Overcapacity in China: What top economists are publicly advising Beijing

from David Daokui LI, Zhiheng LUO, Chuan TAO

Overcapacity unsurprisingly emerged as a key topic during the just-concluded China-EU summit. Ursula von der Leyen told the media on July 24 that the two sides had discussed the issue of overcapacity "at length."

Second, we discussed at length the issue of overcapacity in China’s economy. You know the crucial sectors, for example, steel, solar panels, electric vehicles, batteries and others. The subsidized production does not match the domestic demand and therefore overcapacity produced here [in China] goes to other markets. But the more other markets restrict Chinese exports, the greater the risk of trade diversion and pressure on the EU’s single market. And this puts our own industrial competitiveness at risk, at a time when we are making significant investments, for example, in clean energy transition.

The Chinese leadership has started to look into this issue under the term "involution" and expressed willingness to support more the consumption and less the production part. This is important. We need to see progress on this issue. Because without progress, it would be very difficult for the EU to maintain its current level of openness.

Today's newsletter compiles some sobering policy recommendations from leading Chinese economists on tackling overcapacity.

They broadly agree that, reforming local government performance evaluation system is crucial—otherwise, local officials will keep chasing political gain by rubber-stamping reckless projects and shielding local firms with unfair favoritism, leaving behind a glut of subpar, unsellable capacity.

Moreover, unlike previous sweeping rounds of supply-side structural reforms, the current drive against economic "involution" targets strategically important emerging industries, especially photovoltaics and electric vehicles.

Central authorities are also expected to lead targeted interventions, primarily through regulatory guidance aimed at local governments and market participants. Specific policy measures are anticipated following July's Politburo meeting.

Please note they have not reviewed the following translation, and all the words in bold are added by me.

I. David Daokui LI(李道葵), professor of Economics, Tsinghua University

Professor Li recently published a video on the topic of industrial overcapacity via his WeChat blog, titled "What Does Renewed Talk of Phasing Out Backward Capacity Signal, Years Later? " The video is also available on Bilibili, Chinese equivalent of YouTube.

It is crucial to regulate and standardize local government behaviors. This is because, in some industries, overcapacity, to some extent, derives from the failure of local government policies, thereby contributing to the "involutionary competition."

In China, local governments primarily rely on two main sources of revenue. The first is land sales, which now generate significantly less income than in the past. The second is value-added tax (VAT), collected during the production process. Whenever a new production line is opened locally, the moment production starts, regardless of whether it generates a profit, 3% of the added value must be paid as VAT—half goes to the central government, and half goes to the local government. This means local governments benefit financially whenever businesses begin production.

This arrangement has led many local governments to encourage business investment and capacity expansion without restraint. They may offer enterprises lower land prices or even grant tax exemptions for the first couple of years. Nearly each local government employs these strategies, deliberately creating policy advantages and blindly pursuing numerous emerging and priority industries, ultimately leading to extensive redundant construction and overproduction.

At the same time, to support local enterprises, governments also explicitly or implicitly set up market barriers, allowing local businesses with lower efficiency and poorer quality to survive. For example, during local taxi procurement processes, local governments might mandate the purchase of locally manufactured cars. As a result, the market's natural self-regulating mechanism of survival of the fittest clearly breaks down.

Therefore, the focus of this round of reform is to regulate the behavior of local governments. Once government actions are properly regulated, the market can function effectively. To this end, I suggest several ways to approach this:

1. Accelerating a Unified National Market: There is a need to accelerate the establishment of a unified national market, where the national economy is considered as a whole, rather than focusing on individual local interests.

2. Adjusting Local Government Incentives: For instance, some fiscal policy adjustments could be made to facilitate sharing tax revenues between the regions of production and consumption. In this way, local governments would be treated fairly—some might focus on consumption, while others on production, each finding its niche. Currently, most governments prefer encouraging production rather than consumption, hoping other regions will absorb the resulting products, creating a systemic imbalance.

3. Restricting Government Intervention: It's essential to restrict governmental intervention to prevent excessive interference in corporate investment decisions. If a business is willing and capable of investing, it should be allowed to do so. Local governments should not force companies to hastily expand operations or rush into new investments.

