PKU Prof. Lu Feng on Chinese Overcapacity
PKU Prof. Lu Feng on Chinese Overcapacity
"China's new energy vehicle sector is still in a phase of rapid growth, and there is no overcapacity."
Today’s edition begins with an introduction by Dr. Jost Wübbeke, managing partner and co-founder of Sinolytics, a China-focused consultancy based in Berlin and Beijing. Jost is an expert on Chinese industrial policy and supply chains. My thanks go to him and to Robert A. Kapp, who translated today’s text. – Thomas
Overcapacity has become a big issue in trade disputes with China. The US and the EU use it as a key reason to justify trade defence measures against Chinese imports. China, on the other hand, tries to downplay it to avoid these measures. Chinese policymakers know that overcapacity is both a blessing and a curse for their economy: it helps industries grow quickly and cheaply but also causes harmful price wars and inefficiencies. The new challenge is that overcapacity now affects high-tech industries like electric vehicles (EVs), batteries, and semiconductors, unlike in the past.
Lu Feng's analysis offers a conceptual view on overcapacity, which is a notable effort given how politicised the topic is. He highlights that determining overcapacity is complex, especially in new industries with expected high demand. For example, is low utilisation in a new industry with high future demand still overcapacity?
There are some points where I disagree with Lu Feng. He argues that private companies mainly drive overcapacity, but it is also true that massive subsidies and government support in China contribute to this problem. Additionally, while Chinese companies have the right to compete internationally, the support they receive from the Chinese state makes the market environment unfair. China should take its trade partners' concerns seriously to avoid protectionist responses.
Lastly, the US and Europe should be cautious about falling into a protectionism trap. Imposing tariffs and other measures can backfire if they don't have the innovation and cost-competitiveness to build their own industries, leading to higher costs and reliance on outdated technology.
Jost Wübbeke
Chinese enterprises prone to overcapacity fall into two main categories: first, mature and low-end industries; second, firms undergoing rapid technological changes and those in high-growth sectors.
The first category includes industries that produce such things as traditional fuel cars, petrochemicals and mature-node semiconductors.
The second refers to such goods as electric vehicles and car batteries.
Although overcapacity and overproduction may be concerning for the first type of enterprise, low-capacity utilisation rates in high-tech and high-growth firms can be normal. Immediately stigmatising this second type of industry with the term “overcapacity” is wrong.
Relying solely on traditional methods for assessing overcapacity is not suitable for high-growth and high-tech industries.
Moreover, overcapacity should not only be viewed in a negative light; it can also produce positive outcomes, such as higher efficiency and market competitiveness.
Overcapacity in China is being caused or exacerbated by several factors:
The post-pandemic decline in demand for certain goods.
Large-scale investments by private companies.
Production capacity growing faster than demand due to rapid technological advances.
The imbalance between strong domestic supply and weak domestic demand in China.
Protectionist policies around the world.
To address China’s overcapacity problem, Beijing should rely on a combination of market mechanisms and macroeconomic policies. However, it should ensure that China’s emerging industries are not harmed in this process.
Beijing should also work to reduce China’s trade imbalances with developed countries and encourage Chinese firms to invest abroad. But foreign protectionist measures should be counteracted.
Boosting domestic consumption at home remains a top priority.
Name: Lu Feng (卢锋)
Year of birth: 1951 (age: 72/73)
Position: Professor of economics and director of the China Macroeconomic Research Centre at the National School of Development, Peking University
Other: Advisor to the PRC’s Ministry of Finance, Ministry of Human Resources and Social Security, and to the The People's Bank Of China
Research focus: Open-economy macroeconomics; Chinese agricultural economics; development economics
Education: LLB Renmin University of China (1982); MA Renmin University of China (1985); PhD University of Leeds (1994)
Experience abroad: Visiting scholar at the UK’s Institute of Development Studies (1989), the Australian National University (1996) and Harvard University (2003); Lecturer at Leeds University (1994-1995)
HOW TO VIEW OBJECTIVELY AND DIALECTICALLY THE CURRENT PRODUCTION CAPACITY ISSUES IN SOME INDUSTRIES
Lu Feng (卢锋)
Published by the Shanghai Development Research Foundation on 24.05.2024
Translated by Robert A. Kapp
(Illustration by DALL·E 3)
I. The Concepts of Overcapacity and Redundant Capacity
The term “overcapacity” refers to a condition of inordinately high levels of production capacity. In a market economy, capacity ordinarily can become excessive for a number of reasons, such as short-term imbalances between abnormally high demand and supply, for which reserve supplies are necessary to stabilise the problem. When upgrading critical equipment, in order to maintain normal operations. enterprises might customarily require some advance temporary overproduction. Additionally, enterprises sometimes deliberately maintain certain redundant capacity as a strategic measure to occupy a larger market share or deter potential entrants.
