Cheap Chinese Goods Are Becoming a Costly Problem. Exhibit A: Hong Kong.

Prices are falling in mainland China. That’s a boon for people living in Hong Kong, but a big problem for the city’s businesses.

Consumer prices in China fell 0.8% in January compared with a year earlier, the country’s biggest deflation reading in more than a decade. That is a sign of the tepid state of the world’s second-largest economy, where a sputtering recovery has knocked confidence and encouraged Beijing to censor some economic research .

Hong Kong residents are increasingly hopping across the border to the city of Shenzhen, where they load up on frozen food and cheap furniture at big-box stores such as Costco and Sam’s Club. Hong Kong business owners, unable to compete with their Chinese counterparts on price, are feeling the squeeze.

“Walking on the streets these days, you’ll feel that Hong Kong retailers are in big trouble,” said the city’s former financial secretary, John Tsang, in a recent social-media post.

The pain being felt by businesses in Hong Kong offers a partial answer to a question that has been debated by economists for much of the past year: How will deflation in China affect the rest of the world?

Chinese export prices have dropped steadily since late 2022 and were 8.4% lower in December than they were a year earlier, according to customs data. Economists think that’s probably a good thing for Europe and the U.S., where central banks have been forced to embark on an aggressive series of interest-rate increases to keep rising prices in check. But the impact on smaller countries could be more troublesome.

China is the biggest trading partner for many countries across the world, and is particularly influential for countries in Asia. The risk for them is that Chinese companies dump their goods overseas in response to weak demand at home. They can also undercut manufacturers in countries such as Vietnam and Malaysia, which have slowly been muscling in on China’s status as the world’s factory.

“This Hong Kong story is applicable to countries that are near the neighbourhood of China because the supply chain is much smaller,” said William Lee , chief economist at the Milken Institute, an economic think tank. The shorter supply chain for China’s trade with its neighbours means changes in price pass through more directly, rather than being swallowed up by the various companies that get involved in shipping goods over longer distances.

China’s neighbours in East Asia don’t have the option to impose protectionist policies against it, analysts at Citigroup wrote in a January note. China is simply too big a force in global trade for them to risk its ire.

But if it is hard for China’s neighbours to push back against falling prices, it is even tougher for Hong Kong—which is run by a pro-Beijing government that wants closer integration with the superpower next door.

Hong Kong residents are partly benefiting from the strength of the U.S. dollar. The Hong Kong dollar is pegged to the U.S. dollar, and the city’s de facto central bank has copied the Federal Reserve’s series of interest-rate increases over the past two years. China’s central bank has gone in the opposite direction, cutting rates in an attempt to boost the moribund economy.

Since the end of 2021, the Chinese yuan has lost more than 11% of its value against the Hong Kong dollar.

Counting the cost

Hong Kong’s economy grew 3.2% last year, clawing back some lost ground after a 3.7% contraction in 2022. But the numbers mask a host of difficult problems, including an exit of foreign businesses , a prolonged slump in the real-estate sector and the lowest fertility rate in the world .

The apparent embrace of what mainland China had to offer would have appeared unthinkable five years ago, when the city was swept up in antigovernment protests. Back then, shoppers and diners looked up color-coded maps to help them identify businesses that shared their political stance to patronize—and avoided those perceived as having links to mainland China.

But years spent cooped up in Hong Kong during the pandemic and penny-pinching by anxious residents have helped boost Shenzhen’s appeal.

“We’re seeing a readjustment of our way of life that suggests economic interdependency between Hong Kong and Shenzhen,” said Edmund Cheng, a political sociology professor at the City University of Hong Kong.

Last year, Hong Kong residents made more than 50 million trips up north following the lifting of all pandemic-related travel restrictions in February, according to Hong Kong Immigration Department data. That’s still below pre pandemic levels, but the Hong Kong residents’ spending power helped boost retail sales in Shenzhen, which rose by 7.8% in 2023, recording one of the biggest jumps at any mainland city last year.

In a survey by a business lobby last year, just 37% of Hong Kong businesses said they expected revenue to grow in 2024. Less than a third thought they were on track to beat pre pandemic levels.

Korsy Lee, 39 years old, is one of many Hong Kong residents who make a regular pilgrimage to Shenzhen—and earns a profit from it. He began shuttling goods back from Shenzhen last August as a side hustle, and now goes there four times a week, loading up his Toyota minivan with frozen hamburgers, fish maw soup, Panasonic dishwashing machines and even toilet-paper rolls. He takes orders from customers and charges a flat fee.

“Eighty percent of my customers are housewives who want to make every penny count,” he said.

For years, global companies showcased their Chinese operations as a source of robust growth. A burgeoning middle class, a stream of people moving to cities, and the creation of new services to cater to them—along with the promise of the further opening of the world’s second-largest economy—drew companies eager to tap into the action.

Then Covid hit, isolating China from much of the world. Chinese leader Xi Jinping tightened control of the economy, and U.S.-China relations hit a nadir. After decades of rapid growth, China’s economy is stuck in a rut, with increasing concerns about what will drive the next phase of its growth.

Though Chinese officials have acknowledged the sputtering economy, they have been reluctant to take more than incremental steps to reverse the trend. Making matters worse, government crackdowns on internet companies and measures to burst the country’s property bubble left households and businesses scarred.

