China's Economic Recalibration: Navigating Overcapacity, Involutionary Competition, and the Dual Circulation Strategy's Global Repercussions. Risks for Western Companies: Challenges and New Paradigms

Abstract

China is currently undergoing a critical phase characterized by severe overcapacity and a phenomenon of "involutionary competition", where an excess of supply leads to a downward spiral of declining prices and dwindling profits. This scenario is fueled by a mismatch between capacity and demand, a lack of differentiated innovation, and persistent systemic and institutional distortions, including inter-regional competition based on production expansion. In response, the Beijing government is promoting a strategic reform aimed at building a unified national market and redefining its development strategy towards "internal globalization," which materializes in the Dual Circulation Strategy. The latter seeks to establish China's vast domestic market as the fundamental pillar of growth. This involves structural reforms, a rebalancing of supply and demand, and a strengthening of competition policies. For Western companies, this transition brings significant risks: increased price competition, difficulties in market access, supply chain re-evaluation, impact of weak demand, and regulatory/geopolitical uncertainties. An extremely cautious and adaptive strategy is imperative to navigate this new and complex Chinese economic landscape.

by Gabriele and Nicola Iuvinale

China's Profound Economic Transformation: From Overcapacity to Involutionary Competition and the New Path of "Dual Circulation"

The People's Republic of China is at a pivotal moment, confronting the complex repercussions of a growth model that for decades prioritized the expansion of production capacity. The current scenario is dominated by overcapacity and the related phenomenon of "involutionary competition," terms describing a situation where excess supply leads to a downward spiral of declining prices and profits.

This economic conjuncture not only poses significant internal challenges for Beijing but also raises serious concerns and demands extreme caution from foreign companies operating or intending to operate in the Chinese market. The close interconnectedness of the global economy means that China's internal dynamics inevitably affect the performance of multinational corporations. In such a complex context, a thorough understanding of these dynamics and the Chinese government's responses is crucial for navigating future risks and opportunities. For an in-depth analysis, we will rely on the insights of Professor Liu Zhibiao, President of the Yangtze River Industrial Economics Institute at Nanjing University.

Risks for Western Companies and the Necessary Caution

Western companies, in particular, face an increasingly challenging economic environment in China. Involutionary competition and overcapacity are creating downward pressure on prices and margins, making profitability difficult. The main risks include:

1. Price Wars and Margin Erosion: Overcapacity and involution push Chinese companies to compete aggressively on price to maintain market share. Multinationals, accustomed to higher margins, find themselves forced to drastically lower them to remain competitive, compromising their profitability and shareholder value. This dynamic is already visible in sectors such as electric vehicles, solar energy, and consumer electronics.

2. Difficulties in Market Access and Unfair Competition: Despite declared efforts to create a unified market, non-tariff barriers, local protectionism, and discriminatory practices may persist. Foreign companies might find themselves at a disadvantage compared to local competitors who benefit from hidden government subsidies, preferential access to resources, or administrative favoritism. This undermines the principle of a level playing field and can hinder expansion.

3. Slowdown in Domestic Demand: The persistent decline in the Producer Price Index (PPI), the real estate sector crisis, and insufficient domestic demand mean that Chinese consumer and business purchasing power and willingness to spend may not grow as rapidly as in the past. This translates into lower-than-expected sales and slowdowns in market growth for foreign companies.

4. Regulatory and Geopolitical Uncertainty: China's regulatory framework is constantly evolving and can be applied discretionally. Geopolitical tensions, coupled with "de-risking" or "decoupling" policies from Western governments, create an unpredictable environment. Companies must navigate sanctions, restrictions on critical technology exports, and the risk of being embroiled in political disputes, with potential supply chain disruptions and reputational damage.

5. Risks Related to Intellectual Property and Forced Technology Transfer: Although China has made progress in IP protection, concerns remain. In a context of greater technological self-reliance and national security, foreign companies must be extremely cautious about sharing advanced technologies and rigorously protect their intellectual assets.

Given this complex situation, foreign companies are urged to adopt an extremely cautious approach and undertake a profound strategic review. It is imperative to carefully weigh risks against opportunities, consider diversifying supply chains outside of China, invest in innovation to differentiate products, and develop a granular understanding of Chinese market dynamics and regulations. "Business as usual" is no longer a sustainable option in this new landscape.

The Deep Roots of China's Economic Involution

Professor Liu Zhibiao defines involutionary competition not merely as a decline in profits but as a perverse outcome where, despite increasing investment and production, profits not only fail to increase proportionally but may even decrease, with market prices barely covering variable costs, or even less. This pushes companies to operate at a loss just to maintain market share, in a vicious cycle that compromises economic sustainability.

The main causes of this involution are manifold and interconnected:

1. Mismatch between Market and Production Capacity: The dizzying growth of China's production capacity, often stimulated by government incentives, has far outpaced the expansion of both domestic and external demand. When the market is not large enough to absorb such massive supply, competition becomes fiercely aggressive, leading to downward price wars. Sectors such as photovoltaics, new energy vehicles (NEVs), and e-commerce platforms are striking examples of this dynamic, where leading companies find themselves squeezing margins to the point of loss just to maintain their position.

