SUMMARY
- China’s leadership has not signaled the level of resolve necessary to tackle overcapacity at the macro level; in addition to stronger action forcing local governments to curb capacity growth, Beijing will also need to implement demand-side stimulus.
- At the same time, we are cautiously optimistic that a more decisive policy pivot on overcapacity will come in the next several quarters, driven by the urgency of the problem; industrial weakness will pose a growing threat to the financial system, forcing the central government to act.
- Signposts of a more serious effort would include explicit references to overcapacity and concrete steps such as production cuts; the release of the 15th Five-Year Plan (2026–2030) in October/November and the Central Economic Work Conference in December may provide clearer signals as to whether policy is shifting.
Speculation that China’s central government will take more aggressive action to combat overcapacity and deflation has spiked since a high-level meeting on July 1. A meeting of the Central Financial and Economic Commission (CFEC), chaired by Xi, pledged to “govern low-price and disorderly competition among enterprises.” This has been followed by additional commentary in the state media and a Ministry of Industry and Information Technology meeting on solar industry.
Beijing’s level of concern over industrial “involution” – meant to describe industries engaged in self-destructive cycles of capacity expansion – is clearly rising, and this will be a key watchpoint in coming months.
However, we remain unconvinced that policy has reached a true inflection point. Addressing the overcapacity issue at the macro level, across industries, would require not only strong political will but also a broader shift in macroeconomic policy, including not only supply cuts but also more aggressive demand-side stimulus. We are growing cautiously optimistic that Beijing will be forced to make a more decisive pivot in 2026, leading to progress over the next 12 months. But that remains speculative for now, and we see little chance of significant progress in the next three months.
Concerted Action is Necessary
Any discussion of “involution” needs to acknowledge the core political economy issue. The political and economic support for companies to expand production, even at the expense of crushing profit margins, comes from local governments who rely on these firms for tax revenues and employment. Local officials support their hometown firms by leaning on local banks to extend loans and by arranging other forms of economic support.
The upshot is that any crackdown on overcapacity requires China’s leadership to exert aggressive top-down political pressure on local governments, and at times directly on firms and financial institutions.
With this backdrop, our skepticism regarding Beijing’s determination is based on the following three considerations:
First, recent developments suggest that consolidation efforts remain largely voluntary, with no indication of government-mandated cuts. Notably, just a month ago, Beijing abandoned a planned merger between two central state-owned automakers, Changan Auto and Dongfeng Auto — both of which have struggled in the transition to EVs. We view this as clear evidence that Beijing is not prepared to pursue consolidation through administrative means. If the government is unwilling to force consolidation among state-owned enterprises, it is even less likely to strongly push for consolidation among private firms—many of which dominate overcapacity sectors such as solar and batteries. This is a key difference with China’s successful capacity cuts in 2016-2017, which involved SOE-dominated sectors such as steel and coal.
Moreover, the scale of overcapacity is such that mergers and acquisitions alone are unlikely to suffice. For example, China’s polysilicon production capacity is more than twice global demand. Even if Beijing successfully engineered a merger, industry utilization would remain below 50%. Such sectors will need to see capacity reduction and market exit of struggling firms, a challenge for local governments and an undeveloped corporate bankruptcy system.
Second, we believe intense domestic competition and low prices are essential to Beijing’s overarching goal of making China a global manufacturing superpower. In other words, global market share matters more to Beijing than profits. As a result, we expect government intervention only when market competition begins to cause clearly damaging outcomes. One recent example is the government’s move to require automakers to pay suppliers within 90 days—a shift from previous norms where payments were often delayed more than 200 days, placing significant financial strain on suppliers and weakening their R&D capacity. In our view, such measures may limit further downside in overcapacity sectors but are unlikely to create meaningful upside.
Demand-side Support Missing
Third, the current weak macroeconomic backdrop is also unfavorable for resolving overcapacity. Only a combination of supply-side reform and stronger demand-side support would produce a meaningful reduction in overcapacity. However, as detailed in our recent H2 2025 outlook (link HERE], we are skeptical that Beijing is committed to aggressive stimulus in coming months. Thus far, the policy signals are consistent with the leadership continuing to focus more on controlling debt risk (meaning weak local government investment), rather than stimulating growth.
A weak economy also reduces Beijing’s willingness and ability to absorb the pain associated with aggressive supply-side cuts. These cuts would weigh on already-stretched local government finances, which are suffering from declining land sales revenue and mounting debt repayment burdens. As such, we believe a growth bottoming is a necessary precondition for any serious effort to tackle overcapacity.
Cautiously Optimistic about Future Steps
While our near-term expectations remain low, we see reasons to be more optimistic over the medium term (6–12 months). The necessary conditions for action are already in place: China has been in deflation for three years — the longest stretch since 1978 — with industrial sectors bearing the brunt. The risk that industrial distress evolves into broader banking stress is already elevated and rising. In our view, mounting debt risks are the most likely catalyst for more forceful action on overcapacity. We expect both exports and domestic demand to weaken further in the coming months, while sectors like solar and EVs face added pressure from expiring incentives. As a result, we believe Beijing may have little choice but to address overcapacity more decisively in the quarters ahead to mitigate financial risk.
So far, Beijing has focused primarily on mitigating the symptoms of overcapacity — such as price wars — which are, at best, temporary fixes. For more decisive action to materialize, we would need to see more explicit references to overcapacity and concrete steps such as production cuts. Two key events in the second half — the release of the 15th Five-Year Plan (2026–2030) in October/November and the Central Economic Work Conference in December — may provide clearer signals on whether Beijing intends to take overcapacity more seriously.
