Anti-globalists and China bulls fiercely resist the idea that China can do much of any wrong. And China is certainly better led that the US and has had a simply extraordinary economic run. However, China’s leaders, from Xi Jinpeng on down, are admitting to something they had fiercely denied was happening: that China’s answer to shifting its growth model away from exports to more dependence on investment, has hit its limits and is generating what in the US was once called “ruinous competition.”
One sign has been deflationary tendencies, as confirmed by Chinese investors, as we warned in January in China’s Government Bond Market Sounding Loud Deflationary Alarm. Is the Japanification China Has Warded Off Finally Arriving?. There we also explained long form why deflation is more destructive than inflation.
We explained earlier this month that the Chinese government was not only admitting to an overinvestment/overcapacity problem, but also moving to implement policies to address it. To give a sense of the magnitude:
China producer price deflation intensifies. Now -3.6% YoY. No economist forecast that.
The message for the rest of the world is clear. pic.twitter.com/3OUZ0LTNC8— PPG (@PPGMacro) July 9, 2025
China is bumping up against the “impossible trinity.” By choosing not to devalue in response to US tariffs, it also can’t ease monetary policy to counter rising deflationary pressure. China has tied its hands. Not devaluing means it chooses deflation…https://t.co/syJg8vmHpA pic.twitter.com/ukJBWHP4QH
— Robin Brooks (@robin_j_brooks) June 29, 2025
This is not the first time China had has to deal with deflationary pressures; China had a bout from 2012 to 2016 and did turn it around. But as we explained, it largely exhausted the easy measures.
One thing that may not be evident from articles in the last day or so on the Chinese economy is that senior party official, including Xi, just had a Politburo meeting at which they announced new policy measures, some of which had been prefigured in earlier statements. New official initiatives take some planning and packaging, so these new campaigns were already in the works. But immediately on the heels of their announcement was a fresh data report that suggested that the overcapacity issue may be even more severe than recognized when the anti-deflation program was devised. We’ll turn first to the new information, on factory activity, and then return to what the Chinese government intends to implement.
Let’s go first to the bare facts of the latest development, that of an unexpected fall in Chinese factory activity. It may not sound that bad on the surface, but we’ll peel the onion. From Bloomberg:
China’s factory activity unexpectedly deteriorated in July to a six-month low despite a tariff truce with the US, as early signs emerge that exports are slowing and weak domestic demand persists.
The official manufacturing purchasing managers’ index (PMI) was 49.3, versus 49.7 in June, said the National Bureau of Statistics (NBS) on July 31. The median estimate of economists surveyed by Bloomberg was 49.7. A reading below 50 indicates contraction…
The PMI figures are the first official data available each month to provide a snapshot of the health of the Chinese economy….
That came after the country registered a record trade surplus in the first half of the year on soaring shipments to southeast Asia and stabilizing exports to the US.
But China’s resilience is facing headwinds. Cargo throughput at the nation’s ports last week was the lowest in almost three months and dropped nearly 7% from the previous seven days, a sign trade may be starting to slow…
Weak consumption could intensify deflationary pressures. A recent survey by the central bank found that Chinese households became more pessimistic in the last quarter and their view of the jobs market fell to its worst ever. That has fanned fears of a slowdown in the second half of the year, even after a strong first six months of activity exceeded the official annual expansion target of about 5 per cent.
The lowest factory output level in six months, in the abstract, is a nothingburger. But this follows a period early in the year of US importers stockpiling goods, which was somewhat unwound in the later part of the second quarter, and gave a lift to US GDP reports. And then after the Liberation Day tariffs were announced, exports to Southeast Asia grew markedly. Keep in mind that despite all the noise about the trade deficit with the US, its deficit with ASEAN is even larger. Chinese exports to Southeast Asia similarly exceed those to the US or the EU. Admittedly, some of these exports are transshipments to the US, and analysts opined that a lot of the second-quarter surge to Southeast Asia was a simple effort at circumvention. But Thailand at least complained about China dumping products, so there appears to have been some channel stuffing too. Thailand has also criticized its Chinese factories as “zero dollar” operations, designed to provide as little as possible benefit to the host country and as much as possible to the Chinese owner/operator.
Admittedly, skirting trade rules can be hard to detect, but US tariff threats against Southeast Asian countries have led to tightening in procedures. How much of a difference they make in the long term remaind to be seen.
Nevertheless, the key point is that the continuing deterioration in factory activity came in a six months with a higher level of exports to the US and Southeast Asia than is likely to be sustained going forward.
Now let’s turn to the Politburo admissions that China indeed has a real overcapacity problem and what the government intends to do about it. From Reuters:
China’s top leaders have pledged to support an economy that is facing various risks, by managing what is viewed as disorderly competition and beefing up capacity cuts in key industries in the second half of the year.
The official news agency Xinhua said on Wednesday that leaders have signalled they will rein in price wars among producers, amid growing expectations that Beijing may be about to start a new round of factory capacity cuts in a long-awaited but challenging campaign against deflation….
Analysts said policymakers may feel less urgency to introduce new stimulus measures, as stronger than expected economic data and a continued tariff truce with Washington allow greater focus on supply-side measures to combat overcapacity and deflation.
