industrial base means it has secured chokepoints over some key supply chains and intermediate inputs—indeed, it weaponized its control over rare earths to alarming effect in the advanced industrialized world. Its economic decay at home is making this threat more severe: as economic woes further drive down export prices and force companies to expand their markets overseas in search of profits, China will erode industrial bases elsewhere, including in the United States and among its allies. If countries lose the industrial bases needed to protect their own economic and security interests, Beijing will have even more opportunities to weaponize supply chain vulnerabilities in the future. The world will see episodes like Beijing’s restrictions on rare earths expand to other industrial components and even consumer goods.
The opportunity, however, is that there is a clear and politically popular answer to disinvestment pressures from Beijing: new investments in developed economies. If the West can restore its own industrial resilience with credible sector-specific trade defenses and aggressive investments in its own industries, Beijing will find itself in a tightening vise. Given China’s anemic domestic demand, mounting external trade and investment barriers from the West will quickly erode the country’s strategic position. The macroeconomic conditions in China have so completely changed the nature of strategic competition that if the United States changes its approach as well, it could very well deter and mitigate future economic and security threats from Beijing.
IT’S DIFFERENT THIS TIME
Most analyses of China’s long-term trajectory use a political lens. Beijing’s progress is assessed relative to the stated objectives and targets in its long-term industrial policy plans, such as the Made in China 2025 plan to strengthen the country’s domestic capacity in critical sectors. Such accounting delivers spectacular results—China has, for instance, accomplished much of what it set out to when it released its Made in China plan in 2015—and bolsters the perspective that Beijing’s centralized, long-term planning affords it unique advantages.
But looking at the country’s trajectory through its financial system reveals an entirely different picture. Policymakers often appear highly capable and farsighted during credit expansions and more defensive during credit contractions. Beijing influences economic outcomes by directing credit across the financial system and channels investment through local government-owned companies. If those policy tools are impaired or ineffective, Beijing has far less control over its domestic economy. From 2008 to 2017, China’s banks added credit equivalent to one-third of global GDP, or $27 trillion in new bank assets. No other country has even come close to that pace of credit growth in the last century. After the inevitable bust when many of those loans came due and could not be rolled over, China today simply does not have the same capacity to influence economic outcomes via long-term plans as it did in the last decade. Credit flows enabled Beijing’s political objectives, and the lack of credit growth now constrains them.
This is a profound shift. As recently as 2021, there was still a realistic argument that China would become the largest economy in the world. At the time, economists and bank analysts were debating the year that China’s GDP would overtake that of the United States in nominal U.S. dollars; many believed it could happen as early as 2026. Since the end of 2021, however, based on official figures, U.S. GDP has expanded by 28 percent in dollar terms, whereas China’s grew only 21 percent in renminbi terms and 11 percent in dollar terms.
And there is good reason to be suspicious of Beijing’s official data: in 2022, China claimed that its economy grew by three percent in real terms even as COVID-19 policies restricted people’s movement and the country’s property market—which made up around a quarter of China’s economy at its peak—collapsed. Analysis by my team at Rhodium Group found that actual growth was likely negative that year. Then, from 2022 to 2025, when declining property construction dragged down growth, Beijing still claimed that annual real GDP growth averaged 4.6 percent. The more plausible range of China’s economic performance over those four years is 1.5 to 2.0 percent. Overall, our alternative estimates imply that China’s cumulative expansion since 2021 may have been only around two percent in dollar terms, well below the officially stated growth rates.
The proximate cause of China’s economic slowdown was the collapse of the residential property market. But the ultimate cause was the end of an unprecedented credit bubble that had started immediately after the global financial crisis of 2008. Property was just one of the primary beneficiaries of the vast flows of cheap credit that inflated that bubble. Most of the projects that local governments initiated after the global financial crisis were never intended to generate cash flows that could repay the loans; they were public works and infrastructure investments. As a result, the banking system bore the costs of these investments. As credit expansion was cut in half starting in 2018, defaults started emerging—first in peer-to-peer lending networks, then in smaller banks, then in nonbank financial institutions funding the property sector, then in property developers themselves, and finally in local governments.
