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LU Feng: The Characteristics of the New Wave of Overcapacity and Its International Impact


China's Government Work Report, released in March, recognizes the economic progress made in 2023 but underscores several challenges, including " overcapacity in some industries" and "China’s external environment (has become) more complex, severe, and uncertain". Similar expressions also appeared in the Central Economic Work Conference held at the end of 2023, demonstrating the leadership's acute focus on these issues.

Overcapacity is not a new issue in China. The country grappled with widespread overcapacity back in the late 1990s due to intensified economic transition. This issue continued in the early 21st century, well into 2015 with the introduction of the "Three Cuts, One Lower, and One Strengthen" (otherwise known as the supply-side structural reform), which refers to "cutting excess capacity, reducing excess inventory, deleveraging, lowering costs, and strengthening areas of weakness", persisting for more than a decade. Various sectors have intermittently faced overcapacity issues, prompting targeted interventions by relevant authorities.

However, this old issue has taken on new dimensions: Currently, overcapacity has a range of new characteristics in terms of sectoral distribution and underlying mechanisms. As China's role in the global economy becomes more pronounced, domestic overcapacity and transnational, global overcapacity are increasingly interlinked. Especially against the backdrop of major power competition and the evolving dynamics of geo-economic relations, the interaction between domestic overcapacity and the external economic and trade environment has begun to reveal, and will continue to unearth, a range of novel contradictions and challenges. It necessitates a recalibrated approach to analyze and address this new phase of overcapacity.

Five sectors may be affected by risks of the new wave of overcapacity

"Overcapacity" refers to the situation where the existing production capacity of a specific industry exceeds both demand and reasonable output levels. While any industry can experience overcapacity, discussions typically focus on the industrial sector, particularly manufacturing. These sectors, during initial design, typically define their production capacities with clear technical parameters, enabling straightforward comparisons to actual demand and output levels, which facilitates the evaluation of capacity. Due to the high tradability of industrial goods, especially manufactured products, overcapacity in major economies can impact the external economic and trade environment through trade imbalances, thereby linking domestic and international dynamics.

Top-level documents, such as the Government Work Report, have not specified which sectors are facing overcapacity. An analysis of overcapacity necessitates an initial, precise clarification of the facts. However, accurately pinpointing which industries suffer from overcapacity can be challenging. Now, through the collection and observation of industry data, analyses from industry insiders, and relevant media reports, I shall focus on a preliminary discussion of the overcapacity pressures or risks in several sectors.

I. Petrochemical raw materials such as ethylene

Historically, China's petrochemical industry was underdeveloped. Given the country's extensive manufacturing sector and the resulting high demand for petrochemical raw materials, China has traditionally been heavily reliant on imports. However, in recent years, especially since the implementation of the 13th Five-Year Plan (2016-2020) which involved a surge in major chemical projects, there has been a rapid expansion of the supply of petrochemical raw materials, far exceeding the growth in demand. This shift has notably altered the supply and demand equilibrium and is likely leading to overcapacity pressures. Furthermore, signs and risks of global overcapacity in this sector are also starting to surface.

II. The automobile industry, particularly traditional gasoline-powered cars

Since the beginning of the 21st century, China's automobile industry has witnessed rapid expansion. Yet, in recent years, the pace of capacity expansion has vastly exceeded the growth in demand, particularly for traditional gasoline-powered cars, which, against the backdrop of the green transition, are increasingly replaced by an explosive growth in demand for new energy vehicles. Consequently, the automobile industry has come under substantial overcapacity pressures and witnessed low overall capacity utilization rates in recent years. Recurring drops in car prices in China also reflect the issue of overcapacity.

III. The power battery industry

China has attained a world-class level in power battery technology and industrialization, with six of the top ten global power battery companies headquartered in the country, exemplifying its global leadership in this cutting-edge sector. Despite this success, the rapid pace of development has resulted in significant overcapacity. Reports indicate that the industry's capacity utilization rate is below 50%, with recent price declines and a slowdown in revenue and profit growth.

IV. Certain mature and traditional chips

Chip design and manufacturing are extremely complex and representative of modern high-tech industries. The surge in Artificial Intelligence is expected to continually drive the chip industry forward, particularly fueling the demand for, and occasionally leading to shortages of, cutting-edge chips. It is likely that semiconductor sector as a whole will enjoy promising market development for many years to come.

However, the non-cutting-edge and low-end segments of chips has begun to face risks of excess supply. At the end of 2023, China Electronics News reported that the global chip shortage in 2021 spurred unprecedented investment, leading to overcapacity pressures in the following years as chip demand growth failed to keep up with capacity increases. Mature process wafer foundries in China are even struggling to maintain a capacity utilization rate of 60%.

