‘Involution’, or ‘nei-juan’ in Chinese, is the new buzzword in commentary about China’s economy1. It refers to excessive and self-defeating competition among Chinese companies for limited resources and opportunities. The phenomenon has led to diminishing returns, overproduction and fierce price wars, aggravating deflationary pressures and leading to the longest period of deflation since the 1990s (see Exhibit 1).
Competition’s failure to balance supply and demand
The intense competition began in 2020 when Beijing started re-industrialising the economy under its ‘dual circulation’ economic strategy2.
It promoted new economic sectors such as electric vehicles (EVs), lithium batteries, high-value manufacturing, and e-commerce.
Beijing has allowed market dynamics to drive the development of the new sectors, though (local) government policies have evolved as well. Different provinces have their own programmes allowing them to gain an advantage over other regions. Low barriers to entry allow others to quickly copy any successful policy, increasing competition further.
The unintended consequences of such dynamics are cut-throat competition, overproduction, and the erosion of pricing power and profitability.
The market has, arguably, failed as a mechanism for balancing supply and demand because suppliers focus on competitors’ moves rather than on market needs.
Companies undercut each other by selling below cost. Many companies, especially in the EV, solar panel and e-commerce sectors, have fallen into a “if you have it, I must have it too and cheaper” race to the bottom, slashing margins to unstainable levels, hurting stock prices and resulting in prolonged deflation.
Rebalancing action
Beijing has started to address the fallout, first by moral suasion – asking companies to stop the price wars voluntarily – and then announcing ‘anti-involutionary’ measures to cut capacity and rebalance supply and demand.
Initial measures include amendments of the national Pricing Law to curb irrational competition and price wars, barring companies from selling below cost.
Investors believe these policies will lead to a recovery in prices, improve corporate profitability, and revitalise innovation. Stock prices of Chinese ‘involutionary’ sectors including solar, cement, power batteries and coal have recently rebounded strongly.
Reform again? It is not déjà vu
The ‘anti-involution’ campaign differs from the 2015-16 supply-side reform that many investors are using as a point of comparison. That reform addressed industries with excess capacity, including:
- Steel
- Coal
- Cement
- Plate glass
- Electrolytic aluminium
- Shipbuilding
- Iron and steel
- Nonferrous metals.
These were upstream industries dominated by state-owned-enterprises. Importantly, the reform occurred when export volumes were declining (see Exhibit 2), meaning they aggravated the deflationary pressures already evident in China’s economy.
To cushion the double-whammy from structural reform and a drop in exports (and growth), Beijing implemented large-scale fiscal stimulus, notably through shanty town renovation projects to boost property activity. The subsequent recovery of both the property market and exports quickly pulled the economy out of deflation.
This time, the situation is more complicated. The economy has seen deflation for nine consecutive quarters. The anti-involution policies focus on downstream industries and new sectors which are mostly privately owned, conflicting with Beijing’s prior pledge to encourage the growth of these new sectors and the private sector.
Moreover, there is no shanty-town-style stimulus as Beijing aims to just stabilise the property sector, not boost it. A declining population is leading to a structural decline in property demand, meaning property market boosting measures are less effective.
Aggressive monetary policy easing arrived only recently. Finally, China is facing a trade war with the US and weaker global demand, such that exports are unlikely to rescue aggregate demand.
China’s old habits die hard
The crux of the economic problems is the supply-expansion growth model in which economic agents build, invest, and produce first to expand supply to create jobs and, thus, demand.
Supply-side reform alone is not a panacea. Moreover, Beijing is still using supply-expansion measures to address the shortfall in property demand by boosting infrastructure and manufacturing investment (see Exhibit 3).
This old policy habit has led to diminishing marginal returns on investment, which we believe is unsustainable.
Fighting deflation in China
Supply-side reforms alongside demand-side stimulus can pull the economy out of deflation. Creative destruction is inherently contractionary because the old sectors decline more quickly than new ones are created and develop.
The ‘anti-involution’ campaign focuses on measures and regulations to cut production capacity and curb disorderly pricing schemes. These policies could be self-defeating, hurting employment, and the economy in general, and overwhelming any positive impact on pricing power and profitability.
Measures to boost demand are needed to offset the pressures from production cuts.
With the economy stuck in a liquidity trap, fiscal policy must do the heavy lifting and revive public confidence and demand; monetary easing is a facilitating tool. The recent recovery of the credit impulse marks a start on the road to recovery (Exhibit 4).
At the Central Urban Work Conference in mid-July, Beijing announced that a new phase of urbanisation would be the anchor policy for boosting demand.
This will involve
- Infrastructure projects (such as the world’s largest hydropower dam in Tibet)
- Expansion of city clusters
- Enhancing regional synergies
- Building or converting unfinished real estate projects into affordable housing
- Developing industrial ecosystems
- Fostering innovation to speed up digitalisation of the economy.
Easing monetary policy more aggressively (assuming it occurs) and fiscal expansion could pull the economy out of deflation in late 2025 and early 2026. This would provide a significant boost to the recovery in both the Chinese economy and local asset markets.
[1] It literally means ‘inward swirling’. As a financial concept, it refers to the phenomenon of extreme business expansion resulting in cut-throat competition, excessive price wars and destruction of profitability
[2] An economic development strategy launched in 2020 that prioritises growth of domestic demand (‘internal circulation’) while maintaining, but not relying, on foreign trade for growth (‘external circulation’)
