China is no stranger to overcapacity in production – but the current oversupply is characterized by the fact that it affects a wide range of products this time. Overcapacity can be countered by increasing domestic consumption or reducing domestic production. However, external demand also plays an important role – through exports or, increasingly, through direct investment abroad. In view of the current geopolitical developments towards more protectionism, however, this could lead to an intensification of tensions in world trade. A recent Coface study looks at ways of reducing China's overcapacity.
Overcapacity, not new to China...
China has long been accustomed to an investment-driven growth model that has been central to the impressive economic growth of the last three decades. However, this strategy also makes the economy vulnerable to imbalances between supply and demand, which have repeatedly led to phases of industrial overcapacity. These can be traced back to the 1990s, when accelerated market reforms led to an oversupply of labor-intensive industrial goods. A more recent example occurred in the years 2014 to 2016, when the massive investment-driven recovery after the global financial crisis led to an oversupply of building materials such as metal and aluminum.
...but currently more widespread
These imbalances have become apparent again since the beginning of the COVID-19 pandemic, largely due to a production-oriented economic stimulus package that included tax breaks, subsidies and lower interest rates for companies. However, after the pandemic ended, increases in private consumption in China were unable to offset the increases in production. Meanwhile, the risks of overcapacity are no longer limited to certain industries, but are clearly visible in consumer goods, building materials, machinery and transportation equipment. “According to our estimates, overcapacity in electric vehicles and lithium batteries is sufficiently large to double exports in these areas. Even if the production utilization rate were to return to 80% of full production potential from the current rates of 73% and 77%, respectively, exports of electric vehicles and lithium batteries would have to increase by about 30% and 70%, respectively, to reduce existing overcapacity,” says Junyu Tan, Coface economist for the North Asia region.
Reviving the domestic market takes time
What options does China have for reducing its overcapacity? One answer to this would be to reduce supply, which the government is implementing by regulating excess capacity. In doing so, higher quality standards have been introduced with the aim of producing goods in smaller quantities but to a higher quality. For example, higher standards were set for the production of lithium-ion batteries, solar energy and cement clinker. However, it is unlikely that such measures will be implemented in the majority of the affected industries, as this would also harm short-term economic growth.
A more sustainable solution, on the other hand, is to stimulate demand. The current economic programs include subsidies for private consumption, e.g. through purchase premiums for (e-)cars. It remains problematic that in the wake of the real estate crisis, the prices of real estate and thus the assets of many households have fallen sharply. As a result, consumer confidence has fallen accordingly. Even the current subsidies are not changing this trend. With chronic overcapacity in the market and low demand at the same time, deflationary pressure is building up, which is once again curbing private consumption. As a result, government measures often fizzle out in short-term purchases, but do not stimulate demand.
The era of easy access to export markets seems to be coming to an end
Exports have compensated for the gap between supply and domestic demand in the past. But the “golden days” of free trade that helped make China prosperous seem to be over. Trade restrictions are increasing and will likely expand during the second Trump presidency. Despite China's efforts to strengthen ties with the Global South, many emerging markets have also introduced trade restrictions to protect domestic jobs and manufacturers. Indonesia, for example, is considering imposing tariffs of up to 200% on a range of industrial goods imported from China.
More direct investment abroad to achieve a win-win outcome?
The increasing trade conflicts could therefore prompt Chinese companies to intensify their foreign direct investment in order to circumvent hurdles such as tariffs. This measure could be welcomed by some trading partners, since – in contrast to exports – direct investment creates jobs in the recipient countries and supports the transfer of know-how and the expansion of infrastructure. At the same time, this would also boost exports of Chinese intermediate products.
ASEAN1 was the main target for Chinese investment in 2022/2023, while Hungary was the main beneficiary in Europe, with 4.5% of Chinese foreign direct investment. However, Chinese investments are coming under increasing scrutiny from governments in industrialized countries – not least for reasons of national security. In Europe, scrutiny has intensified, but some countries such as Hungary, Poland and Italy continue to welcome such investments, particularly in the field of electric vehicles.
> Learn more by downloading our full study (pdf 2MB) available in this page
1The Association of Southeast Asian Nations (ASEAN) comprises 10 member states. Created by Indonesia, Malaysia, Singapore, Thailand and the Philippines in 1967, it was joined by Brunei (1984), Vietnam (1995), Laos and Burma (1997) and finally Cambodia (1999).