2. Product Homogeneity and Lack of Differentiated Innovation: Another critical cause lies in the insufficient investment in technological innovation and product differentiation by many Chinese companies. "Homogeneous competition," as Liu Zhibiao calls it, forces a large number of companies to compete on the same level, making involution inevitable. Only companies that manage to innovate and elevate the technological content of their products, like the example of the "Goodbaby" stroller, can escape the low-price spiral and increase their bargaining power.

3. Systemic and Institutional Factors: Professor Liu Zhibiao emphasizes that the deepest roots of involution lie in the system and institutional framework.

   • Evaluation of Local Officials: For decades, the performance evaluation of local officials has predominantly been based on production capacity expansion and GDP growth. This incentivized local governments to promote investment and production, regardless of actual market demand, contributing to overcapacity.

   • Fiscal System: China's current fiscal system, particularly value-added tax (VAT) primarily levied on production, pushes local governments to expand production capacity to increase tax revenues. This mechanism creates a distortion that favors supply over demand. Liu Zhibiao suggests reforms, such as sharing VAT with high-consumption provinces or converting part of the VAT into a consumption tax, to reorient local authorities' focus towards demand and reduce the incentive for indiscriminate production.

Inter-regional Competition and the "Three-Powers-in-One" Model

A central element in Liu Zhibiao's analysis is the role of inter-regional competition and China's peculiar "three-powers-in-one" model. China's reform and opening-up delegated extensive powers from the central government to local administrations. However, these powers were not entirely transferred to the market or to enterprises, but to local administrations themselves, which became primary economic actors. This model, where local authorities hold administrative, judicial, and economic powers, was a driver of rapid growth in an economy of scarcity.

However, with China's transition from an economy of scarcity to an economy of surplus (since the early 2000s), this model has revealed its shortcomings. If local administrations continue to pursue production capacity expansion as their main objective, the rate of supply growth will inevitably outpace demand growth, leading to chronic overcapacity.

In the past, the severity of this situation was mitigated by the fact that foreign markets, particularly Western ones, absorbed a large portion of China's production capacity. China functioned as the "world's factory," with a vast share of its output destined for export. However, recent geopolitical tensions, tariffs imposed by the United States, and de-risking/decoupling policies by numerous Western countries have drastically reduced this outlet. Deflationary pressure has internalized, making involution an even more acute problem.

The Dual Circulation Strategy

In this context of increasing internal deflationary pressure and external uncertainty, China has strategically introduced and reinforced the concept of the "Dual Circulation Strategy." This strategy represents a fundamental pillar of China's new development model and aims to rebalance economic growth.

Dual Circulation is based on two interconnected circuits:

1. Internal Circulation: This constitutes the main pillar and aims to strengthen the domestic market as the primary engine of growth. The goal is to stimulate domestic demand, boost consumption, promote autonomous technological innovation, and create a robust national production base. This circuit seeks to make the Chinese economy more resilient to external shocks and less dependent on export markets.

2. International Circulation: This complements internal circulation and refers to maintaining and deepening global economic ties. However, the way China interacts with the world is changing. While in the past the main goal was export to meet foreign demand ("external globalization"), now the emphasis is on attracting foreign resources and talent and on the overseas expansion of Chinese companies, but always with internal circulation as the "main element."

According to Professor Liu Zhibiao, "internal globalization" and the concept of Dual Circulation mean that "the future market should be dominated by the domestic market." China will continue to pursue globalization, but no longer relying almost exclusively on Western markets. The goal is to use China's vast and growing market to promote domestic growth and, in turn, contribute to world economic growth. This strategy is a recognition of the need to rapidly expand the domestic market to avoid severe "internal circulation" that would not only fail to contribute to global economic growth but would also worsen the domestic situation.

Beijing's Response: Towards a Unified National Market and "Internal Globalization"

The Chinese central government has recognized the seriousness of the situation and has intensified efforts to address involution and promote the construction of a unified national market. This initiative has become a strategic priority, as evidenced by the following actions:

• "Guidelines for Building a Unified National Market": The publication of these guidelines and their inclusion in the government work report testify to Beijing's commitment to creating a more coherent and less fragmented market environment.

• Fair Competition Symposiums: The convening of these symposiums and voluntary commitments (such as that of 17 automakers to settle accounts within 60 days) aim to rectify "involutionary" competition practices and promote fairness.

• Targeted Interventions in Key Sectors: The sixth meeting of the Central Financial and Economic Commission (July 1) reiterated the need to "deepen the construction of a unified national market, focus on major difficulties, manage disorderly low-price competition among enterprises in accordance with laws and regulations, and guide enterprises to improve product quality." Specific interventions have been directed at the new energy vehicle, photovoltaic, and e-commerce platform sectors, with the goal of correcting irrational competition and promoting the orderly exit of backward production capacity.

