More and More? Why Chinese Overcapacities are a Significant Challenge for the EU

In recent decades, China’s economy has been characterised by growth rates that are significantly higher than those of developed economies. The main driver of this dynamic growth has been investment activity, leading to high production capacities. If demand for Chinese goods declines, excess capacity is being – or could be – exported. This leads to price declines across global markets, which is good news for EU consumers.

But European companies that compete with Chinese suppliers are now under considerable pressure as a result. There is a risk that they will be squeezed out of the market. This could increase critical dependencies on Chinese suppliers, or create new ones, which would be contrary to the EU’s de-risking strategy.

China’s economic growth has been investment-driven

Annual rates of change in China’s real gross domestic product (GDP) since 1980 reveal that the country’s economy has grown significantly faster than developed industrialised nations, such as Germany, Japan and the US. Between 1980 and 2009, the average annual growth rate of China’s GDP was around 10 percent. This development is not unusual. It is often the case that the lower a country’s level of economic development – measured by real GDP per capita, for example – the higher the growth rates.

Nevertheless, China’s economic development is special. Growth is driven by extremely high levels of investment. This is particularly true over the past 25 years. Between 2000 and 2024, the share of investment in GDP averaged just above 42 percent. In Germany and the US, it is only 21 percent, in Japan, around 25.5 percent – and even in fast-growing South Korea, just below 32 percent.

Additionally, the high investment ratio can be attributed to the characteristics of the Chinese economic system, which the Chinese government officially describes as a “socialist market economy”. State intervention and political targets play central roles alongside market economy elements.

As a result, local cadres have considerable influence on regional economic structure and development. As high GDP growth rates are assumed to have been an important aspect in cadre promotion in the past, the incentives for local investment promotion were high, regardless of efficiency and profitability.

Another factor is the competition between the provinces for local champions and the development of production capacities in those industries that the central government gives special attention and support to in its plans, along with a systemic tendency to favor producers over consumers when it comes to state support.

This means that many companies do not face hard budget constraints or the risk of bankruptcy, which helps maintain local employment rates. Some loss-making companies may thus continue to exist and produce alongside profitable companies. This contributes to overcapacities in production that would not exist in a market economy.

The pandemic has amplified this problem. According to a study by Rhodium Group, the ratio of loss-making companies grew from about 10 percent in 2011 to more than 20 percent in 2023, of which five percentage points were added in the three-year-period between 2021 and 2023.

Domestic consumption lags behind with no improvement in sight

The high share of investment in GDP is offset by a correspondingly low share of domestic demand for consumer goods. And relatively low levels of consumption mean high savings. Consequently, China has an above-average savings rate by international standards.

The International Monetary Fund estimates that China’s overall economic savings will account for almost 44 percent of GDP in 2024. This is significantly higher than in South Korea (around 34 percent), Japan and Germany (just under 30 percent) and the US (just under 17 percent).

There are systemic and social reasons for the low consumption rate and associated high savings. China has inadequate social systems. Illnesses, incapacity to work and pensions must essentially be covered privately, especially in rural areas. This requires reserves. Additionally, many families save for the education of their only child – or two children, if they had a second child after the one-child policy ended in 2016.

Purchasing a family property – or additional property for one or two children – has been another reason for high savings. A real estate sector in permanent crisis has led to private households’ equity being eroded by falling house prices, or even lost when houses are bought but never built. This has a negative impact on consumption and is one reason why China has been facing deflation since July 2023.

High investment, low consumption and policy priorities drive overcapacities

If investment flows into capital goods, this expands overall economic production capacities that can be utilised over many years. Sensible use of existing production capacities presupposes there is solvent demand for goods produced. However, this is likely to become increasingly difficult for China because of its substantial structural problems.

The results of the March 2024 National People’s Congress indicate the systemic preference for giving state support to producers over consumers will continue or even increase. This means we can expect to see increasing overcapacities that require buyers outside the domestic market. This especially holds for the so-called ‘new three’ – electric vehicles (EVs), lithium batteries and solar products, all of which will attract state support.

These represent China’s new focus on high quality goods for production and export, replacing furniture, clothes and consumer electronics as the main drivers of the export market.  EVs, lithium batteries and solar products represent a move away from non-strategic non-critical goods to strategic high-tech products that are critical to achieve important policy goals, such as carbon neutrality.

To manage potentially increasing overcapacities, exports are an essential solution for Chinese companies. This is in line with Beijing’s dual circulation strategy, part of which is to make the world more dependent on Chinese products.

But a high supply of Chinese goods can lead to a supply surplus on the global market now or in future, making demand for China’s exports lower than supply. If China still wants to sell its products, it can only do so below the market price.

Dependency on China and growing security risks

If Chinese state-induced overcapacities – and the resulting glut of exports – lead to decreasing prices on the world market, it would appear to be a good thing for consumers keen for bargains. This increases consumption opportunities, but from the perspective of companies outside China, this leads to market distortions and unfair competition.