II. Zhiheng LUO(罗志恒), Chief Economist at Yuekai Securities

Dr. Luo published an article in Caijing Magazine in April, titled "The Causes and Solutions of 'Involutional' Competition."

The emergence of "involution-style competition" in recent years is not a result of companies or employees suddenly becoming shortsighted or impatient for quick success, nor is it due to abrupt changes in individual behaviors. Rather, it reflects deeper macroeconomic forces, driven by economic cycles, institutional factors, and technological trends.

1. Economic cycle factors: In the short term, sluggish domestic demand, uncertain external markets, and supply-demand mismatches in certain sectors have intensified this hyper-competitive environment.

2. Institutional and policy factors: Under short-term performance evaluation systems, local governments, motivated by a desire to showcase their achievements, engage in a "race to the bottom" by offering preferential tax policies and differentiated incentives to attract investment. This distorts the entry cost structure within industries. Coupled with issues like local protectionism and inadequacies in bankruptcy and restructuring mechanisms, these practices slow down industry clearing, preventing market mechanisms from naturally resolving supply-demand imbalances.

3. Technological development factors: The inherently discontinuous and disruptive nature of technological innovation naturally creates structural overcapacity, especially pronounced in emerging industries. Technological advances often proceed unevenly and discontinuously; prior to the establishment of dominant technologies, multiple uncertain technological pathways typically coexist. Enterprises, aiming to mitigate the risks posed by rapid technological shifts, tend to diversify investments and simultaneously pursue multiple technologies, thus expanding their production capacities excessively.

To address this issue, policymakers could focus on three key areas:

Firstly, in the short term, measures could include extending consumption-stimulating policies such as "trade-in" programs to cover products shifted from export to domestic markets and service consumption. Appropriate fiscal subsidies could be used to boost household consumption capacity and willingness, alongside increased financial assistance for specific groups, including families with two or more children, unemployed youth, and urban/rural pension recipients.

In the long run, further improvements are needed in the national income distribution structure, raising the proportion of labor compensation. Concurrently, reforms integrating state-owned capital, public finance, and social security systems should significantly boost the contribution of state-owned capital to fiscal budgets, specifically dedicated to social security system development. This includes progressively elevating urban and rural residents' pension insurance benefits to approach subsistence allowance standards.

Secondly, optimize performance evaluation systems for local governments and reform industry self-regulation mechanisms. Specifically, this requires shifting local governments' approach to development and performance assessments. By establishing clear industry standards and rules, regulating market behaviors, and fostering consensus, cutthroat competition can be curbed.

At the same time, enterprises should be encouraged to pursue differentiated competitive strategies -- clarifying their market positioning, strengthening core advantages, and exploring new growth avenues -- to transition toward higher-quality competition.

Thirdly, targeted supply-side guidance should be implemented according to the technological development patterns of different industries, coupled with enhanced support for corporate innovation.

III. Chuan TAO(陶川), Chief Economist at Minsheng Securities

Dr. Tao wrote on his WeChat blog on July 3rd that:

"Anti-involution" is highly likely to become a key theme in China's 15th Five-Year Plan period (2026-30), aligning closely with the strategic goal of "strengthening domestic circulation 做强国内大循环."

Looking ahead, how will the next phase of "anti-involution" unfold?

Currently, efforts to curb involution rely primarily on industry self-regulation, which may lead to relatively slow progress. As early as March of this year, the head of the National Development and Reform Commission proposed that "industry-specific plans will be introduced to address structural imbalances in key sectors."

We anticipate that following the policy direction set at July's Politburo meeting, the National Development and Reform Commission (NDRC) will likely take the lead in implementing a governance model of "ministry-led initiatives supplemented by industry self-regulation" to comprehensively address industrial involution.

Drawing lessons from the supply-side structural reform period, quantitative KPIs for overcapacity reduction were established across key sectors.

For instance, since 2016, the central government employed administrative measures to set specific overcapacity reduction targets for industries like steel and coal. Even when employing environmental policies or market mechanisms to facilitate capacity clearing, quantitative objectives such as production control mandates or elevated energy efficiency standards were implemented. Post-factum analysis reveals that sectors like coal mining and non-ferrous metal processing achieved significant overcapacity optimization after adopting this ministry-led approach.