Deflation and Overcapacity: The Looming Industrial Reforms in China

China's industrial landscape is undergoing a seismic shift. In 2025, the Chinese Communist Party (CCP) has escalated its campaign against "involutionary competition"—a term describing the destructive cycle of price wars and overcapacity that has plagued sectors like steel, aluminum, and renewable energy. This regulatory crackdown, coupled with supply-side reforms, is reshaping market dynamics for global investors. The stakes are high: China's $19 trillion economy, once a magnet for cheap commodity exports and low-cost manufacturing, now faces a recalibration that could redefine its role in global industrial supply chains.

The Anatomy of the Overcapacity Crisis

China's overcapacity problem is not new, but it has intensified in 2025. Steel production, for instance, fell 6.9% year-on-year in May 2025, the first contraction since Beijing's 2024 policy meeting. Aluminum output, however, rose 5% to a record 3.83 million tons, buoyed by falling power costs. The divergence highlights the uneven impact of regulatory interventions. While the government has curbed steel production to align with climate goals, it has allowed aluminum to grow, recognizing its critical role in electrification and infrastructure.

The root cause of overcapacity lies in the misalignment between supply and demand. Local governments, incentivized to attract investment, have historically created "policy havens" through tax breaks and subsidized land, leading to redundant capacity. Meanwhile, firms in sectors like photovoltaics and e-commerce have engaged in cutthroat competition, slashing prices to gain market share. The CCP's Qiushi magazine has explicitly criticized this behavior, warning that "involutionary competition" risks wasting social resources and stifling innovation.

State vs. Private: The New Industrial Hierarchy

The CCP's reforms are tilting the playing field in favor of state-owned enterprises (SOEs). Central SOEs are being consolidated into "aircraft carrier-level enterprises" through mergers, creating global champions in sectors like energy, aerospace, and high-tech manufacturing. For example, the Aviation Industry Corporation of China (AVIC) and China Aviation Industry Group (AVIC II) were merged in 2023 to form a single entity capable of competing with Airbus and Boeing. These SOEs are now tasked with driving China's "Innovation-driven Development Strategy," prioritizing R&D in technologies like third-generation steel and microelectronics.

Private firms, by contrast, face a more constrained environment. While they are permitted to operate in non-critical sectors, the government has introduced stricter regulations to prevent them from challenging SOEs in strategic industries. For instance, new rules in the electric vehicle (EV) sector require private EV manufacturers to partner with SOEs to access critical infrastructure, effectively capping their growth potential. This "Grasp the Large, Release the Small" approach ensures that SOEs remain the backbone of China's industrial strategy, even as the private sector contributes to economic dynamism in less sensitive areas.

Commodity Markets and the Deflationary Dilemma

The regulatory push to curb overcapacity has sent mixed signals to global commodity markets. In the steel sector, Beijing's production cuts have temporarily stabilized prices, but the long-term outlook remains deflationary. The property market slump—a key driver of steel demand—continues to weigh on prices, and the U.S.-China trade war has further eroded margins. For aluminum, the story is different: falling power costs and government support for electrification have improved profit margins, making the sector a relative bright spot.

Coal, meanwhile, is caught in a policy tug-of-war. While the government aims to peak coal consumption by 2025 and expand renewables, it has also signaled a "phase-down" rather than an outright phase-out during the 15th Five-Year Plan (2026–2030). New coal-fired power projects are still being approved under exceptions for energy security and grid stability. This duality creates uncertainty for investors, as coal remains a critical energy source despite its environmental liabilities.

Strategic Implications for Global Investors

For investors, the key takeaway is clarity on sector-specific risks and opportunities. Sectors prone to overcapacity—steel, traditional coal, and low-end renewables—will likely see smaller players exit or consolidate. Firms with strong R&D capabilities and global supply chain integration, particularly in high-tech industries like EVs and advanced materials, will thrive. However, the dominance of SOEs in these sectors means private equity and foreign investors must navigate a complex regulatory landscape.

Diversification is crucial. As China's reforms push for cleaner energy, Southeast Asia and India are emerging as alternative manufacturing hubs. Investors should consider allocating to supply chains in these regions to mitigate risks from China-centric overcapacity. For example, Vietnam's solar panel manufacturing sector has grown rapidly in 2025, offering a less politically sensitive alternative to China.

The Deflationary Outlook: A Long-Term Challenge

While the CCP's reforms aim to stabilize prices and reduce deflationary pressures, the structural issues driving overcapacity are not easily resolved. The expansion of the Emissions Trading Scheme (ETS) to include steel, cement, and aluminum is a positive step, but enforcement remains uneven. Local governments, criticized for both "absence and overreach," continue to distort markets through preferential policies.

The deflationary risk is most acute in sectors where demand growth is stagnant. The property market, for instance, is expected to shrink further in 2026, dragging down demand for construction-related commodities. Investors should prioritize sectors with clear demand drivers, such as renewable energy and EVs, while avoiding those reliant on cyclical demand.

Conclusion: Navigating the New Normal

China's industrial reforms are a double-edged sword for global investors. On one hand, they offer opportunities in innovation-driven sectors and cleaner energy. On the other, they expose investors to the risks of overcapacity, regulatory arbitrage, and deflationary pressures. The path forward requires a nuanced strategy: bet on SOEs with global ambitions, diversify supply chains into emerging markets, and avoid sectors where demand is no longer growing.

In the end, the CCP's vision of a "high-quality" economy may not be as open as the market once assumed. But for those who adapt to its new rules, the rewards could be substantial.