On the same day [as the Politburo meeting], Xi held a symposium on the economy with prominent figures from outside the party, stressing the need for stability and calling for efforts to boost consumption and break free from destructive intra-industrial competition – reiterating the sentiments in the Politburo’s statement….
Action was urged [by the Politburo] to “regulate disorderly corporate competition in accordance with laws and regulations” and “advance capacity governance in key industries”, part of a broader push to combat neijuan – a term referring to cutthroat competition between firms that erodes profits and fuels deflationary pressure.
Local governments were also instructed to regulate their promotional activities for investment, prevent the accrual of new hidden debts and continue to clean up local government financing vehicles – hybrid public-private entities used to bypass borrowing limits.
Channel News Asia unpacked these developments in Why China is finally starting to acknowledge its overcapacity problem:
For years, Beijing dismissed Western concerns about Chinese overcapacity as protectionist rhetoric..
That narrative has now fundamentally shifted. In a remarkable policy U-turn, China has not only started acknowledging the overcapacity problem but is treating it as a national priority that requires urgent intervention….the clearest signal of this messaging transformation came through recently on China’s own policy channels.
In July, the Communist Party’s leading journal Qiushi warned that “disorderly competition has destroyed entire industry ecology”. This wasn’t diplomatic language about market dynamics – it was an admission that destructive competition had reached crisis proportions.
Around the same time, President Xi Jinping chaired a meeting of the Central Financial and Economic Affairs Commission, calling for “low-price competition to be regulated” and outdated production capacity to be “phased out in an orderly manner.” Weeks later, the State Council explicitly linked “irrational competition” to weak domestic economic circulation, naming high-profile sectors like new energy vehicles as targets for immediate oversight….
The shift reflects a sobering recognition that China’s industrial overcapacity has moved beyond an export problem to become a domestic economic threat.
The cost of some raw materials has reached historic lows due to supply chain deflation, yet factory prices are being cut even further as manufacturers engage in suicidal price wars. The result is unsustainable profit margins that are forcing many manufacturers to suspend operations entirely.
This deflationary spiral now threatens what Chinese leadership calls the “whole-chain manufacturing model” – the integrated production networks that Mr Xi recently reaffirmed as a national priority. When factories cannot operate profitably, the entire industrial ecosystem becomes vulnerable..
Importantly, China is not using the language of “overcapacity” that has dominated international criticism. Instead, Beijing frames the problem as “price wars” and “disorderly competition”.
This distinction matters because it allows Chinese policymakers to address the underlying issue while avoiding the admission that their industrial policy created systemic overproduction.
By focusing on pricing behaviour, China can position itself as promoting fair competition rather than acknowledging fundamental structural imbalances. This semantic shift enables policy action without losing face internationally or undermining confidence in China’s economic model.
However, the practical effect may be similar. Whether addressed as overcapacity or predatory pricing, the solution requires reducing output, consolidating industry players, and restoring sustainable profit margins across key sectors.
Note that a sector widely viewed as one of China’s stellar successes, electronic vehicles, is now a target for rationalization. A fresh story in OilPrice includes another one-time celebrated success, solar panels:
China’s undisputed leadership in electric vehicle sales and renewable energy expansion has come at a cost for numerous companies that have been running a race to the bottom in recent years.
The surge in EVs and solar and wind power installations has resulted in excessive manufacturing capacity in these key clean energy industries, igniting price wars that have hurt most companies in the cleantech sector, including the biggest solar panel manufacturers.
Chinese authorities realized last year that cutthroat competition, overcapacity, and low-quality manufacturing are hurting enterprises.
Overcapacity has been a persistent issue in China’s clean technology industries, undermining the profitability of solar panel and EV manufacturers….
The manufacturing boom and the competition for market share have prompted some Chinese manufacturers to sacrifice quality for the sake of higher profits. Companies are looking to survive in the race to the bottom in China’s solar component market, and some are skimping on quality and testing.
The Chinese solar panel market remains oversupplied, and this glut could last up to two more years, one of the top manufacturers, Longi Green Energy Technology, said last year….
In the EV market, “fierce competition among EV and battery manufacturers in China for state-based incentives has led to a sharp decline in EV and battery prices, helping scale deployment, but has led to massive overcapacity in batteries,” research firm Rhodium Group said in a report last month.
Today, China’s battery manufacturing capacity is two times the demand in China and 1.2 times global demand, according to Rhodium Group.
Going after high-fliers won’t be easy. As Channel News Asia adds:
But meaningful action faces significant obstacles. Local governments have strong incentives to protect regional champions, often offering subsidies to maintain employment and economic output. Provincial leaders compete to attract investment in priority sectors like artificial intelligence, electric vehicles and semiconductors – creating the very fragmentation that fuels destructive competition.
Recall that China had shifted its growth strategy away from housing as a significant driver to investment in high-tech industries. There’s still a deflationary overhang in property; even though prices are not too much out of line in Beijing and Shanghai, they are still reportedly elevated in most of the rest of the country. That continuing unwind will make it hard to get consumers to spend more, since the loss of wealth tends to lead households to save more to try to restore their finances.
In other words, rectifying this situation is a lot harder than it might seem. China may finally have run into Stein’s Law: “If Something Cannot Go on Forever, It Will Stop.“