V. The new energy vehicle (NEV) industry

Opinions within the NEV industry vary on the potential for capacity to exceed demand. The mainstream opinion in the industry considers that the sector remains in a development phase, far from facing oversupply. Two important considerations support the relatively optimistic assessment above: EVs are rapidly becoming substitutes for traditional petrol vehicles so there is a large pool of market demand from which EVs may be utilized to some extent. On the other hand, EVs represent the trend of green transition and China’s firms now assume industrial lead right now, so the potential of the international market is substantial.

However, even the Ministry of Industry and Information Technology of China has highlighted issues in the EV industry, such as disorderly competition, hasty local project development without adequate planning, and redundant construction—factors that have historically been precursors to overcapacity. If supply grows faster than demand, the over-supply is still possible. Actually, there are calls within the industry urging vigilance over the risks of overcapacity. Recently, a significant slowdown in NEV sales growth and a noticeable drop in sale prices have indicated that this emerging sector also needs to be wary of the risks associated with supply exceeding demand.

It should be noted that the demand for chips, NEVs, and power batteries continues to grow rapidly, especially as NEVs and batteries - their core components - are part of emerging, technologically advanced industries. Their demand growth benefits from a special advantage in substituting the existing stock of gasoline-powered cars, promising even greater potential for future growth. Therefore, assessing whether supply capacity in these industries exceeds demand requires careful consideration of these characteristics. For instance, increased production due to economies of scale may lessen the impact of early innovation monopolies, potentially leading to price reductions. On the other hand, intensified market competition could also result in price drops. Furthermore, frequent technological updates or the phasing out of existing capacities might influence what constitutes reasonable capacity utilization. Nonetheless, even for emerging industries, if capacity expansion consistently outpaces demand, the risk of overcapacity in growth-oriented sectors still cannot be dismissed.

Other traditional industrial sectors are not without their overcapacity problems. Industries like steel and home appliances are still dealing with years-long problems of demand deficiency with the potential pressure of excess capacity, but as these sectors have passed their rapid development phase and the market has largely stabilized, the pressure of overcapacity no longer attracts widespread attention and discussion. Sectors such as photovoltaics and polycrystalline silicon have also faced overcapacity challenges in the past, which were mitigated through market and policy adjustments, including international trade disputes. However, with the advent of new business conditions, excess supply risks in these areas have resurfaced in recent years. The shipbuilding industry in China, which saw commendable growth in spite of the pandemic-induced economic slump, may also face oversupply challenges as global demand begins to plateau.

Characteristics of the New Wave of Overcapacity

I. Overcapacity pressures and risks have extended to mid- and high-end and even emerging industries.

Unlike the traditional focus of discussions on overcapacity – textile and home appliance industries, for example, the sectors discussed above that are currently experiencing excess supply or risks of overcapacity are characterized by their high technological and capital intensity. These sectors predominantly belong to the mid- and high-end industries, some even within the realm of the emerging and cutting-edge industries, shifting away from low-end supplies. This challenges the earlier presumption that overcapacity primarily affects lower-tech industries. Even mid- and high-end industries, as well as emerging industries, may also face oversupply and overcapacity if investments and supply capabilities grow faster than demand persistently.

II. The significance of industries and products facing excess supply or risks of overcapacity has increased.

The sectors in the new wave of overcapacity are large in scale, typically involving markets worth hundreds of billions of dollars, with some, like the automobile industry, even exceeding a trillion dollars. The impact of any subsequent adjustments due to overcapacity in these sectors would be profound. Additionally, certain industries, such as automobiles, petrochemical raw materials, and chips, have traditionally been pillars of developed economies with strong international competitiveness. They occupy critical roles within their economic frameworks and employment landscapes. Overcapacity in these industries could provoke more sensitive and complex reactions in these countries than in previous instances.

III. The overproduced products are highly tradeable and exhibit global characteristics.

Earlier overcapacity industries such as cement, coke, and calcium carbide are less tradeable. However, outputs from sectors experiencing the new wave of overcapacity generally have a higher value per unit of physical quantity. This characteristic binds them more closely to international trade within an open business environment. Consequently, overcapacity in these areas can significantly influence international economic and trade relations, potentially challenging the existing international economic rules and order. Moreover, industries such as automobiles and semiconductors, characterized by modular production methods and a high degree of internationalized division of labor, are the most typical sectors with wide-reaching global supply chains. Overcapacity in these sectors can cause more complex transnational or global repercussions through disruptions in supply chain networks.

Causes of the New Wave of Overcapacity

The root causes of the new wave of overcapacity exhibit characteristics different from those of earlier instances.