In a planned economy, utilisation rates can approach one hundred percent, with no overproduction. But under market economy conditions, this would indicate a relatively severe shortage.
Of course, overcapacity is not a case of “the less the better.” If redundant capacity is too low, that either means that utilisation rates are too low or that production capacity is too high.
While it is not hard to come up with a qualitative definition of overcapacity, it is not so easy to reach quantitative conclusions as to the presence of overcapacity in a particular industry, or to measure the gap between excess and shortage. Generally speaking, we can determine whether a business is or isn’t facing overcapacity by examining a number of different indicators. Is the capacity utilisation rate below a certain threshold? Are the enterprise profits – or profits across the entire industry – in line with normal trends? Such quantitative indices and examination of real economic situations are valuable, but they don’t embody mathematical formulae that lend themselves to computerised calculations. Only by moving into the detailed data of a particular sector can we reach meaningful conclusions as to whether overproduction is present.
For example, with respect to the emerging and high-growth industries, because they must employ new technologies to meet such high levels of demand, the production capacities that they enjoyed a year or two earlier and the technologies that supported those capabilities might quickly become outdated, even backward. In this context, the calculated capacity utilisation rate may be very low, yet the market demand is still rapidly expanding with continuous improvements in supply efficiency; thus it is not appropriate to simply label it as overcapacity.
II. Historical Retrospect
During the development of the market economy in our country, problems of overcapacity and its management appeared early. In the late 1990s, various textile mills were forced to reduce their spindles or take other stringent steps to deal with overcapacity. By the early 2000s, managing overcapacity became a key focus of macroeconomic policies. Over a very short period, policy shifted from focusing on investment restriction to the implementation of broad macroeconomic coordination. This often led to industries’ either facing or falling into structural overcapacity. So it was that excess capacity became routinised as macroeconomic policy was implemented. Steel, cement and aluminium electrolytic [industries] all became objects of overcapacity management at an early point; later this expanded to include ten sectors. Relatively late in the day, around 2015-2016, the policy known as the “Three Cuts, One Reduced and One Strengthened” came into play [Note: this policy involved “cutting overcapacity, reducing excess inventory, deleveraging, lowering costs, and strengthening areas of weakness”]. Its main objective was reduction of overcapacity in the steel sector and elsewhere. You are all familiar with these situations.
When visiting companies, one often hears private firms lament, “The only way private companies can find opportunities is by overproducing.” This perspective stems from the fact that China’s economy transitioned from a state-owned enterprise-dominated planned system. For a long time, private firms trying to get into a number of important production sectors have suffered many restrictions. In some cases, although in principle private firms had the right to enter a field, investment projects under special circumstances had to go through “Examination and Approval” procedures or even formalities requiring “reporting” to higher authorities. All of these could prove to be obstructions. Only in situations where competition levels were rising rapidly and a certain level of excess capacity existed might state-owned enterprises facing financial pressures gradually withdraw, leaving some space for private firms to compete fully and grow.
In the case of the newly emerging industries, where no traditional state-owned enterprises monopolise the field, private firms can establish their own footprints relatively fully, investing vigorously and competing fiercely. That can create conditions in which supply exceeds demand. From the expansion of the video compact disc industry in the 1990s to the explosive rise of the New Energy sector in recent years, although their technologies reflect contrasting eras, they display similar characteristics in the relationship between rapidly rising production capacity and rapidly increasing demand.