Lowered Expectations

Now, multinational companies are taking a hard look at their Chinese operations and tempering their outlooks. Marriott International narrowed its global revenue per available room growth rate to 3% to 4%, citing continued weakness in China and expectations that demand could weaken further in the third quarter. Paris-based Kering , home to brands Gucci and Saint Laurent, posted a 22% decline in sales in the Asia-Pacific region, excluding Japan, in the first half amid weaker demand in Greater China, which includes Hong Kong and Macau.

Pricing pressure and deflation were common themes in quarterly results. Starbucks , which helped build a coffee culture in China over the past 25 years, described it as one of its most notable international challenges as it posted a 14% decline in sales from that business. As Chinese consumers reconsidered whether to spend money on Starbucks lattes, competitors such as Luckin Coffee increased pressure on the Seattle company. Starbucks executives said in their quarterly earnings call that “unprecedented store expansion” by rivals and a price war hurt profits and caused “significant disruptions” to the operating environment.

Executive anxiety extends beyond consumer companies. Elevator maker Otis Worldwide saw new-equipment orders in China fall by double digits in the second quarter, forcing it to cut its outlook for growth out of Asia. CEO Judy Marks told analysts on a quarterly earnings call that prices in China were down roughly 10% year over year, and she doesn’t see the pricing pressure abating. The company is turning to productivity improvements and cost cutting to blunt the hit.

Add in the uncertainty created by deteriorating U.S.-China relations, and many investors are steering clear. The iShares MSCI China exchange-traded fund has lost half its value since March 2021. Recovery attempts have been short-lived. undefined undefined And now some of those concerns are creeping into the U.S. market. “A decade ago China exposure [for a global company] was a way to add revenue growth to our portfolio,” says Margaret Vitrano, co-manager of large-cap growth strategies at ClearBridge Investments in New York. Today, she notes, “we now want to manage the risk of the China exposure.”

Vitrano expects improvement in 2025, but cautions it will be slow. Uncertainty over who will win the U.S. presidential election and the prospect of higher tariffs pose additional risks for global companies.

Behind the Malaise

For now, China is inching along at roughly 5% economic growth—down from a peak of 14% in 2007 and an average of about 8% in the 10 years before the pandemic. Chinese consumers hit by job losses and continued declines in property values are rethinking spending habits. Businesses worried about policy uncertainty are reluctant to invest and hire.

The trouble goes beyond frugal consumers. Xi is changing the economy’s growth model, relying less on the infrastructure and real estate market that fueled earlier growth. That means investing aggressively in manufacturing and exports as China looks to become more self-reliant and guard against geopolitical tensions.

The shift is hurting western multinationals, with deflationary forces amid burgeoning production capacity. “We have seen the investment community mark down expectations for these companies because they will have to change tack with lower-cost products and services,” says Joseph Quinlan, head of market strategy for the chief investment office at Merrill and Bank of America Private Bank.

Another challenge for multinationals outside of China is stiffened competition as Chinese companies innovate and expand—often with the backing of the government. Local rivals are upping the ante across sectors by building on their knowledge of local consumer preferences and the ability to produce higher-quality products.

Some global multinationals are having a hard time keeping up with homegrown innovation. Auto makers including General Motors have seen sales tumble and struggled to turn profitable as Chinese car shoppers increasingly opt for electric vehicles from BYD or NIO that are similar in price to internal-combustion-engine cars from foreign auto makers.

“China’s electric-vehicle makers have by leaps and bounds surpassed the capabilities of foreign brands who have a tie to the profit pool of internal combustible engines that they don’t want to disrupt,” says Christine Phillpotts, a fund manager for Ariel Investments’ emerging markets strategies.

Chinese companies are often faster than global rivals to market with new products or tweaks. “The cycle can be half of what it is for a global multinational with subsidiaries that need to check with headquarters, do an analysis, and then refresh,” Phillpotts says.

For many companies and investors, next year remains a question mark. Ashland CEO Guillermo Novo said in an August call with analysts that the chemical company was seeing a “big change” in China, with activity slowing and competition on pricing becoming more aggressive. The company, he said, was still trying to grasp the repercussions as it has created uncertainty in its 2025 outlook.

Sticking Around

Few companies are giving up. Executives at big global consumer and retail companies show no signs of reducing investment, with most still describing China as a long-term growth market, says Dana Telsey, CEO of Telsey Advisory Group.

Starbucks executives described the long-term opportunity as “significant,” with higher growth and margin opportunities in the future as China’s population continues to move from rural to suburban areas. But they also noted that their approach is evolving and they are in the early stages of exploring strategic partnerships.

Walmart sold its stake in August in Chinese e-commerce giant JD.com for $3.6 billion after an eight-year noncompete agreement expired. Analysts expect it to pump the money into its own Sam’s Club and Walmart China operation, which have benefited from the trend toward trading down in China.

“The story isn’t over for the global companies,” Phillpotts says. “It just means the effort and investment will be greater to compete.”

Corrections & Amplifications

Joseph Quinlan is head of market strategy for the chief investment office at Merrill and Bank of America Private Bank. An earlier version of this article incorrectly used his old title.

Cheap Chinese Goods Are Becoming a Costly Problem. Exhibit A: Hong Kong.

Shoppers are hopping across the border after a prolonged decline in prices

Counting the cost

Multinationals like Starbucks and Marriott are taking a hard look at their Chinese operations—and tempering their outlooks.

Lowered Expectations

Behind the Malaise

Sticking Around