China’s Deflationary Pressures: How Overcapacity May Be Both a Cause and a Strategy

Over 190 “large-scale” AI models, dominance in the robotics sector with more than 200 humanoid robot manufacturers, and over 16 million electric vehicles sold in 2025: these are among China’s most visible industrial achievements in recent years. Yet, despite industrial progress over the past three years, the country’s consumer price index has been hovering around 0%, raising concerns about deflationary pressure and broader economic weakness. Weak domestic consumer demand is often presented as one of the main causes. However, less attention is paid to the large-scale subsidy programs that helped enable this rapid industrial expansion. This raises an important question: could government-driven increases in production capacity be one of the main reasons behind the decline in consumer prices?

After the People’s Republic of China (PRC) was founded in 1949, China adopted a Soviet-inspired planned economy. This established a tradition of using the state to direct industrial development, with a strong emphasis on heavy industry, steel, machinery, defence, energy, and infrastructure.

When Deng Xiaoping became China’s leader in 1978, the country moved towards more reformist economic ideas. China Communist Party (CCP) shifted from having a centrally planned and highly selective industrial policy to a more market-enhancing approach. Instead of the state directly choosing specific sectors or firms to support, markets were increasingly allowed to indicate which firms, sectors, and regions were the most productive. This proved instrumental in shifting the country from a primarily state-owned economy to a more market-oriented one, it increased significantly the foreign direct investment in the country and later supported China’s adhesion to the WTO in 2001.

The changes were remarkable but highlighted a new risk: China getting trapped in low value-added manufacturing. The experience of some Latin American economies, such as Brazil and Mexico, resemble this phenomenon. They achieved industrialization and middle-income status but struggled to sustain productivity growth and move into high-value technological sectors. To avoid such outcome and shift from cheap to advanced manufacturing, China announced in 2015 the “Made in China 2025” plan. It introduced a new era in the country’s industrial policy, in which the government once again took the role of selecting the strategic high-value industries to target: advanced information technology, robotics, electric vehicles, maritime engineering, among others.

This time the CCP was ready to allocate the necessary funds to develop them coupled with the contribution of an aligned political structure. This structure helps explain the scale and intensity of this industrial push. Provincial leaders were strongly incentivised to deliver high annual industrial growth, as economic performance remained an important pathway for political advancement within the Communist Party. Consequently, “Made in China 2025” was amplified by fierce competition between provincial governments, each seeking to attract investment, expand production, and strengthen its industrial base. While this dynamic accelerated development in strategic sectors, it arguably contributed to excess production capacity, driving producer and consumer price indexes down as the following graph shows.

Figure 1: China remains under deflationary pressure; Source: National Bureau of Statistics of China; Bloomberg

The capacity utilization rate (Actual Output / Total Potential Output) is a useful indicator of whether an industry may be experiencing overcapacity. Values below 75 % tend to indicate weak utilization or possible overcapacity. The following table, with data extracted from the National Bureau of Statistics of China, shows that 10 out of 15 analysed industries were potentially operating in overcapacity in 2025, with year-on-year changes reinforcing this trend. Both car manufacturing and solar cell productionfrequently cited examples for achieving price competitiveness in the global market, indicate persistent overcapacity since 2024. These are precisely some of the sectors denominated as priorities in the “Made in China 2025” program.

Figure 2: Overcapacity persists in certain sectors; Source: Adapted from data of the National Bureau of Statistics of China

Although, even if targeted industrial overcapacity is part of the explanation behind the CPI trend, several factors continue to limit household consumption in China. The Mao-era hukou system restricts many rural citizens from accessing urban public services such as healthcare and education. This encourages China’s large migrant workforce, estimated at over 300 million people, to save more as a form of self-protection. The property market crisis that began in 2021, following the collapse of Evergrande, also reduced household wealth and confidence. In addition, stagnant wage growth and a weak labour market have further limited consumer spending, which translates to the CPI index.

Government subsidies may therefore not be the only driver behind China’s deflationary pressures. However, weak domestic consumption may be an over-communicated reason in detriment of government over subsidization, which is something the CCP is willing to tolerate in exchange for long-term industrial upgrading, export growth, and productivity gains. Openly acknowledging this strategy would likely be poorly received in the West, especially because of its potential to disrupt domestic industries in other countries, as it’s happening in Europe.

Going forward, as China successfully prepares to enter in the “club” of highly productive countries it will aim to solve the factors constraining demand. These won’t be solved through minor policy adjustments. They will require a large-scale relocation of funds from targeted sectoral development programs toward demand-side stimulus or deeper structural reforms. Ultimately, despite China’s impressive industrial progress, it remains to be seen whether the next wave of technological change, including artificial intelligence, will act as an economic tailwind or serve as a further disruption to domestic consumption.