Rewiring Incentives: How China Can Avoid a New Excess Capacity Spiral

Lizzi C. Lee is a fellow on the Chinese economy at the Asia Society Policy Institute’s Center for China Analysis, where she leads the Center’s Economics and Technology Pillar. She co-leads the Center’s initiatives “The Art of Dealing with China,” which focuses on global MNCs’ China strategies, and “The Business of Being Well,” which examines the frontier of China’s health economy. She holds a PhD in Economics from MIT and has published extensively in Foreign Affairs, Financial Times, Nature, Foreign Policy, and Harvard Business Review. She is also a frequent commentator in international media, including Bloomberg, CNN, NPR, BBC, WSJ, and more.

When people talk about China’s “overcapacity,” what does that term get wrong, and what common misconceptions do you see US businesses and policymakers carrying into the conversation?

It’s a useful shorthand but a sloppy term. What is overcapacity, and when is it a problem? Producing more than your domestic market demand is not by itself evidence of economically harmful or inefficient overcapacity. Other manufacturing economies — Germany, Japan, South Korea — have built their industries around exports. In industries with excess capacity like solar panels and batteries, low-cost Chinese production has also dramatically lowered the cost of the global green transition. So, in many ways, demand catches up because of overproduction, especially if it can lower the cost of adoption. We need to keep that dynamic in mind.

Overcapacity is an issue when capacity is built beyond what we can reasonably expect after taking global demand into account. If you are producing more than the world can absorb in the near future, then there is inefficiency. Overcapacity is also harmful when supply exceeds what is sustainable under a reasonable revenue and cost structure. If you produce so much that you are selling below your cost, and if that’s the enduring model of your industry, then something is wrong. It’s even more serious when that problem flows to the international market, which explains a lot of tensions.

Normally, there’s bankruptcy — if you cannot sustain your business operations, you get washed out. What’s problematic is when local governments intervene to prevent that process, propping up zombie firms to preserve jobs and avoid the disruption of plant closures. Firms with no prospect of ever making their business model work are therefore surviving.

Another misperception is that Beijing is deliberately subsidizing its model of overcapacity to dump goods abroad. Are there inefficiencies when it comes to China’s industrial policy? Absolutely. But industrial policy, by and large, is not about dumping abroad. A lot of the sources of overcapacity are decentralized, which is hard for Beijing to control. If we compare this period of overcapacity with previous ones in traditional industries like steel and textiles, a key difference is that many of the bloated firms in those sectors were state-owned, so there was a centralized way to rein in the issue. But with EVs, solar, and batteries, you have a decentralized system involving the private sector, local governments, and state banks. Many of the firms cutting prices to compete fiercely against each other are private.

Beijing can provide guidance and impose punishment, but this is a much thornier issue to solve because it’s not a command-and-control problem. You need to rewire the incentives of multiple players across the system.

With oversupply now taking a life of its own among firms, what more should Beijing be doing beyond its anti-involution campaign? How does Beijing balance fostering private-sector growth while curbing these price wars?

Over the past two years, the anti-involution campaign has moved beyond rhetoric. Regulators have issued price guidance for the auto industry and rules requiring large firms to pay suppliers within 60 days, with major automakers including BYD pledging compliance. Enforcement against unfair competition has strengthened, with regulators calling on the food delivery firm Meituan to rein in its pricing behavior. Beijing has also explicitly encouraged market-based mergers and restructuring as part of the broader effort to address excess capacity and involution. The 15th Five-Year Plan emphasizes building early warning systems to monitor capacity.

Many of these tools, however, depend on industry self-discipline and shifting the burden of good behavior to firms. There’s a critical limit to what rhetoric and policies can accomplish because those companies are doing the only thing in their control to survive. If everyone else is cutting prices, the only way to hold your market share is to do the same.

