China's surge in manufacturing capacity over the past five years, partly a reaction by the authorities to the need to create a new growth driver (beyond the real estate market) and partly to match the US in strategic economic competition, has become overstretched and produced a surplus of industrial capacity. For example, China's flooding of European markets (monthly imports of Chinese automobiles have recently hit 1 million cars¹) is driven by a desire to conquer the European market and assert its economic strength, and also to alleviate its own overcapacity problem.

Added to that is the ability of Chinese firms to produce goods like chemical products and automobiles at a much lower cost than European competitors (thanks to intense competition, state support, and cheap energy). This overcapacity has materialised into a major threat to European industries, such that it is now referred to as the China 2.0 shock, with the EU (and Germany) preparing strong countermeasures. These countermeasures will take the form of a new EU-wide trade 'bazooka' or anti-coercion instrument. Relations between China and the EU are poor, and there is a risk of a full trade war in 2027. It is also worth stating that many of China's trading partners in the emerging world are suffering in a similar way.

Fading growth momentum

The fact of this overcapacity problem begs the question as to how strong the Chinese economy really is, and relatedly how healthy its drive into new technologies like AI is.

China recently printed one of its lowest official GDP growth readings, and its property market has been struggling for some time.² Despite some deleveraging, it is not clear at all that Chinese banks, amongst some of the largest in the world, have fully reduced exposure to property losses. Also, an amalgam of very detailed, micro indicators (e.g. electricity usage) builds a picture of an economy that is struggling to recapture growth momentum. The domestic economy is weak: property investment³ and retail sales⁴ are close to their lowest levels of the past two decades. China's equity market reflects this and is one of the weakest performers across the emerging markets complex.

Derisking the economy

The response of the Chinese government has been muted. In the past year China has pursued an 'involution' policy of reducing spare capacity across a range of industries, but this does not yet appear to have borne fruit and raises the risk that there is still a lot of operational leverage in the economy. More recently, it has added liquidity to the economy, but the suspicion is that the goal of this is to stabilise the property market and banking sector. China's public debt overshadows that of Western economies, such that an unspoken policy goal is to slowly deleverage and derisk the economy.

In that context, private equity investors will have to continue to contend with the adverse effects of China's overcapacity problem, and the implication this has for Europe's industrial structure. The hope is that it acts as a catalyst for broad restructuring across Europe.

The other aspect worth watching is China's drive into new technologies — batteries, electrification, and of course AI, where it is already setting the standard in terms of accessible language models. In particular, China's renewable energy sector is worth following, and in the next five years may revolutionise access to energy (with electrification technology) across the emerging world. The other concern, for American AI giants, is to launch their IPOs before the Chinese catch up.