In the long term, this can lead to serious problems for companies struggling to compete with China. If Chinese companies permanently offer products below market price, they can drive other companies – including European companies – out of the market. And once these companies have disappeared, Chinese companies have market power they can use to the detriment of European consumers.

This would increase economic dependency on China, which the EU’s de-risking strategy aims to reduce. The EU and Germany would become more susceptible to economic coercion if strategic and critical dependency on China increased in regard to the supply of key goods and inputs goods that are difficult to be replaced through suppliers from other countries.

Is such a scenario just grey theory or is this the reality faced by countries struggling to compete with China? The latter possibility can be illustrated by the example of gallium. Gallium is an industrial metal primarily used in the production of semiconductors.

In 2011, Germany was still the world’s largest producer of gallium with a market share of 49 percent, followed by Kazakhstan (26 percent) and Russia (18 percent). But the EU now sources almost 70 percent of its gallium requirements from China. Only two percent still comes from the EU.

How did this development come about? Between 2008 and 2011, the price of a kilogram of gallium fluctuated relatively strongly between USD 500 and USD 1,000. China’s gallium production was less than 100 tons per year until 2009. It then rose rapidly, reaching a volume of 600 tons in 2015 and 2016.

This corresponded to just over 80 percent of global gallium production. The consequence of this increase in supply was a drop in price, from just under USD 1,000 in 2011 to less than USD 200 from 2016 to 2018. At this low price, which was also due to Chinese subsidies, German gallium production was no longer competitive.

In addition to the economic risks, dependency on Chinese imports might bring serious security risks. Data gathering and security regarding EVs is one prominent example. The smarter EVs become, the more this becomes a security issue that cannot be neglected.

For example, at the beginning of 2024, China temporarily banned Tesla EVs from the surroundings of government and military compounds. The ban was only removed, after Tesla ‘won an endorsement from the country’s top auto industry association that said in April the data collection by Tesla fleets in China was compliant’, along with Tesla CEO Elon Musk meeting Premier Li Qiang in April in Beijing.

This move – be it geopolitically or security-motivated – should alert the EU and its member states to consider security-related aspects of seemingly harmless Chinese consumer goods more closely and not to focus solely on economic aspects.

What should the EU do?

Being a free trade bloc by nature, the EU has always tried to take measured responses to disputes on market distortions and unfair competition. The bloc’ measures tend to follow the two golden rules of being country-agnostic and compatible with WTO rules.

Against this backdrop, it would be desirable from the EU’s perspective to address the problems of state-induced overcapacities through talks with China. Trying to find negotiated sectoral case-by-case solutions would be a constructive approach.

Given the current state of EU-China relations, incentivising China to talk on eye-level will likely require more frequent anti-subsidies and anti-dumping probes, following the example of EVs and other products. But the outcome of such talks is highly uncertain and EU investigations could trigger Chinese retaliation.

This has already happened with China reacting to the EU imposing provisional countervailing duties on EVs imported from China: in what is assumed to be a direct reaction, China launched an anti-subsidy probe into a number of EU dairy products.

In the short term, countervailing duties as a possible result from an investigation might still cushion some negative effects caused by state-induced overcapacities. But the roots of the problem will remain, as China’s overcapacities are largely systemic by nature.

Looking ahead, the Chinese government might do even less than in the past to reduce those overcapacities that raise red flags with trade partners. Even though the National People’s Congress’ March 2024 report cited preventing overcapacities as a goal, the Chinese Ministry of Foreign Affairs has started to refer to this as a “false narrative” by the US and the West. If this was the official Beijing position in talks with the EU on overcapacities, it would probably cut a long story short, as the Chinese delegation would be in denial about the very reason for such a negotiation.

Protecting against unfair competition resulting from overcapacities now and in future will remain a significant challenge for the EU. Making full and smart use of the newly overhauled trade defense toolbox will be vital.

This would include considering the scope of the forced labour regulation, when it is applied from 2027 by member states, as well as giving more scope to meet ESG criteria in supply chains for imports. At the same time, the EU must continue looking for further gaps in its toolbox, where existing instruments are not effective, especially regarding potential security risks of imported goods.

As ongoing Chinese state-induced overcapacities are not solely a challenge for the EU or the political West, it makes sense to work with partners, including from the Global South, to address this issue systematically and potentially develop a common response. Analogous to the much discussed Climate Club, a “coalition of the active” to defend against market-distorting behaviour could form the basis of an international trade defence club.

About the authors

Cora Jungbluth is Senior Expert in the Europe’s Future Programme at the Bertelsmann Stiftung. Her research focus is on China, foreign direct investment and international trade, especially the role of emerging economies.

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specialising in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises as well as the chances and risks of globalisation. Most recently, he worked on the effects of carbon pricing and the benefits of a potential global climate club.