What’s needed is a systematic rewiring of the entire incentive system. The tax revenue sharing model is one issue. Especially since the property market crackdown, local governments desperately need a new source of revenue and now rely more heavily on value-added tax (VAT) revenue. Because the major share of VAT revenue accrues to local governments where production takes place, local governments are incentivized to anchor entire supply chains in their jurisdictions by competing with neighboring jurisdictions to provide the most favorable terms to attract firms. If every locality in China does that, you get carbon copies of different firms, and the issue takes on a life of its own.

Local governments first need to manage their debt in the short term through debt swaps and refinancing — replacing high-cost hidden debt with lower-cost government bonds is one way to bridge the current resource gap. In the long term, shifting more spending responsibility to the central government and more tax revenue to local governments is the way to go. But there’s tension because the central government wants greater command over fiscal resources. This explains the pushback and dragging of feet. The redistribution of political power is significant.

We’ll likely see small tweaks that shift the point of tax collection further downstream to the point of consumption, with some consumption tax revenue going to local governments.

What about on the demand side?

The supply side is the real issue. It’s not that Chinese household consumption is shrinking. China’s total consumption has grown over the past two decades, with a dip during the pandemic. The magnitude and speed of production increase just dwarfed everything on the demand side. So, the model is increasingly imbalanced, but not because Chinese households are getting poorer over time. They’re getting richer. That’s a key nuance.

But China’s domestic demand picture remains bleak. The critical parts of demand are the household side and the private business side. Most Chinese household wealth is locked in property. China’s capital market, by contrast, has played a much smaller role in household wealth accumulation. The decades-long property boom was a substitute for growth in this market. But now, that wealth-building engine is completely torn down. There’s no near-term prospect for the housing property market to stabilize and pick up, and we’re going to be in an L-shaped recovery. It’s never returning to the original. We’re seeing some tentative signs to reinvigorate China’s capital market. If Chinese households can take a share of the current investment boom in “new quality productive forces” sectors, for example by investing in the stock market, that could substitute for some property market loss, but it will be a long process.

An important challenge is to revive households’ ability to spend — how do you open their purses? People need more security. Currently, employment prospects are poor, even for STEM graduates from prestigious universities. Firms are struggling and not hiring. First, basic social welfare infrastructure like unemployment insurance must be in place. On the firm side, there needs to be more direct support for small businesses, whether that’s tax relief or other fiscal support. Currently, far more policy resources are being poured into the tech sector, while small retail businesses are struggling. Unless their profits pick up, they won’t hire or invest.

Fundamentally, you are locked in a death spiral of low demand, low investment, low hiring, low employment, low income, and low demand. It’s a self-reinforcing cycle. So many pieces must work in tandem for China to get out of this — hukou reform to mobilize laborers, child support to alleviate some of the families’ burdens, public health system reform, together with support for small businesses and the property market. None will be easy. For example, Chinese officials are hesitant to give households direct money, but the Chinese people are going to work hard, regardless.

How can multinational firms help rebalance China’s economy toward boosting domestic demand and efficient investment, whether through joint ventures or other investment?

A lot of media narratives say that the Chinese market is no longer there. That firms will retreat because profit is so thin. Part of it is true, but there’s recognition at the top level that this is a problem to fix. Multinationals will not rebalance the Chinese economy out of altruism. The key question is how to leverage China’s current policy initiatives to make profitable investments align with China’s rebalancing agenda.

The easiest opportunity is services. When it comes to healthcare, elderly care, education, financial services, and digital services, China craves foreign expertise. China’s domestic supply and expertise in these sectors still have gaps. We’re seeing real openings to attract more foreign investment and collaborate with multinational firms to create more services consumption. China’s 2026 foreign investment action plan for utilizing foreign investment emphasizes this.

In China, we need to use “invest” in the macro sense, not the micro sense. Previously, investing meant greenfield investments — building factories in China and selling to the Chinese market. But Chinese laborers are not cheap anymore, and domestic market profits are thin. We’re increasingly seeing investment in China for Chinese technology and innovative assets. The metaphor that Chinese policymakers often use is that China is a “gym.” Firms are in China to learn how to innovate and then use that innovative capability to be more competitive in global markets.

