“Vicious Cycle of Weak Demand, Subsidies and Cut-Price Exports”: China Offloads Excess-Capacity Burden Abroad, Unleashing ‘China Shock 2.0’ on Korea, Germany and Japan

China’s Manufacturing Sector Contracts for the First Time in Five Months Amid Weak Domestic Demand and Investment
Cut-Price Exports to Clear Inventories Encroach on Core Markets in South Korea, Germany and Japan
Industrial Policy Fallout Spills Into Falling Corporate Profits and Trade Frictions

China’s manufacturing sector entered contraction territory for the first time in five months, weighed down by weak domestic demand and shrinking investment. As the domestic slump swelled inventories and accounts receivable, Chinese companies cut prices to expand overseas sales, putting pressure on the steel, automotive and machinery industries of South Korea, Germany and Japan. Beijing argues that technological innovation and economies of scale underpin its export competitiveness, yet Chinese firms have received as much as eight times the industrial support available to rivals. China’s industrial policy, which has delayed capacity cuts even as corporate profits and local-government finances deteriorate, is increasingly spreading a “China Shock 2.0” across global manufacturing.

China’s July Manufacturing PMI Falls to 49.2, Entering Contraction Territory

According to China’s National Bureau of Statistics on the 5th, the official manufacturing purchasing managers’ index (PMI) fell 1.1 points from 50.3 in June to 49.2 in July. It marked the first reading below 50—the threshold separating expansion from contraction—in five months. The result fell well short of consensus expectations, with median forecasts compiled by Bloomberg and Reuters standing at 50.1 and 50.0, respectively.

The new-orders index also plunged from 51.2 to 48.5, while the production index fell to 49.9, heightening concerns over weak domestic demand and a broader economic slowdown. New export orders, a gauge of overseas demand, slipped 0.5 points from the previous month to 49.6. It was the first decline below 50 in two months. By company size, the PMI for large enterprises fell 1.2 points month on month to 49.5, while both medium-sized and small enterprises remained below 50.

Equipment and high-technology manufacturing maintained expansion, extending the divergence from traditional manufacturing. The equipment-manufacturing PMI stood at 51.4 and the high-technology manufacturing PMI at 53.3, both remaining in expansion territory. In certain sectors, including computer, communications and electronic-equipment manufacturing, both output and new orders exceeded 53, indicating relatively robust production and demand.

By contrast, the consumer-goods manufacturing PMI fell to 47.8, while the PMI for high energy-consuming industries declined to 47.0. Production and new orders weakened across sectors including non-metallic mineral products, ferrous-metal smelting and rolling, and automobiles. Raw-material and factory-gate prices also slowed. In July, the index for major raw-material purchase prices stood at 53.2, while the output-price index came in at 47.8. Both continued a four-month downward trend, partly reflecting fluctuations in raw-material prices.

A July manufacturing PMI compiled by private data provider RatingDog and S&P Global from a survey of roughly 650 manufacturers also declined from 51.7 in June to 50.9, its lowest level in four months. Although it remained above 50 for an eighth consecutive month, the index has now slowed for four straight months.

Table 1. Key Chinese Manufacturing Indicators for July

Weak Consumer Sentiment and Falling Domestic Orders Drive the Downturn

The immediate cause of the manufacturing downturn lies in the contraction of domestic consumption and investment. While new export orders showed some signs of recovery, the imbalance between external demand and domestic demand has persisted. China’s gross domestic product grew 4.3% year on year in the second quarter, down from 5.0% in the first quarter. Fixed-asset investment fell 5.7% in the first half, while property-development investment and private investment declined 18.0% and 8.5%, respectively. As households deferred spending and companies curtailed investment, domestic demand lost the capacity to absorb goods produced by factories. Extreme weather conditions in July—including rising temperatures, typhoons and flooding—also disrupted logistics and production, but the more fundamental causes are seen as depressed consumer sentiment from the prolonged property downturn and households’ preference for preserving assets.

With domestic sales constrained, Chinese companies turned to overseas markets. China’s exports in June rose 27% from a year earlier. The monthly trade surplus widened by roughly 19.2%, from $105.4 billion in May to $125.6 billion in June. Automobile exports reached 1 million units for the first time in June, while first-half trade in artificial intelligence-related products—including electronic components and computer parts—rose by roughly 57% to about $756 billion.

Yet the expansion in exports has not improved Chinese manufacturers’ financial conditions. As of the end of May, finished-goods inventories at industrial firms above a designated size rose 8.8% year on year, while accounts receivable increased 7.7%. This indicates that more companies are failing to collect payment promptly even after selling their products. The PMI output-price index also fell to 47.8 in July.

China’s Cut-Price Export Drive Pressures Manufacturing in South Korea, Germany and Japan

As companies cut prices to convert inventories into cash, China’s destructive domestic competition is increasingly spilling into overseas markets. South Korea, whose export portfolio overlaps with China’s, has maintained its overall export performance on the strength of high-bandwidth memory (HBM) and high-value ships. However, Chinese low-priced products are intensifying pressure in steel, petrochemicals, batteries, commodity semiconductors and industrial machinery. In particular, as Chinese shipments divert to Southeast Asia, India and the Middle East to circumvent U.S. tariff barriers, South Korean companies are facing simultaneous pressure on market share and profitability in third-country markets.

