Chinese government and overcapacity: historical patterns, current context, and response strategies

Gao Shanwen, Chief Economist at SDIC Securities, says overcapacity, inevitable in the development of any large-scale emerging industry, is not favored by the Chinese government.

Gao Shanwen, Chief Economist at SDIC Securities Co., Ltd. (formerly Anxin Securities), delivered the following speech at the seminar "Understanding and Resolving the Issue of Overcapacity," organized by the China Finance 40 Forum (CF40), a Beijing-based think tank focused on macroeconomics and financial policies. The original Chinese text is available on CF40's official WeChat blog.

Gao and CF40 have graciously given us permission to translate and publish the speech. —Yuxuan Jia

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“产能过剩”问题观察： 历史规律、现实背景与应对策略

Observations on the Issue of Overcapacity: Historical Patterns, Current Context, and Response Strategies

I. Overcapacity is an Unavoidable Phase in the Development of Emerging Industries.

In the development of any large-scale emerging industry with foreseeable future demands, severe overcapacity is almost inevitable due to market dynamics. This is because nobody can predict the level of demand the industry will eventually settle on, hence perpetual trial and error.

The trial-and-error phase will never result in continuous insufficient capacity, as price hikes and profit expansions from undercapacity make this state unsustainable. Conversely, severe overcapacity often leads to a belief that the surplus is temporary and future demand growth will absorb the excess. The market will not realize the true level of stable demand until anticipated demand growth repeatedly fails to materialize, by which time the industry is already entrenched in overcapacity.

Thus, emerging industries must endure a painful but inevitable phase of overcapacity and subsequent capacity reduction. Only after this phase can the industry mature, stabilize, and enable companies to achieve profitability and provide sustainable dividends to shareholders.

Even in the United States, which claims minimal government intervention and full reliance on market forces, industries such as railroads, automobiles, telecommunications, and computers have faced similar overcapacity issues, demonstrating the universality of this phenomenon.

II. Historical Evidence Shows that the Chinese Government Does Not Favor Overcapacity.

Some critics argue that overcapacity in China is a result of the country's industrial policies and government subsidies, but this perspective is a misunderstanding.

In the late 1990s, following rapid expansion throughout the 1980s, China's textile industry experienced severe overcapacity. Market mechanisms for natural selection and exit were not functioning smoothly, forcing the government to implement large-scale administrative measures to reduce excess capacity, known as the "spindle reduction campaign." Since the 21st century, China's textile industry has not faced severe overcapacity again and has become relatively stable and globally competitive with limited growth.

In 2016, China launched the policy to "三去一降一补 cut overcapacity, reduce excess inventory, deleverage, lower costs, and strengthen areas of weakness." The “overcapacity” component targeted excess capacity in industries like steel, cement, and coal. Between 2017 and 2019, despite limited overall economic growth, the prices and profitability of these industries significantly recovered. These examples indicate that the Chinese government does not favor overcapacity but is compelled to resort to strong administrative measures to reduce it due to inefficient market competition and exit mechanisms.

Other sectors, such as home appliances and baijiu (Chinese liquor), have also experienced significant overcapacity and transitioned to market-driven clearance, which cannot be attributed to government subsidies.

As mentioned earlier, severe overcapacity followed by long-term market-driven survival of the fittest is a natural development model for emerging industries. However, the role of local government incentives in exacerbating overcapacity remains contentious.

From a micro perspective, the issue is clear: local governments swarming to provide cheap land, credit support, and various subsidies to relevant enterprises naturally leads to more new capacity and worsening overcapacity.

From a macro perspective, however, the situation is more complex. In an open economy, the increased competitiveness to an industry, driven by local government subsidies, would result in more exports, leading to stronger pressure for RMB appreciation. Currency appreciation would counteract the effects of government subsidies, discriminating against industries that did not receive subsidies and weakening their competitiveness. Thus, competitive advantages in some industries develop simultaneously with disadvantages in others.

While fiscal subsidies might increase the competitiveness of specific industries at a micro level, whether they can systematically enhance a country's overall competitiveness at a macro level remains doubtful. Theoretically, the competitiveness boost and surplus expansion from subsidies would be offset by currency appreciation. This means trade surpluses might not change in equilibrium, and overall, competitiveness in other countries might not be harmed.

From the perspective of trade partners, although their competitiveness in subsidized industries might weaken, their competitiveness in non-subsidized industries might strengthen, resulting in no overall loss. Therefore, the macro effects of government subsidies are not clear-cut under a floating exchange rate system.

III. From the American Perspective, the Root Cause of the Current Overcapacity Dispute Lies in the Impact of Chinese Export Competition on U.S. Income Distribution.

