What Xi Jinping gets wrong about China’s economy

The EU is no stranger to overcapacity. Its economic landscape once featured butter mountains, milk lakes and other landmarks of excess production—the surreal results of its common agricultural policy, which guaranteed high prices to dairy farmers. Thus the president of the European Commission, Ursula von der Leyen, knew what she was talking about when she warned Xi Jinping, China’s ruler, about his country’s “structural overcapacities” at a recent meeting in Paris.

Her concern was not farming but manufacturing. Europe is worried about a flood of electric vehicles and steel from China, which could displace cherished industries and jobs in the union. China’s steel exports, measured in tonnes, increased by more than 28% in the first three months of this year, compared with a year earlier. Its exports of new-energy vehicles increased by almost 24%. In response, the EU is considering “countervailing” tariffs to offset the subsidies that have assisted the growth of China’s industry.

Mr Xi is also familiar with Chinese overcapacity. In his first term, his main economic policy was supply-side structural reform. In 2016 the state cut coal capacity by 290m tonnes and steel capacity by over 60m. China removed more capacity in these industries than most countries have ever possessed. But in Paris, Mr Xi rejected Europe’s concerns, at least in the new-energy industry: “The so-called ‘problem of China’s overcapacity’ does not exist, either from the perspective of comparative advantage or in light of global demand.”

Who is right? China’s problem is not always as easy to spot as Europe’s mountains and lakes. “Capacity” sounds like a technical term, which might be measured in tonnes or cubic metres. But it is rarely economical to run a plant at its full technical limits. Moreover, in a rapidly growing economy that is evolving quickly, existing capacity can become obsolete or overwhelmed faster than in a mature economy, as Dianqing Xu of Huron University College and Ying Liu of Dongbei University of Finance and Economics have argued.

Theorists have tried to define full capacity as a level of production high enough to defray the fixed costs of a plant and low enough to prevent costly strain on men and materials. But in practice, economists measure capacity by asking managers. Surveys in China show “capacity utilisation” fell to low levels in the first quarter of this year, about two percentage points below the pre-pandemic average. Utilisation was lower only when covid-19 first struck and in 2016, when Mr Xi introduced his supply-side surgery. From the perspective of this official statistic, China’s overcapacity exists, whatever the country’s president says.

It may even be understated. Take the steel industry. At 77%, its utilisation level is close to the average since 2016, seemingly belying Europe’s concerns. But that level masks falling prices and profits. An industry can use a lot of capacity if it is willing to sell its wares at ruinous prices.

Measures of capacity utilisation can also miss the role of subsidies. China’s support for its electric-vehicle industry included clever inducements to demand, such as reduced parking fees and free licence plates. Buyers are still able to benefit from a tax break worth up to 30,000 yuan ($4,100). Other subsidies were not directed at consumers, but could be passed on to them through lower prices. Together, they increased demand as well as supply, bolstering capacity utilisation and profits.

China’s purchases of conventional cars, powered by internal-combustion engines, used to soak up almost all domestic production. Owing to the success of electric vehicles, that is no longer the case, meaning subsidies in one area have contributed to excess capacity in another. Conventional carmakers, many of them including joint ventures with foreign firms, have therefore turned to customers abroad. The surge in exports of conventional cars dwarfs the electric vehicles Mrs von der Leyen singled out for concern (see chart).

Mr Xi could argue that some subsidies are warranted on environmental grounds. China, a middle-income country, is dipping into its pockets in order to subsidise products that will benefit everyone. And there is no good economic reason why China should limit production of these goods to the scale of its domestic demand. According to the principle of comparative advantage, it should concentrate on its strengths, becoming a net exporter of such products. Its capacity should thus be judged relative to global demand. Even in this light, however, China’s plans look ambitious. If they are fulfilled, then by the end of next year, China will make more than enough lithium-ion batteries to meet global demand three times over, according to BloombergNEF, a research firm.

Why is China so prone to overcapacity? The problem is often attributed to central-government diktats. But China’s worst excesses are not a result of classic central planning, which could at least keep a lid on output. They instead reflect the combination of central directives and competition between local governments to fulfil them. China’s attempts to cull capacity can also backfire. Firms know consolidation will favour the strong. That gives them added incentive to grow before the axe falls.

Likewise overcapacity is often most glaring not in sectors dominated by state-owned enterprises, such as telecoms or tobacco, where a small clutch of firms keep their output limited and their profits high. The problem is more serious in industries with a mixture of private and state-owned enterprises, as Zhou Qiren of Peking University once pointed out. In the face of private competition, state-owned enterprises lose custom but do not retreat or disappear. They linger under government protection. That keeps capacity higher than it otherwise would be.

The industries suffering most from overcapacity today are casualties of China’s ill-starred property sector, where private and state developers have long vied with each other. A collapse in property sales has left many neighbouring industries looking oversized. Adam Wolfe of Absolute Strategy Research cites the example of excavators. Until mid-2021, China bought most of the diggers it produced. But domestic sales have plunged, meaning China has abruptly emerged as the world’s biggest exporter of such equipment. Another case is cement, and similar materials, where capacity utilisation is down to 62%.

Could anything other than more supply-side reform ameliorate overcapacity? Even in China, the problem can be self-limiting. In property-adjacent industries, such as home appliances and steel, falling prices are both a consequence of overcapacity and a potential cure. Low prices are a signal to entrepreneurs and investors to steer resources towards other, more promising sectors. It was precisely Europe’s refusal to let dairy prices fall that perpetuated its butter mountains and milk lakes.

But in China price declines have been more widespread. Producer-price inflation has been negative for 18 months in a row. The GDP deflator, a broad measure of prices, has declined year on year for four consecutive quarters. When prices fall in an industry, it can be a sign that supply is excessive. When prices fall across an economy, it usually means demand is deficient, because confidence is low and macroeconomic policy too tight.

At her meeting with China’s president, Mrs von der Leyen also complained, entirely reasonably, about the country’s weak demand. If consumer confidence were higher or its budget deficit bigger, China’s capacity utilisation would be healthier, regardless of subsidies. In such a world, Mr Xi would spend less time under fire from Europe’s leaders, and more time enjoying the continent’s mountains and lakes.

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