In short, because of this system-transition background, the growth of private enterprises is often more associated with involution, competition and the pressures of overcapacity. Beyond that, if excess capacity rises to certain levels, that can lead to the reorganisation of entire industries, evidenced by more and more firms going through mergers and acquisitions, until at last such fields reach a stable market balance. In this way, the frenzied horse races ignited by large-scale market entries, massive investments and involution-style competition can be worked out internally. Excess capacity is usually linked to a combination of low costs and high efficiency, signifying increased market competitive strength and other positive factors. Yet overcapacity can result in misallocation of resources and economic losses. And so, we must examine this situation dialectically.
III. Characteristics of the New Round of Production Capacity Issues
In researching real economic problems, the first question to clarify is the nature of reality. Most of the time this is relatively difficult. From comprehensive data for a given field, internal analyses, media reports and individuals’ investigations we can see that in our country there are two different questions of productive capacity.
The first realm contains a proportion of mature, traditional, low-end outfits facing slow demand growth or no demand growth at all. These units, whether for cyclical reasons or because they have encountered other shocks, have low-capacity utilisation rates and face extreme pressures from redundant capacity.
In addition, in the case of a few mid- to high-end firms in advanced technology or other newly emerging sectors where demand is growing rapidly, ensuing increases in investment and rapid expansion of capacity can overtake existing demand, leaving such firms facing the lurking danger of abnormally excessive supply.
Production units of this latter sort clearly lie within a set of new conditions, whether their importance derives from their positive significance or from other, complex factors.
These entities must be further examined and analysed both objectively and dialectically. On the basis of information we currently possess, let me offer some preliminary observations about new production capacity issues appearing in such industries.
First of all, the traditional fossil-fueled auto industry now faces overcapacity. There is little disagreement about this among insiders and outside observers.
Second, investment in petrochemical base raw materials is rapidly exceeding demand, and again, insiders are already concerned that supply is going to exceed demand in coming years. In the past, China’s petrochemical bases have depended on imports of raw materials. But thanks to periodic breakthroughs in Chinese technology and the heavy increases in petrochemical investments during the 13thFive Year Plan, in recent years rising supply has already outpaced rising demand, rapidly transforming supply-demand relations and bringing into the open this problem of excessive supply. Globally speaking, rates of capacity utilisation in this field have fallen to levels not seen for decades.
Thirdly, the microchip industry is showing early signs of structural supply-demand imbalances. Microchips are a representative example of a leading-edge industry. Broadly speaking, as AI has become universal, demand for chips has reduced excess capacity. Demand for high-end chips is robust, and foreign technology blockades have created shortages. At the same time, however, we know from experience that because each nation has poured investment into higher production capacity, there are now portents of oversupply.
Fourth, the sector producing automotive batteries is in danger of structural overcapacity. In recent years, all the leading battery makers have been simultaneously investing. Second- and third -tier firms have joined the investment race, further pushing both investment and production capacity to abnormal levels.
But technology in this sector is advancing by leaps and bounds. Capacity utilisation among Chinese firms is relatively high. If it were not for trade barriers, the underlying potential in external markets would be huge, as it has been in the past. Furthermore, demand for high-energy-density batteries is booming; risks of overcapacity are mostly found in the lower-end battery sector.
Fifth, although New Energy Vehicles (NEVs) are currently at the stage of rapid development, in the future they too will come face to face with worries about supply exceeding demand.
Industry insiders and leading [Chinese] analysts concur; China's NEV sector is still in a phase of rapid growth, and there is no overcapacity. Domestic demand is growing rapidly. Potential growth in external markets is very great. And technology in battery-powered vehicles is currently full of innovation. When we add to that the important positive role in global green transition, the above viewpoint has a reasonable basis.
But even as we fully affirm these positive conditions for NEV development and the enormous potential for future growth, we still have to pay attention to the fact that the rapid expansion of production capacity in this sector is clearly outpacing effective demand growth. Whether, in the future, foreign market demand will fully materialise, and whether we will be able to take advantage of it, remain undetermined. Just where the proper resolution of supply-demand and production capacity issues will lie, in this context of demand-supply challenges, will ultimately be proven by actual demand, and will require further analysis.