The late 1970s and early 1980s saw neoliberalism dominate U.S. economic policy, emphasizing laissez-faire, free trade, and deregulation. With the end of the Cold War and China's reform and opening up, this neoliberal wave accelerated global economic integration, leading to unprecedented economic prosperity.

However, the 2008 global financial crisis and subsequent geopolitical and economic changes, including China's rise, resulted in the decline of neoliberalism. Issues neglected by neoliberalism, such as income distribution, security concerns, and social equity, have become key policy topics. This context is essential for understanding current debates on overcapacity.

Neoliberal economic policies theoretically aim for Pareto optimality. Proponents like Milton Friedman and Friedrich Hayek rarely addressed income distribution, believing laissez-faire policies would naturally achieve Pareto efficiency.

This assumption rests on one or more of the following:

• Income distribution issues are unimportant.

• The government can address the needs of those disadvantaged by economic growth through redistribution policies, thereby achieving a Pareto optimal distribution of economic gains from laissez-faire policies.

• A free-market economy, through the unrestricted movement of labor, capital, and land, can reallocate resources efficiently, quickly mitigating pressures on disadvantaged groups.

In reality, these assumptions may not hold. If China were a small economy like Singapore, the impact on the U.S. would be minor, affecting only a few thousand workers' jobs or income levels, which the large U.S. economy could easily absorb without significant political repercussions.

However, China is a massive economy, and its enormous export competition has created strong political opposition from affected U.S. groups. Meanwhile, beneficiaries of China's rise, such as Wall Street, multinational corporations, and ordinary consumers, are either too dispersed or politically marginalized to counterbalance this opposition. This dynamic is an important backdrop to the U.S.-China trade disputes.

Some American scholars argue that China's accession to the WTO caused the first "China shock," leading to the collapse of many Rust Belt communities and immense social distress. While the rapid decline of the Rust Belt cannot be solely attributable to the China shock, it remains the most politically exploitable cause.

Currently, after years of dormancy and effort, Chinese industries such as new energy vehicles have gained significant competitive advantages over the U.S. and other major Western countries. The U.S. political and business sectors fear this may constitute a second China shock, much more severe in scale and intensity than the first.

Moreover, even if the government manages the resultant unemployment, the U.S. cannot accept the disappearance of its major auto companies in Detroit due to the significant impact on patriotic sentiment.

IV. The Adjustment of China's Real Estate Market and the Lingering Effect of the Pandemic Have Led to a Significant Expansion of Trade Surpluses, Forming the Cyclical Context for the Current Overcapacity Dispute.

Analyzing the aggregate data on the Chinese economy reveals two key conclusions:

First, when excluding the impact of price factors, China's current manufacturing trade surplus as a percentage of GDP has surpassed the levels seen in 2007-2008, reaching a historical high.

Second, this significant trade surplus is primarily due to major adjustments in China's real estate market, which created a gap in domestic demand. To fill this gap, China turned to international markets, resulting in a substantial expansion of its trade surplus. Additionally, the lingering effects of the pandemic have weakened domestic demand further, increasing reliance on foreign markets.

This significant adjustment in China's trade surplus has exerted competitive pressure on the manufacturing sectors of other countries, forming the cyclical context for the current overcapacity dispute.

V. Recommendations for Response Strategies

It is important to recognize that the continuation of protectionist policies implemented by the United States such as tariffs will not result in a robust domestic manufacturing sector. Instead, these policies will protect inefficient industries and increase the burden on consumers, making the situation unsustainable in the long term.

In reality, apart from the aim of decoupling the U.S. economy from China, U.S. protectionist policies like tariffs are primarily intended to buy time for the adjustment and catch-up of key domestic industries such as the automobile sector. For the U.S., this remains a process fraught with uncertainty and significant challenges.

Regarding China's strategies to address overcapacity disputes:

First, strategically, China should unwaveringly shift towards expanding domestic demand, with a particular focus on increasing domestic consumption to drive economic growth.

Second, efforts should be made to maintain stable aggregate demand, smooth out economic fluctuations, maintain exchange rate flexibility, and ensure international coordination and communication of macroeconomic policies.

Third, when emerging industries achieve competitive advantages, China should promptly phase out related supportive industrial policies. This includes guiding the internationalization of industry supply chains, production, and sales systems to enhance resilience against trade frictions and promoting the timely market-based elimination of inefficient capacity.

Finally, China should strive to uphold a rules-based international trade system centered around the WTO, continue to advocate for and promote free trade, maintain restraint and rationality, and address trade disputes through agreed-upon dispute resolution mechanisms.