The bill for all of China’s past investment-led growth is now coming due. But paying it would require restructuring the $72 trillion banking system, which involves not only enormous fiscal costs but also, and more importantly, accepting slower economic growth as state-led investment slows so that the same problems will not be repeated. To avoid these consequences, China is choosing to roll over these bad loans indefinitely and continue to fund nonproductive companies and local government investments—essentially throwing good money after bad.
Managing the old debts, however, weakens banks’ capacity to extend new credit every year. As a result, China’s financial system is decaying and experiencing a significant slowdown in credit growth. The current pace of bank lending growth is 5.3 percent, which is less than one-third the level it was during China’s boom years. And according to the country’s central bank, a full 58 percent of all new loans are currently extended at or below the loan prime rate of three percent—a level at which profits are minuscule, with most of these loans likely going to state-owned enterprises and local governments, not innovative technology firms or Chinese households. The past, in other words, is strangling the future.
China’s economic slowdown and the collapse of the property sector have caused its tax revenues to plummet, both in absolute terms and relative to the size of the economy. Total tax and nontax revenues reached only 15.4 percent of GDP last year, a level below that of all members of the Organization for Economic Cooperation and Development. As a result of these declining revenues, China’s annual fiscal deficits are now around nine to ten percent of GDP (about $2 trillion per year), which means that Beijing has extremely limited bandwidth to pump more money into the economy. To maintain growth, authorities have only one option: lean on overseas markets.
BUY CHINESE…OR ELSE
The rise in China’s global export share is a direct result of the slowdown in the domestic economy. As property construction waned, the vast industrial ecosystem that had previously produced raw materials, chemicals, and other intermediate goods to build residential and commercial buildings inside China’s borders saw its domestic customer base disappear. Credit was still flowing to many of these enterprises, which meant they kept producing. But without domestic markets, they started to cut prices and sell whatever they could overseas, depressing profit margins globally and reducing incentives for new investments in multiple sectors around the world. China is increasingly expanding its export share not only in Europe but also in developing economies in Southeast Asia and Latin America.
Because Beijing wants to ensure that global markets stay open for Chinese exports, it has been alarmed by recent global de-risking measures, which aim to develop alternative and diversified supply chains to reduce reliance on Chinese inputs. Beijing has been reaching out to individual countries to emphasize the benefits of maintaining trade relations with China. In case its diplomatic efforts are eventually rebuffed, it is also taking new, sweeping actions to push back against countries that are attempting to develop industrial capabilities outside China.
After the announcement in March of Europe’s Industrial Accelerator Act, for instance, which creates incentives for EU-based procurement and production in certain industries and imposes caps on foreign ownership, Beijing directly threatened countermeasures against Europe. In April, China issued new decrees authorizing retaliatory measures against foreign laws seen as “discriminatory” against China and as harming its supply chain security. And in early June, Beijing introduced new controls on outbound direct investments to provide the legal basis for punishing countries that restrict Chinese corporate investments. Beijing is also increasingly brandishing the threat of economic warfare as a deterrent, such as using new export limits on rare earths against Japan in its ongoing economic conflict with Sanae Takaichi’s administration.
Yet the increasing use of sticks rather than carrots to keep export markets open is also a byproduct of China’s domestic economic slowdown. During its spectacular rise, Beijing overcame global pushback to the first “China shock” because it offered trading partners access to a growing market in which to sell their goods and services. American consumer firms, German machinery and capital equipment manufacturers, and Australian and Latin American commodity exporting firms all benefited from reaching an expanding market of Chinese consumers and resource-hungry industrial enterprises. But now, given China’s collapsing domestic demand, trade tensions are inevitable. If all that Beijing can do to keep its economy growing is to threaten to withhold critical goods from the rest of the world, the benefits of trading with China will continue to erode for most countries.