Beyond this, problems of abnormally high capacity and declining utilisation rates appear in a whole array of mature, traditional, low-end and low-demand-growth industries such as steel and household appliances, which face cyclical pressures and other adversities. Yet for a long time, such industries have undergone scrutiny and the harsh baptism of overcapacity, and the market structures have by and large settled down. Impulsive investments by firms have thinned, and in addition, the effects of higher production capacity on international markets have already been absorbed. These industries thus face only limited challenges arising from overcapacity. In such sectors, increased capacity will be handled by the mechanisms of the market. They will see relatively high levels of internal consolidation. Overcapacity issues are not likely to become focal concerns in these sectors.
IV. Causes of the New Round of Production Capacity Issues
These new problems of production capacity, particularly in the sectors discussed in the preceding section, are connected to many new elements in both our domestic and external environment. This requires a systematic examination of their distinctive features.
Number one, the economic effects of the pandemic are relevant. During the pandemic, in a situation of collapsing demand, especially in the developed economies, investments surged, so that by the time the pandemic receded, production capacity was at new levels. But as demand returned to normal, post-pandemic demand for some products declined, leading to a contradiction of oversupply and overcapacity.
Second of all, the partial failure of traditional international mechanisms for handling overcapacity issues is relevant here. In the past, when production capability expanded among highly efficient producers within a certain economy, the mechanisms of the international market would suppress and replace the inefficient capacities of other countries, thus ensuring that global production levels would not be excessive. Additionally, the Product Lifecycle Theory suggests that the laws of new product creation, substitution and adoption would implicitly help to restrain overcapacity.
Third, another relevant matter is [our] “strong supply, strong demand” domestic macroeconomic situation. In recent times, the macroeconomic workings of our economy have been characterised by “strong supply, weak demand.” That is to say, capacity expansion has been strong, but the potential of increasing demand has remained incompletely unleashed and lopsided. As a result, at the margins, production capacity’s absorptive power has remained constricted.
A fourth relevant matter is that technologies in our New Production sectors are now at the stage of successful breakthroughs. In the Reform and Opening era, we went through three rounds of technological upgrading in the manufacturing sector. The first occurred in light industry, textiles, daily-use items and labor-intensive industries as well as the processing sector, which saw great development. In the second phase, much development took place in fields connected to heavy industry. Lately this has entailed a round of new production technologies applied system-wide in important manufacturing sectors. Meanwhile, individual strategic newly emergent sectors are seeing major leading-edge breakthroughs. These technological ascents in this new round of industrial production are major steps forward in expanding our country’s high-end production strengths.
Nevertheless, in a situation where domestic absorptive power is limited, it is still possible for rapidly increasing capacity to exceed demand growth and present real problems
A fifth issue is global protectionism and associated rising uncertainties. Our manufacturing industries, with their newly-ascendant technologies, generate highly tradable products. Objectively speaking, competition across global markets should yield appropriate market shares for them. But in foreign markets, particularly those of the major developed economies, protectionist policies have put up trade walls. The accompanying structural uncertainties have created a new round of production capacity issues in an especially complex real environment.
V. Dialectical Analysis and Comprehensive Response
In addressing the production capacity situation now confronting us, our leaders have most recently pointed out that “we must dialectically and objectively view these capacity questions from the perspective of the market, taking a global view, and starting from the laws of economics”. Such a correct way of thinking about this, deploying a systematic and sweeping elaboration from the rooftop down, plays a vital guiding role in researching ways to deal with the production capacity question.
For instance, on the basis of the principles of objective dialectics, determining proper production capacity levels still must be based on actual demand. On the one hand, we have to recognise the latent power of market demand, consider tradability levels in relevant sectors, and draw on the combined efforts of enterprises, whole sectors and government to turn potential foreign demand into actual demand. Thus can we fully establish the demand conditions needed for sectoral expansion while averting, as far as possible, opportunity cost losses arising from blunders that would damage firms' development.
Furthermore, we have both to keep in mind that in the global marketplace those with the highest efficiency have substitution power and to watch and see whether the most efficient firms in our emerging industries themselves develop new global markets. All of that presents potential new areas of friction, not only economic or employment-related but also political. By tying the rhythms of our capacity expansion to actual demand conditions, we can avoid, or minimise, the dangers of costly wasted investments.
