China’s Biggest Trouble Is Not Its Stock Market, but Serious Overcapacity

August 16, 2015 Updated: August 17, 2015

Today I will talk about innovation and the Internet. I will start with the macro economy. Why do I raise the topic of innovation at this time? It’s because right now the Chinese economy cannot move forward without innovation.


Macroeconomic data in the past year or two showed a slowdown of China’s economic growth rate. Although GDP rates for this year’s Q1 and Q2 were posted as 7 percent, indicators of electricity, freight transport growth, enterprises, and so on clearly tell us that the economy is sliding into recession.

Why would there be a recession? Because after years of rapid growth, structural problems accumulated within the economy can no longer be ignored. Problems manifest at the macro level as growth rate slowdown, and on the micro level, businesses find it more and more difficult to operate.

We are covering up old bubbles of production capacity with new bubbles, and the result is bigger bubbles.
— Xu Xiaonian

How did this all happen? And how can we get out of this predicament? The reason for the slowdown is that we over drafted today’s economic prosperity. If, during the 2008 international financial crisis, we had seized the opportunity, endured some pain, made structural adjustments, and upgraded our industries, there would not be today’s difficulties. But we launched a 4 trillion yuan stimulus plan. We avoided a recession and an extremely good opportunity to make adjustments.

The adjustments we must make today are much more difficult than what they would have been in 2008. The 4 trillion yuan stimulus in 2009 further worsened the serious structural economic imbalance. Many traditional manufacturing businesses experienced overcapacity at that time. Their technologies were outdated. They could not sell their products, and they should have replaced their old products with new ones.

The massive government stimulus, however, helped these outdated technologies and products to linger on and has even sustained these businesses to this day. When the inherent growth momentum of the economy weakened, we needed to enhance its health. But, not only did we not eliminate the sick internal structural, we boosted it and allowed the outdated production capacity to expand.

Broken Steel Industry

Not long ago I visited a private steel mill. They told me the nation’s steel production capacity was about 1.1 billion tons to 1.2 billion tons, while the country’s consumption was only 600 million to 700 million tons. In other words, China’s steel production has 30–40 percent excess capacity. The steel price will not rebound until the issue of overcapacity is resolved.

Under the pressure of excess capacity, steel plants are trying to sell at low prices, and as a result, no one makes a profit. Some steel companies rely on government handouts. They should have closed long ago. With them not closing, plants that do have high efficiency operations cannot conduct normal business because of the low prices.

The nation’s steel production capacity was about 1.1 billion tons to 1.2 billion tons, while the country’s consumption was only 600 million tons to 700 million tons.
— Xu Xiaonian

The steel industry is one example of conditions in the traditional manufacturing sector. We are covering up old bubbles of production capacity with new bubbles, and the result is bigger bubbles. There are bubbles in the capital market as well, but most bubbles are in the real economy in the form of excess capacity.

Eliminating Excess Capacity

China’s economic growth has relied on investment for a long time. When there is excess capacity, enterprises dare not invest, hence growth slows down. This is an inevitable result of structural distortions. What’s the way out? Eliminate the excess capacity! If we do not eliminate excess capacity, prices will remain down, making it very difficult for businesses to operate and make a profit. The economy will be running in low gear for a long time.

Bad Loans

Excess capacity in the real economy corresponds to high number of loans in the banking sector. Had banks not given so many loans, there wouldn’t be so much overcapacity. The real economy needs to get rid of this excess capacity, and the financial sector needs to deleverage.

If the equity loans given to A-share stock investors is said to be a problem, it is still just a small problem compared with the bad debt accumulated by the financial sector and local governments. A-share equity stock lending totals 2 trillion yuan to 3 trillion yuan ($324 billion–$486 billion). Outstanding loans in the financial sector total over 80 trillion yuan (approximately $13 trillion). With a default rate of 10 percent, there would be 7 trillion yuan to 8 trillion yuan ($1.13 trillion–$1.29 trillion) bad debt or more. The government’s debt is estimated to be 20 trillion yuan ($3.24 trillion). This is a big issue for China’s economy.

The A-share bull market was created by the government. When the risks gradually surfaced, the government jumped in and crushed margin trading. After the crash, the government again stepped in to bail out the market.

Despite considerable social repercussions, the A-share stock market is only a minor issue in China’s economy. Big problems are government debt, bad loans in the banking sector, and excess capacity.

How serious is the overcapacity? Each industry is different. It is said the excess capacity in the cement industry is more than 60 percent. These figures tell us that the process of deleveraging and excess capacity can be quite a lengthy one. So, we must be fully prepared.


I just talked about the steel industry. Many small- and medium-sized steel companies will go bankrupt. This is a good time for acquisitions. However, intervention by local governments block acquisitions. I suggested that the government not impede acquisitions or prevent businesses from going under.

When businesses are about to fail, local governments first think about lost tax revenues and employment. They use a variety of ways to save dying businesses. I told them that the economy is just like nature: birth, aging, sickness, and death are natural laws. If it is time for some businesses to die, you should let them die, otherwise, those who should live will have a hard time making it. The businesses about to go bankrupt would try to maintain their cash flow at all costs. They would drive down prices, making it hard for healthy businesses to make a profit and survive.

Governments and economists do not think alike. Because of the intervention by local governments, good companies dare not make acquisitions when there is a precondition of no layoffs. How could that work? If I wanted to buy an enterprise, of course I would want to cut redundant expenses. Local governments forbid layoffs and hence hinder industry reconstruction. If not for local governments’ obstruction, there would be a lot of opportunities for mergers and acquisitions. Good businesses can improve their market share through acquisition, gain the ability to decide pricing, and improve profit margins, and achieve better operating conditions.

This is an abridged translation of a lecture by Professor Xu Xiaonian dated July 26, 2015. The original lecture discussed two main issues troubling China’s economy: serious overcapacity, and bad bank loans and government debt.

Xu Xiaonian is a professor of economics and finance at China Europe International Business School in Shanghai.