I. The surge in investment, triggered by shortages of certain goods during the pandemic, is a distinct cause for the new wave of overcapacity.

The pandemic's asymmetric impact on supply and demand led to temporary shortages of some goods in many countries. This was particularly pronounced in the US and Europe, where unprecedented macroeconomic policy stimuli inflated demand amidst severe inflation, sparking widespread global investment. Taking the capital formation of the global semiconductor industry as an example, data from shows that the average annual investment in the global semiconductor sector from 2020 to 2023 reached $148 billion, approximately two and a half times the average of $59 billion per year over the previous two decades. The sharp increase in investment, prompted by the pandemic's unique circumstances, has translated into an abnormal growth in capacity. When market demand cannot match such swift growth, it inevitably results in overcapacity.

II. China's accelerating industrial upgrade in recent years, coupled with capacity expansion, also has a role to play.

Driven by industrial upgrading, incentives to innovate, and a surge in external demand during the pandemic, China's manufacturing sector has seen accelerated upgrades and capacity expansion, highlighting the long-term achievements of China's economic catch-up.

However, a combination of factors has led to weak domestic demand growth, resulting in a scenario of "strong supply, weak demand" that hinders the full utilization of domestic capacity. This, coupled with the pandemic-induced surge in external demand, has prompted a swift enlargement of China's trade surplus in industrial goods, serving as a background condition for the new wave of excess capacity.

For instance, in recent years, China has markedly increased its investments in the semiconductor industry, growing at rates that far exceed those of other regions. Additionally, significant investments have been made in large-scale chemical projects, significantly increasing China's share of global petrochemical raw material capacity. Over the past three years, China's growing average annual trade surplus in industrial goods has exceeded $1.6 trillion, nearly double the average of $860 billion from 2010-2019. In the last two years, the trade surplus in industrial goods accounted for more than 30% of the total value added of the domestic industry. Strong growth of investment capability in the more advanced sectors and competitiveness in the global market are encouraging achievements, but they may also present a new challenge in keeping a necessary balance between supply and demand.

III. The existing international mechanisms for spontaneous coordination of overcapacity have partially failed.

Modern global economic history has been shaped by phenomena like the international relocation and assimilation of industrial activities—illustrated through concepts such as the product life-cycle theory and the flying geese paradigm. This dynamic, in tandem with the evolution in international trade and outward investment, has naturally played a role in regulating and mitigating overcapacity.

Furthermore, in an open market context, industries showing clear signs of overcapacity would see a cautious reduction in investment and capacity expansion by businesses across different nations, driven by profit motives and the desire to avoid loss. This helps prevent global capacity from becoming imbalanced or spiraling out of control.

However, in recent years, with the backdrop of great power competition and the evolving geo-political and economic relations, both developed countries and emerging economies have expanded investment or sought import substitution in certain sectors deemed of special significance through industrial policies, leading to partial failure of the spontaneous coordination mechanisms previously in place. These developments have systematically heightened the risk of cross-border and worldwide overcapacity in certain industries and impose new challenges on the existing frameworks of international economic coordination, governance, and rules.

Impacts of the New Wave of Overcapacity

The new wave of overcapacity is poised to have multifaceted impacts on both the domestic and international economic landscapes. For example, diminishing capacity utilization rates and falling prices will compel domestic industries to merge and reorganize, thereby enhancing industrial concentration and maturity, and leading to a survival of the fittest. However, a retreat from peak price levels and investment intensity will exacerbate the imbalance between supply and demand in marginal activities.

Moreover, under the combination of decreasing efficiency gains, overcapacity, and a falling real exchange rate, companies in oversupplied sectors may further increase exports to alleviate pressure, which could have complex effects on external economic and trade relations, necessitating prudent and preemptive attention.

The primary concern is the United States and other Western countries emphasizing overcapacity issues in both bilateral and multilateral settings. For example, last summer, Gina Raimondo, the U.S. Secretary of Commerce, singled out China's substantial subsidies for chip investments, which she argued led to an oversupply in mature and legacy chips. Similarly, Janet Yellen, the U.S. Secretary of the Treasury, raised issues about China's overcapacity on multiple occasions last year, cautioning that "China is too large to export its way to growth, and its economic policy choices have far-reaching consequences." During a visit to China in early February of this year for discussions within the framework of the two nations' Economic Working Group, Jay Shambaugh, the Under Secretary for International Affairs at the U.S. Department of the Treasury, emphasized that China should not address overcapacity problems by engaging in dumping practices and warned that, should China attempt to ease domestic overcapacity with cheap exports, the United States and its allies would take responsive measures.