• Strengthening Administrative Anti-Monopoly: Liu Zhibiao emphasizes the crucial importance of rigorously implementing competition policy as the "fundamental law of the market economy." This includes strengthening regulations against administrative monopolies and increasing penalties, to ensure that local administrations do not improperly interfere in the market.

The Path to a "Large" and "Strong" Market: The Three Phases

To achieve the goal of a unified and strong market, Liu Zhibiao outlines a three-phase process:

1. Unification of Market Rules: The initial and most crucial phase is the harmonization of market rules nationwide. This involves removing administrative barriers and creating a coherent and transparent regulatory system. It is the prerequisite for any further development.

2. Market Expansion ("The Market Must Be Large"): Once the rules are unified, the focus shifts to the actual expansion of the market. This requires coordination between supply-side structural reform and the expansion of domestic demand. In a surplus economy, demand becomes the limiting factor. It is therefore imperative to prioritize demand management, promoting the continuous improvement of citizens' living standards, consumption levels, and well-being. Liu Zhibiao challenges the idea that "supply always creates demand" in a surplus economy, emphasizing the need for policies that expand overall social demand.

3. Building a "Strong" Market: The final phase aims to endow the market with powerful functions, beyond mere scale. A strong market is capable of more effectively regulating resource allocation, reducing transaction costs, optimizing enterprise structure, and proactively guiding international circulation through internal circulation.

Supporting Macroeconomic Policies: The Challenge of Demand

To support this transformation, fiscal and monetary policies must be closely integrated with demand management. Faced with a Producer Price Index (PPI) that has been declining for over 30 consecutive months, Liu Zhibiao suggests a predominantly accommodative orientation for macroeconomic policies, through a combination of expansive fiscal and monetary policy.

While easing policies might raise inflation concerns, Liu Zhibiao argues that China, given its massive production overcapacity, currently lacks the conditions for severe inflation. The more pressing issue, however, is the liquidity trap, where funds from the central bank and the fiscal budget struggle to reach the real economy. The challenge, therefore, is not only to maintain accommodative policies but also, crucially, to facilitate channels for funds to flow into the real economy. The slowdown in the real estate sector has disrupted a key financing mechanism for local governments, making the search for new avenues for capital circulation, such as the development of the capital market, urgent.

Implications for Western Companies: Challenges and New Paradigms

The profound economic transformation underway in China and the transition to "internal globalization" present significant challenges and opportunities for Western companies.

1. Increased Internal Competition and Margin Pressure: Involutionary competition amplifies pressure on prices and profit margins. Western companies will face fiercer competition from Chinese players, who often operate with lower costs and are willing to sacrifice profits for market share. This is particularly true in sectors with overcapacity (such as automotive, electronics, consumer goods).

Source: A Rhodium Group (2023) report highlights how the increasing intensity of competition in China is eroding the profits of foreign companies, forcing them to revise their pricing and cost strategies. While "anti-involution" policies could theoretically lead to greater stability, competitive pressure remains high in the short to medium term.

2. Difficulties in Market Access and Veiled Protectionism: Despite declared efforts to create a unified market, non-tariff barriers, local protectionism, and discriminatory practices may persist. Foreign companies might find it difficult to compete with Chinese companies that benefit from hidden government subsidies, preferential access to resources, or administrative favoritism, as mentioned by Liu Zhibiao regarding subsidies and "local protection."

Source: The European Union Chamber of Commerce in China (2024) in its "Business Confidence Survey" indicates that European companies continue to report market access barriers, implicit discrimination, and a lack of a level playing field compared to Chinese competitors, despite government statements on liberalization.

3. Redefinition of Value Chains and De-risking/De-coupling Risks: China's push for "internal globalization" and reduced reliance on foreign markets, coupled with Western de-risking policies, is leading to a redefinition of global value chains. Western companies will need to evaluate whether to maintain production in China for the global market or only for the Chinese market, or to diversify their production bases.

Source: An analysis by Bank of America (2024) on "Reshoring and Friendshoring" suggests that a growing number of global companies are reconsidering their manufacturing footprint in China, shifting some production to other regions or bringing it back home, due to geopolitical tensions and supply chain disruption risks.

4. Impact of Real Estate Sector Distress and Weak Demand: The lingering crisis in China's real estate sector, coupled with weak domestic demand and the "liquidity trap" described by Liu Zhibiao, can negatively impact sales and revenues for Western companies reliant on the Chinese market. Reduced consumer spending and the difficulty for funds to reach the real economy create a less favorable environment.

Source: The International Monetary Fund (IMF) in its "World Economic Outlook" (April 2024) has repeatedly flagged the real estate crisis and weak domestic demand as key downside risks to China's economic growth, with significant repercussions for global economies and foreign companies operating in China.

5. Trust Deficit and Regulatory and Legal Issues: Western companies may continue to face regulatory uncertainties, discretionary enforcement of laws, and intellectual property protection concerns. The drive for technological self-reliance and increased regulatory oversight in key sectors can create a less predictable environment. The effectiveness of administrative anti-monopoly efforts against local practices will be crucial in establishing a more equitable environment.

Source: The **U.S. Department of Commerce (2024) in its "Investment.