Looking at the overcapacity issue demands an even broader-gauge perspective. Price trends for example, and capacity utilisation rates offer important indicators. But these are of limited value in the context of those newly emergent sectors which are expanding so rapidly. Outfits with high-speed technological advances and entities with rapid rates of technology refreshment will wipe out most inefficient firms, leading to overly low-capacity utilisation statistics. But because demand would still be growing fast it would not be appropriate to speak of overcapacity. The most advanced and innovative firms will set high prices, thanks to their pricing power in unique, distinctive markets. With time, as the technology becomes more widely available and market entrants compete, and as markets expand and the laws of economics are freed up, these very high prices will for the most part trend downward – and it still won’t be appropriate simply to adjudge that as overcapacity. Traditional measurement standards remain relevant, but judgments of what constitute proper levels of production capacity in these sectors require even broader consideration.
Such broader observation may reveal strikingly different supply-demand details in apparently closely-related industries. A structural perspective for analysing production capacity in mid-to-high-end and emerging sectors is even more important.
If, in the current discussion of proper levels of capacity, the whole microchip sector is found not to have excess capacity, it is still the case that supply exceeds demand when it comes to products made with mature or traditional technologies. In recent years, furthermore, in the case of automotive batteries capable of generating 160 kilowatt hours as a national technical specification, at the time this specification was issued there were some practical discrepancies in the suitability of supply-demand relationships for products with differing technological standards. From a dialectical standpoint, in industries under pressure from overcapacity, or facing that impending peril, high-efficiency firms can still find opportunities for real growth.
With respect to these complexities of production capacity in the New Industries, we must come up with strategies that weave together the internal and the external. To start with matters of enterprise management and regulatory policies, even as we make use of three traditional indicators of overcapacity, we also have to look closely at supply and demand growth patterns in these emerging industries, as well as other special features, including their track records in technological upgrading. Beyond that, we have to avoid errors in judgment resulting from over-reliance on one or another single index of overcapacity.
Another important issue is the way in which this new tranche of capacity problems has become an even more conspicuous, structural factor among [these] new actors. Responding to this with new measures will require close attention to, and coordination with, the mechanisms of the market, so as to avoid overly stringent or simplistic approaches that would bring unnecessary damage to firms with distinguished levels of exceptional efficiency, and to leave adequate space for such firms to grow.
Furthermore, by taking positive steps in the direction of macroeconomic policies and structural reforms, we can actively promote increased domestic demand, especially consumer demand. Presently, relevant government bodies are pushing sales of cars, home electrical appliances and household goods, using the theme of “replacing the old with the new”, while encouraging enterprises to upgrade their equipment and their technologies, in order to help absorb industrial capacity and avoid the dangers of overcapacity. It will also be necessary, by adopting policies aimed at deepening and perfecting income distribution over the middle and long term, to strengthen financial support for the social insurance system and raise the overall share of consumption in the nation’s economy.
Finally, we must realistically deal with the new contradictions arising from multinational factors attendant on the New Product sectors’ capacities. Our companies have a natural right to compete fairly for, and gain global market shares in, open environments. [We] must preserve the right to oppose, or take countermeasures in response to, foreign unilateral protectionist actions. At the same time, we have to adopt measures to respond to foreign pressures impinging on our trade and economic relations.
For instance, we can support [our] domestic firms’ direct overseas investments and cooperation with foreign partners, and actively explore bilateral cooperation in third-party investments. This can safeguard China’s production capacity development while mitigating conflicts with developed countries' interests.
The bulk of our country’s global trade surplus lies with the United States and Europe. Government procurements, as well as measures to increase imports from the relevant countries and reduce those imbalances, will at one and the same time be useful in negotiations for broadening bilateral cooperation and easing bilateral conflicts. The deep and complex nature of the issues arising from production capacity in the emerging industries may place additional pressure on the international trading system. As a newly risen great power, China will play an ever more active role in the arenas of multilateral trade, finance, development structures and the G-20. In turn, this will motivate the international community to deal constructively with this new round of concerns over production capacity.