China's Industrial Rebalancing: From Overcapacity to Innovation-Driven Growth

China's industrial landscape is undergoing a seismic transformation. Over the past decade, the country's economic strategy has pivoted from a reliance on traditional, labor-intensive sectors to a focus on innovation-driven growth. This rebalancing, driven by policy frameworks like “high-quality growth” and “industrial modernization,” has created a stark divergence in performance between legacy industries and high-tech sectors. For investors, understanding this shift—and its implications for capital allocation—is critical to navigating the opportunities and risks in the world's second-largest economy.

The Widening Profit Gap: Traditional Sectors vs. Innovation-Driven Industries

From 2023 to mid-2025, China's traditional sectors—steel, coal, and basic manufacturing—have faced mounting headwinds. Industrial profits for major firms fell by 9.1% year-on-year in May 2025, with the Producer Price Index (PPI) declining by 3.6% in June 2025, the steepest drop in nearly two years. Overcapacity, deflationary pressures, and weak domestic demand have eroded margins. For example, Daqo New Energy, a polysilicon producer for solar panels, reported a Q2 2025 EBITDA margin of -64.0%, reflecting the sector's struggles with oversupply and falling prices.

In contrast, high-tech sectors like electric vehicles (EVs), semiconductors, and AI have shown resilience. Despite price wars in the EV industry—BYD and Xiaomi slashed prices to remain competitive—government subsidies and global demand for green technology have cushioned margins. CATL, a leader in battery technology, maintained EBITDA margins of 12–15% in 2025, supported by its dominance in the global EV supply chain. Similarly, semiconductor firms like Semiconductor Manufacturing International Corp (SMIC) have benefited from state-backed R&D incentives, even as U.S. export controls create friction.

Risks of Underpenalized Overcapacity

The overcapacity crisis in traditional sectors remains a systemic risk. Steel and coal industries, for instance, face structural imbalances: excess supply, high production costs, and weak pricing power. In July 2025, China's Manufacturing PMI fell to 49.3, signaling contraction, with capacity utilization declining across energy-intensive sectors. This has led to margin compression and valuation deterioration, with many firms trading at unattractive or negative P/E ratios.

The government's response has been uneven. While local governments have struggled with the fiscal costs of overcapacity, Beijing has prioritized consolidation and exit strategies for inefficient producers. However, the lack of strict penalties for overcapacity—such as forced plant closures—risks prolonging the pain for investors. For example, steelmaker Grupo Simec trades at a P/E of 8.3, far below the industry median of 24.8, reflecting undervaluation amid reshoring trends but also highlighting the sector's vulnerability to policy shifts.

Strategic Capital Reallocation: Overweighting Innovation Sectors

For investors, the case for overweighting innovation-driven sectors is compelling. These industries align with China's long-term rebalancing agenda, supported by tax incentives, R&D subsidies, and global demand for clean technology. Key opportunities include:

1. Electric Vehicles and Renewable Energy: China's EV market is projected to grow at a 25% CAGR through 2030, driven by domestic firms like BYD and NIO. Renewable energy technologies, including solar and wind, also benefit from policy tailwinds, with the government targeting 30% of electricity generation from renewables by 2030.
2. Semiconductors and AI: Despite U.S. export controls, China's push for self-sufficiency in semiconductors is accelerating. SMIC and other domestic players are gaining traction in mid-end chips, while AI infrastructure—led by firms like Baidu and Alibaba—is expanding rapidly.
3. Biotechnology and Robotics: These sectors are underpenetrated but offer high-growth potential. Biotech firms are advancing in medical devices and pharmaceuticals, while robotics companies are closing the gap with global leaders in automation.

Policy Tailwinds and Global Demand

China's industrial rebalancing is not just a domestic story—it's a global one. The country's push for technological self-sufficiency has spurred innovation in sectors critical to the global economy. For instance, China now exports more EVs than Germany, and its dominance in solar panel production has reshaped energy markets. Investors should also monitor the “dual circulation” strategy, which emphasizes both domestic consumption and international market expansion.

However, geopolitical risks remain. U.S.-China trade tensions and export controls could disrupt supply chains, particularly in semiconductors. Yet, these challenges also create opportunities for domestic players to fill gaps. For example, the C919 commercial aircraft program, though still in its early stages, signals Beijing's intent to reduce reliance on foreign aviation technology.

Conclusion: Navigating the New Industrial Paradigm

China's industrial rebalancing represents a pivotal shift in its economic trajectory. For investors, the key is to align capital with sectors that benefit from policy support, global demand, and technological innovation. Traditional sectors, burdened by overcapacity and deflation, offer limited upside. In contrast, high-tech industries—despite their own challenges—present a more resilient and growth-oriented investment case.

As the government continues to prioritize innovation, the winners will be those who adapt to the new paradigm. By overweighting sectors like EVs, semiconductors, and AI, investors can position themselves to capitalize on China's long-term rebalancing agenda while mitigating the risks of its legacy industries. The future of China's economy—and its markets—lies not in the past, but in the technologies that will define the next era of global industrialization.