The impact on German industry has been even more severe. As Chinese companies narrow the technological gap in automobiles, machine tools, chemicals and industrial equipment while building price competitiveness, they are directly challenging Germany’s core export industries. German industrial production has fallen by roughly 10% since early 2022, while an estimated 250,000 industrial jobs have disappeared since 2019. The machinery industry lost 22,000 jobs in 2025, while the automotive sector cut 51,000 positions between 2024 and 2025. Germany, which once grew by selling equipment and vehicles to China, now finds itself defending its domestic market against Chinese industrial machinery and electric vehicles.

Japan, too, is struggling against the price offensive of Chinese finished goods. It retains competitiveness in semiconductor materials, manufacturing equipment and precision components, but Chinese companies are rapidly gaining ground in automobiles, electronics and general-purpose machinery. In particular, Chinese electric-vehicle makers are expanding sales networks and local production facilities in Southeast Asia, reshaping markets in Thailand and Indonesia that Japanese automakers had long dominated. According to the Nikkei, Japanese brands’ share of the six largest automotive markets in the Association of Southeast Asian Nations (ASEAN) fell from 77% in the 2010s to 62% in the first half of 2025. A supply-chain reversal has also become increasingly evident, with Chinese products made using Japanese materials and equipment competing against Japanese companies abroad.

As Chinese products encroach on core markets in major economies, criticism of China’s overcapacity has intensified, particularly in the United States and the European Union (EU). Critics argue that domestic consumption and investment have weakened while companies supported by subsidies and policy financing maintain production capacity and sell surplus goods overseas at low prices. The fact that China’s manufacturing weakness is not being resolved through domestic capacity reductions, but instead translates into a widening trade surplus and job losses among trading partners, has also strengthened the case for trade pressure.

Chinese Industrial Subsidies Reach Up to Eight Times Those of Rivals

The Chinese government, however, has categorically rejected allegations of overcapacity. In a 10,000-character policy statement released on July 28, China’s Ministry of Commerce argued that large exports and trade surpluses alone cannot establish the existence of overcapacity. It said appropriate capacity-utilization rates vary by country and industry, and that the price competitiveness of Chinese products stems from technological innovation, economies of scale and integrated supply chains. The ministry also argued that the United States and the EU provide massive support to their semiconductor, electric-vehicle and clean-energy industries, characterizing their efforts to restrain Chinese industries as protectionism. China further countered the West’s “China Shock 2.0” assessment by describing its industrial development as a “China Opportunity 2.0” that lowers global production costs.

However, an Organisation for Economic Co-operation and Development (OECD) survey of 525 global companies across 15 manufacturing industries found that support received by Chinese companies was three to eight times greater than that received by competitors. Of the $108 billion in industrial subsidies provided to major global manufacturers in 2024, Chinese companies accounted for 52%. Roughly 60% of the gains in global market share secured by Chinese companies between 2005 and 2023 were also attributed to government support. In addition to direct subsidies and tax incentives, Chinese companies received a range of support, including low-interest loans from state-owned banks, land supplied by local governments and discounted electricity rates.

The scale becomes even larger when tax, land and financing support are included. The International Monetary Fund (IMF) estimates that China’s industrial-policy support—including cash subsidies, tax incentives, low-cost land and preferential credit—reached as much as 4.4% of GDP in 2023. Based on China’s GDP at the time, that amounts to approximately $780 billion. Cash subsidies accounted for 2.0% of GDP, tax incentives for 1.5%, land support for 0.5% and low-cost financing for 0.4%. Comparable state aid in EU member states amounted to roughly 1.5% of GDP in 2022. The IMF said a substantial portion of the support had generated duplicate investment and distorted resource allocation, recommending that the scale of industrial support be reduced to around 2% of GDP over the medium term. It also noted that subsidized companies had distorted market competition by cutting prices and expanding capacity without sufficiently improving productivity or profitability.

Capacity Expansion Continues Despite Sharp Profit Declines, Worsening Public Finances

The problem is that production capacity continues to expand even as subsidies conceal deteriorating profitability in Chinese industry. Total profits at Chinese industrial firms above a designated size rose 18.8% year on year between January and May, but the gains were concentrated in electronics, communications equipment and certain raw-material sectors. Over the same period, profits in the automotive sector fell 19.8%, those in electrical machinery and equipment declined 13.7%, and those in ferrous-metal smelting and rolling plunged 37.4%. Even as export volumes rise, the greater extent of price cuts is reducing the profits companies retain. Companies that would face financial distress without government support continue production, intensifying both domestic price competition and low-priced export pressure abroad.

The finances of local governments, which bear the cost of subsidies, have also weakened. China’s official general-government debt stood at 60.9% of GDP in 2024, according to the IMF, but expanded debt—including off-balance-sheet liabilities of local-government financing vehicles and government-guided funds—reached 117.0% of GDP. If current policies persist, the expanded debt ratio is projected to rise to 162.7% by 2034. Yet despite declining land-sale revenue and tax receipts due to the property slump, local governments continue to attract factories, build industrial parks and provide low-cost financing. The longer China delays the exit of loss-making companies and capacity reductions, the greater the fiscal burden and the larger the volume of low-priced exports. Unless China resolves its overcapacity problem, deteriorating profitability among its companies, rising local-government debt and capacity cuts in major manufacturing economies will all inevitably be prolonged.