Assessing the Sustainability of China's AI-Driven Equity Rally Amid Signs of Overheating

The Chinese AI sector has experienced a remarkable equity rally in Q4 2025, fueled by a confluence of policy tailwinds, technological innovation, and robust capital inflows. However, as valuations rise and trading volumes surge, investors are increasingly scrutinizing whether this momentum is underpinned by sustainable demand or speculative fervor. This analysis examines the interplay between sector-specific momentum and broader macroeconomic fundamentals to assess the sustainability of the rally.

Sector Momentum: Policy, Innovation, and Capital Inflows

China's AI-driven equities have surged on the back of aggressive policy support and structural reforms. The MSCI China index rose 36% year-to-date in 2025, with AI hardware, semiconductors, and cloud infrastructure leading the charge. Companies like Semiconductor Manufacturing International Corporation (SMIC) and Alibaba have surged by over 180% and 120%, respectively, reflecting investor confidence in state-backed initiatives such as "Digital China".

This momentum is further amplified by favorable capital market dynamics. Total A-share trading value in 2025 exceeded 410 trillion yuan, a 60% increase from 2024. Analysts attribute this to a combination of low energy costs, domestic innovation, and strategic investments in AI infrastructure. Notably, valuations remain attractive relative to fundamentals, with analysts suggesting the market is not yet overvalued.

Macroeconomic Fundamentals: Growth, Inflation, and Debt Dynamics

While the AI sector thrives, China's broader macroeconomic landscape presents a mixed picture. The IMF projects 2025 GDP growth at 5.0%, driven by policy stimulus and reduced U.S.-China trade tensions. However, Q1 2025 GDP growth slowed to 1.2%, below the 1.4% consensus, signaling lingering structural challenges. Inflation remains subdued, averaging 0% in 2025, with deflationary pressures persisting due to weak consumer demand.

Monetary policy has leaned toward easing, with the central bank planning rate cuts "at an appropriate time" to stimulate domestic demand. Yet, public debt concerns loom large. China's public sector external debt reached 178,979.2 in Q4 2025, while the general government debt stood at 89,105.2. Morningstar DBRS projects the debt-to-GDP ratio to rise from 60.5% to 79% by 2025, driven by higher deficits and slower nominal GDP growth. These figures underscore the fragility of the macroeconomic foundation supporting the AI equity rally.

Interplay and Risks: Balancing Optimism and Caution

The AI sector's outperformance relative to the broader economy highlights a key divergence. While policy-driven liquidity and retail investor optimism have propelled AI-linked stocks, macroeconomic fundamentals have yet to confirm a sustained recovery. For instance, industrial output and retail sales have fallen short of forecasts, raising questions about the depth of demand.

Structural risks include stretched valuations in certain AI subsectors and geopolitical uncertainties. The IMF has emphasized the need for fiscal reforms to address imbalances, warning that elevated debt levels could undermine long-term growth. Additionally, trade tensions and global demand fluctuations pose external threats to China's AI ambitions.

Conclusion: A Tenuous Equilibrium

China's AI-driven equity rally reflects a strategic pivot toward innovation and digital transformation, supported by state-backed liquidity and policy frameworks. However, the sustainability of this momentum hinges on resolving macroeconomic vulnerabilities. While the sector's fundamentals-such as technological advancements and domestic demand-remain compelling, investors must remain vigilant about debt dynamics, deflationary pressures, and geopolitical risks.

For now, the AI sector appears to be riding a wave of optimism, but the broader economy's ability to sustain this growth remains unproven. As the IMF notes, structural reforms and fiscal discipline will be critical to ensuring that the AI boom translates into long-term productivity gains rather than a speculative bubble.