In the meantime, however, in the absence of a concerted response from developed economies, the threats from Beijing could become more intense. The longer countries allow China to weaponize the global trading system and transgress redlines of industrial resilience, the more difficult it will be to marshal the specialized technical knowledge and assemble the requisite industrial clusters to provide sustainable alternatives to Chinese suppliers. Germany is discovering this to its peril, as its manufacturing sector is reportedly losing around 10,000 jobs per month at present. Others in Europe, particularly France, are also aware of the challenge and are attempting to coordinate a response: the European Council’s mid-June debate on trade safeguards revealed how significantly the continent’s internal calculus regarding trade with China has changed.
Beijing is currently trying to manage the consequences of its internal economic imbalances through diplomatic means, not by reforming its own system. If its diplomatic efforts and combinations of sticks and carrots fail, Beijing may resort to even more aggressive economic statecraft tools to keep export markets open, which would be a recipe for larger global economic disruptions and supply chain-related conflict. Deterring Beijing from pursuing these tactics requires the United States and its allies to coalesce around a different strategy.
BAD BET
The primary economic challenge from China is emerging now rather than over the next decade. But a U.S.-led response that mounts trade defenses, protects Western sources of demand, and develops new industrial clusters outside China would not only meet the current threat but also create cumulative, long-term advantages for the United States and its allies. In other words, acting now to restrict Chinese exports and make meaningful new investments would generate strategic benefits vis-à-vis Beijing for years to come.
Coordination between the United States and its allies within the G-7 economies would accelerate this endeavor. Such a collective response is not easy to pull off, however, and the tariffs imposed on U.S. allies by the Trump administration have narrowed the economic and political scope for a coordinated effort against Beijing. Indeed, critics will argue that Beijing now has more negotiating leverage than the Western side and that a concerted response is futile. In this view, China’s export controls and limits on intermediate products, such as rare-earth magnets, are more powerful than Western tariffs and trade restrictions because they have an immediate economic impact and involve components that cannot easily be replaced. Instituting barriers to Chinese imports is seen as less effective because China can always find new markets for its exports.
Apart from being defeatist, this viewpoint fails to consider the current constraints on Beijing’s policy tools and the pressure on its economy. China is already the world’s largest exporter; diversifying to new markets would be extremely difficult for Chinese enterprises, especially when the West still accounts for most global growth in final consumer demand. China’s rapidly accelerating exports of electric vehicles generate headlines globally, but the industry as a whole is still barely growing because the domestic market for Chinese cars has stagnated, with sales down 20 percent this year. The benefits of further export gains for Chinese firms, and the broader economy, are diminishing.
Beijing’s export control strategy is also not as strong as many make it out to be. As the United States has learned, such controls are very difficult to enforce. If China intends to sustain or broaden its export control regime, it will have to aggressively monitor its trade activity, especially because global prices in controlled goods will rise and encourage circumvention. Controlling trade in just one industry requires an extensive bureaucratic apparatus to cover all producers and exporters. China was only able to assert its control over rare earths, for instance, because it forced consolidation within the industry and, over the course of two decades, concentrated production within only two firms. When China can limit trade in 90 to 100 percent of global supply of a particular product, its export controls will be effective. But this level of dominance is rare, especially as the rest of the world scrambles to develop alternative supply chains. Once the world can find an alternative source of even ten to 20 percent of global supply, China’s controls will become far less threatening.
Beijing is betting that it can stop a coordinated trade response from the West long enough to assemble new supply chain chokepoints in other industries. It is responding to Europe’s planned defense buildup, for example, by tightening export controls on “dual use” products and placing defense firms on controlled lists. But if China faced significant restrictions on its own exports, the world’s developed economies would see their leverage over Beijing increase. An economy that is dependent on global demand for growth cannot remain in perpetual trade conflict with its customers.
DEMAND LEVERAGE
Many observers view strategic competition between the United States and China as a race to develop capabilities that can blunt the leverage of the other side: the United States is trying to develop sources of rare earths and critical minerals quickly, while China is trying to develop advanced semiconductors. But such an analogy is misleading because the “race” can never be won, and trade activity between the two sides does not stop as this “race” continues. In a long-term strategic competition, the tools of economic statecraft will always find new targets. This is especially true for the G-7 and other developed economies, which collectively run a trade deficit, and China, which runs a large trade surplus; supply chain vulnerabilities for the United States and its allies will always exist within this economic structure.