The new Geely-Ford partnership in Europe is not an investment in China per se, but it illustrates where this relationship is going. It combines Chinese technology, engineering, and cost-effectiveness with Ford’s existing global brand and manufacturing footprint in Europe. It’s also using an underutilized Valencia plant to manufacture for Europe, sharing the development cost. That’s a smarter form of globalization that we will see more of.

Another part of China’s rebalancing is its innovation model — moving from “one to 100,” or scaling existing innovations, toward “zero to one,” or true first-in-class innovation. Once it has a prototype, China can quickly scale and deploy it. With truly frontier R&D, China still has a lot to learn from MNCs. We are seeing a lot of policy initiatives, including tax support, for global MNCs to expand R&D centers in China. AstraZeneca, for example, is establishing a new global strategic R&D center in Beijing. Companies are recognizing that China is an innovation center.

China’s industrial robotics sector is showing signs of oversupply, with government-driven purchases raising questions about demand. Is robotics headed down the same path as EVs and solar? What would it take for Beijing to avoid repeating that cycle as it moves up the manufacturing value chain?

There’s an important distinction between industrial robots and humanoid robots. China’s industrial robot market is enormous, and the demand is real. China has more than two million operating in different factories. That does not look like a broad-based bubble or overcapacity story.

Humanoid robots are a different story. Chinese firms accounted for the large majority of the roughly 18,000 humanoid robots shipped globally last year. The commercial application is still immature, and policy enthusiasm is running ahead of end-user economics. Dancing robots are a great political signal to the central government, but the commercial use case is unclear. Many go to training centers for research and government pilot programs, with government demand largely creating the market.

The Ministry of Industry and Information Technology’s policy agenda lists robotics as one of the key priorities, and people mention the potential for humanoid robot assistants in healthcare. But there’s a huge psychological and institutional hurdle to jump before you can get there.

Robotics could repeat the same issues as EVs and solar. But China’s underlying technologies in robotics, especially motion-control and sensor technologies, are not necessarily overcapacitated. There are other uses, just as existing technologies in the EV sector can be moved to drones. You see China’s low-altitude economy picking up.

There are signals in China’s 15th Five-Year Plan about targeting excessive price competition. But the plan also designates robotics as a priority sector. What’s your read on these competing aims?

That is the central contradiction. If you’re a local bureaucrat watching Beijing pouring resources into its industry and tech ambitions, and seeing those areas prioritized in the five-year plan, you will do more on AI and robots. But the center is also telling you to rebalance to support the household sector. Well, where’s the money? KPIs are still based on deliverables, and currently the deliverables are AI and robotics. So, the signals from the 15th Five-Year Plan are contradictory, but on the ground the localities are still prioritizing industrial tech.

Ultimately, the top-level rebalancing agenda must be conveyed across the entire incentive system in a convincing and verifiable way to get local governments to do the right thing. You can’t just say that you want to invest in people. How do you do that and how does that affect your incentive system? Tell localities how they should use their resources and what they should support, and build that into KPIs.

What’s interesting is a lot of the genuine experimentation when it comes to rebalancing is quite grassroots. Last year, Jiangsu bureaucrats organized soccer games across different municipal localities in the province. It helped spur a lot of household spending. It was a local initiative because local bureaucrats know their local conditions best. They knew this was doable in Jiangsu because there’s fierce locality-versus-locality competition and lots of grassroots passion.

There needs to be more political delegation by the top level because every locality and province is different. Rebalancing in Beijing will be very different from rebalancing in Jiangsu, so there has to be more political trust given to localities for them to experiment and figure out on their own what works best for them. But again, that’s contentious. Will Beijing willingly delegate more responsibility to local governments?