During the pandemic, the severe inflation in Western countries necessitated increased imports from China, leading to their relatively tolerant and neutral stance on China's growing trade surplus. However, as inflation began to ease and their domestic economic policies shifted toward maintaining growth and employment targets, the issue of trade imbalances with China has regained attention and is increasingly subject to intervention. Against this backdrop, overcapacity may emerge as a new topic in multilateral platforms such as the WTO and G20.

In October 2023, the EU initiated an anti-subsidy investigation into EU imports of battery electric vehicles (BEVs) from China, a move that could be replicated by other nations and expanded into other industries affected by overcapacity. In recent years, the United States has increasingly relied on unilateral mechanisms afforded by its domestic laws when initiating trade conflicts and may exploit issues of overcapacity and growing trade surpluses to provoke disputes.

Given that 2024 is an election year in the United States, it is likely that American politicians will adopt a tough stance on China to garner votes, focusing particularly on issues of overcapacity and trade imbalances. A minority of U.S. hardliners have long advocated for revoking China's Permanent Normal Trade Relations (PNTR) status. For example, at the end of 2023, the U.S. House Select Committee on the Strategic Competition Between the United States and the Chinese Communist Party released a special report titled "Reset, Prevent, Build: A Strategy to Win America's Economic Competition with the Chinese Communist Party," the first recommendation of which is "Aggressively counter the PRC’s economic and trade strategy and the harm it inflicts on the United States and the global economy," claiming that "granting the PRC PNTR did not lead to the benefits expected for the United States." This suggests that the issue of overcapacity risks being amplified by this group.

Suggested Policy Responses to the New Wave of Overcapacity

Considering the distinct characteristics of the new wave of overcapacity, it's imperative to adopt measures that are synchronized domestically and internationally. After years of development, China's industrial technology and production capabilities have achieved significant milestones, positioning a number of sectors at the global forefront. Yet, there is still a notable disparity compared to major developed nations, and some key sectors exhibit obvious supply shortages. This underscores the necessity for continuous investment in innovation and the cultivation of new productive forces. There is still a long way to go in upgrading China's industrial and technology systems and maintaining the momentum of catching up through developing innovative capacity.

Future investments aimed at expanding capacity must clearly define the roles of government and market, adhere to supply and demand principles within an open market economy framework, and prioritize the prevention of overcapacity while nurturing new productive forces. The Government Work Report in March states that "We will strengthen coordination, planning, and investment guidance for key sectors to prevent overcapacity and poor-quality, redundant development." In light of the present conditions, there is an urgent need to accelerate policy reforms to meet these requirements.

It is essential to adopt proactive macroeconomic and structural reform measures to stimulate domestic demand, correct the imbalance characterized by "strong supply and weak demand," and enhance domestic capacity utilization. China's State Council has recently released the "Action Plan for Promoting Large-Scale Renewal of Equipment and Trading-In of Consumer Goods." This initiative encourages the trading-in of durable consumer goods such as automobiles, home appliances, and furniture with newer models, aiming to boost consumption in related sectors, thereby mitigating the challenge of overcapacity. Furthermore, deepening reforms to refine and enhance medium- and long-term income distribution policies is crucial. This involves gradually raising the proportion of household income in the national income distribution structure, which will fundamentally increase consumer demand and effectively address the macro-level imbalance of "strong supply and weak demand" as well as the pressure of overcapacity in selected industries.

The new wave of overcapacity introduces new challenges for the transnational allocation of production factors. It's important to recognize that, in the era of globalization, it is a logical decision for a country's businesses to consider both domestic and international markets in their capacity planning and allocation. Securing a fair share of the international market through equitable competition is a fundamental right of Chinese enterprises in an open environment. We need to rightfully oppose protectionist measures implemented by trading partners under the guise of overcapacity. These measures violate international economic and trade norms, and China reserves the right to take reciprocal measures to safeguard the legitimate interests of its enterprises and the development of its domestic industry.

Efforts should also be made to address external economic and trade pressures. Beyond stimulating domestic demand and consumption, as previously mentioned, a package of measures should be implemented to stabilize the trend of a relatively weak real exchange rate in recent years. A gradual appreciation of the Renminbi will aid in the adjustment of trade imbalances. Considering that a significant majority of China's trade surplus is with economies like the U.S. and Europe, governmental purchases from these countries could be increased to alleviate imbalances.

The new wave of overcapacity may exacerbate strains on the international economic and trade framework. As an emerging major country, China can play a more proactive role in multilateral economic, trade, and financial institutions, as well as the G20, to foster a constructive global response to the new wave of overcapacity. Upholding international economic and trade rules and order is not only beneficial to the global economy but is particularly advantageous for emerging powers.