The ongoing strategic competition is thus better understood not as a race to develop capabilities but as an ongoing negotiation over managing the pace and scope of decoupling trade flows between China and the rest of the world. Beijing wants to slow the decoupling process and narrow its scope; the United States and its allies want to speed it up. The challenge for the United States and its allies in this form of strategic competition is minimizing the impact of China’s threats to withhold critical intermediate goods and raw materials as tools of political leverage. The obvious first step is to develop alternative sources of those materials; operating supply chains independent of Chinese influence is a useful capability in itself and improves resilience and security while also mitigating China’s bargaining power.
But the more important measure is to use these negotiations to threaten Beijing with similarly targeted escalation via restrictions on consumer demand. Import quotas, tariffs, technical standards, and other limits on China’s exports would create price pressures on Chinese industries, reducing profits, fiscal revenues, and Beijing’s capacity to support its sectors with industrial policy preferences. China itself has used limits on demand—restricting its imports from Lithuania for political reasons, for example, or turning the spigot on and off for U.S. soybean purchases—precisely because they immediately affect corporate revenues.
The Trump administration lost critical leverage in its last round of negotiations with China by meeting Beijing’s supply threats with its own focus on supply. To reach a deal on access to rare earths, it agreed to scale back the expansion of the Commerce Department’s proposed export controls on semiconductors, offering more Chinese firms the possibility of buying American chips and related equipment. But this approach gave Beijing a path to escalation dominance: with a huge trade surplus, China can always find more exports to restrict than the United States can. By contrast, it has no real alternative to the consumer markets of the United States and its allies.
The United States should instead actively lead its allies to engage China in a long-running formal or informal negotiation process in which it meets China’s export controls on rare earths with sector-specific trade defenses in the areas where China’s exports are growing fastest, such as machine tools, industrial robots, chemicals, and ships. Washington can also impose nontariff barriers, such as technical standards that many Chinese technologies would be unable to meet, to credibly and sustainably meter China’s access to U.S. and allied demand.
This kind of negotiation would introduce a series of unattractive tradeoffs for Beijing. Exiting an ongoing negotiation and withholding critical supplies to the United States or the rest of the world is a time-limited strategy, as a full-blown trade war would quickly remove China’s primary sources of growth. Furthermore, the more industries in which China pursues supply chain restrictions, the more aggressive the response will be from the rest of the world.
Yet continuing to engage in a negotiation that has put access to G-7 demand on the table also works against Beijing’s interests in the long run. In order for Beijing to restore its access, it will have to continue the flow of critical supplies to allied producers. Growth is still occurring outside China rather than inside it, and the rest of the world will gain the time it needs to loosen China’s grip over key supplies. In other words, Western restrictions on demand become more powerful over time, while China’s restrictions on supply become less so. Beijing already seems to recognize this constraint: it is pursuing more targeted export controls that would limit new investments outside of China, not broad-based export controls that would limit China’s growth.
DETERRABLE, NOT INEXORABLE
The current strategic competition between the United States and China was not inevitable. It emerged as a product of policy choices throughout the 2010s, most of which were made in Beijing. But the U.S.-Chinese strategic economic competition has been transformed by China’s economic slowdown. Threats from China are now contingent, time-limited, and more deterrable than inexorable. Beijing’s capacity to execute long-term economic and industrial plans is impaired by the decay within the country’s fiscal and financial systems, and China’s decision to stick with its decaying economic model rather than change course is shortening its time horizons even more.
The United States thus has a real but urgent opportunity to focus on the near-term threat of deindustrialization and, in so doing, mitigate the intensity of strategic competition in the next decade. The consensus in Washington that China presents a long-term challenge to U.S. economic primacy will not change overnight. But the sooner that consensus does change, the better positioned the United States will be.