# China's Deflationary Trap and Global Trade Implications

**Podcast:** The Economics Show
**Published:** 2026-02-13

## Transcript

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China's economy is unbalanced.
It's struggling with weak demand and energetically pushing out exports to the rest of the world.
You could think of the global economy as a dinner table, where China is making huge amounts of food, but without the appetite to eat much itself.
You could also argue that there's no problem.
The food is delicious and nutritious and everyone's getting fed.
But behind the scenes, China is working really hard to produce all of those elaborate dishes.
So hard that it feels unsustainable.
It feels like a problem.
Yan May is a senior associate fellow at the Baketa Institute for China Studies and an expert on Chinese political economy and geopolitics.
Yanmei, hello.
Hello, thank you for having me.
Thanks so much for being here.
Okay, so on a scale of one to 10, how big of a priority is it for the Chinese leadership to reduce China's external imbalances?
So its trade imbalances with the rest of the world.
I would say perhaps one.
I would say, in terms of Chinese policy priority, you know, solving this trade imbalance with the rest of the world is not very high.
Perhaps it's more concerned about solving this internal supply demand gap.
But to the extent that it's generating such huge trade surplus versus the rest of the world, it is driving the Chinese growth, it's driving China's techno-industrial upgrade.
So I think it's serving the national purpose.
Let's focus first on this issue of internal imbalances.
I think from the outside, there's a perception that you know the Chinese leadership has been talking about raising domestic consumption.
Could you talk a bit about that and kind of how that's being dealt with right now?
So, first, forgive me for being a little bit pedantic.
Let's talk about this word consumption.
So if we go to the origin of Xi Jinping speeches, oftentimes what they're talking about is expanding domestic demand versus consumption, right?
So when they refer to domestic demand, that includes investment-driven demand as well.
The demand can come from government investment in infrastructure, can come from factories buying capital equipment, can come from property investment, right?
Those all contribute to domestic demand, although you know household consumption is part of the equation.
When Xi Jinping and Chinese officials talk about expanding demand, investment is still part of the equation, right?
So there's no chance of Chinese government trying to just reorient the structure of the economy towards a consumption driven economy.
Okay, but we have seen these schemes to try to boost spending on, say, household appliances, right?
There were these trade-in schemes where the government was saying, oh, look, we've got this very depressed household demand, and we're going to essentially subsidize people to buy new air fryers or what have you.
Was that not recognition that consumption needed to be a bit higher?
There is, right?
As I said earlier, consumption is part of the equation.
But also want to say that this program of giving consumers voucher to buy appliances, buy uh you know, durable goods, it's also a detour to stimulus factory production, isn't it?
That's kind of like very different from this Western concept of no string attached consumption stimulus.
Okay, so is what you're saying that these vouchers look like they're meant for households, but really they're meant to be helping out the producers of the appliances?
The party wants to control the structure of the economy, right?
So it's repeatedly stressed that the economy has to be led by the real economy, meaning manufacturing.
There's still a lot of concern of what if the consumers spend the money on the wrong things, right?
So the party is concerned about that.
They're concerned the consumers can be spending the money on, say, internet consumer platforms, which it have been cracking down for the last couple of years, or spending it on internet education, which they also cracked down a couple of years, spending it on housing speculation and reflate the housing bubble, right?
So still the party wants to have its hand, wants to have the hands on the wheel on the structure and direction of the economy.
I mean, it may be that the Chinese leadership isn't so concerned about consumption, but I mean you do agree that consumption is an issue, right?
Yes, consumption is an issue, and I think the Chinese policymakers they do what consumers consume more, right?
So they do see the issue.
I think what they diverge from some of the kind of Western commentators is what to do about it.
So oftentimes I think the Western approach or IMF approach is one, you just stimulate an aggregate demand by issuing consumers lots of cash, right?
That's how the US did it during the pandemic.
Or uh the IMF remedy of redistribution, you give household more transfer, physical transfer through, you know, better pension, better health care, better education subsidies, right?
I think the party is also doing a little bit of that tied to its welfare program and tied to its effort to encourage people to have more children.
So there's more a little bit more childcare subsidies.
But I think fundamentally, if we go back to read Xi Jin King's speeches going back to 2014, 2019, what he sees is still drive consumption through supply.
So it's this idea that if the supply side provide better, more varied products, higher quality products, and make it easier for people to buy through better infrastructure, better logistics, then people will purchase.
His perception is that it's not that people don't have money to buy or not willing to buy, it's that the production side doesn't provide the right kind of products or right kind of service for people to buy, or it's not convenient enough for people to buy.
So there's still continuous sort of like supply side structural reform.
So there is a kind of bureaucratic system that knows how to do the production side stimulus, that knows how to do supply side management, but they lacks a little bit of the tools or willingness to do the kind of like hands-off consumption side stimulation.
Can I ask you now about the supply side?
Because perhaps the Chinese leadership is happy with its approach to demand, but in terms of supply, it does seem like there are problems.
Could you walk us through the main indicators, you know, economic indicators that they're unhappy about?
Right.
I think the problems are quite evident.
Deflation is quite entrenched, and corporate profit margin has been, I think, on the fourth year of decline.
And then in some sectors like the cars, there have been years three or four of pretty vicious price wars.
There was a survey that a large number of car manufacturers have been selling their products at below cost prices.
And also just to give you an anecdote as an indication of how unsettling this dynamic it is to Beijing.
Recently, the central government issued an edict to local governments saying that they have to set a price floor in the procurement, that they have to investigate companies who submit the bidding in government contract at too low a price, right?
So essentially they're saying the local government has to spend more than necessary to fight involution, to fight deflation.
So I think those problems are very much recognized, and the way to tackle is summed up in what they call this anti-involution campaign.
Before we get on to the policy reaction, could you just talk a bit more about the primary mechanisms you see for how companies are able to engage in these price wars and I suppose charge these rock bottom rates when bidding for local government contracts?
Let's talk about this real-time example of China trying to build this AI plus economy.
So last year, about August, the central government issued another action plan called the AI Plus Action Plan.
The idea is that you sprinkle the magic dust of AI on everything, on production, on daily life, on transportation, on governance.
And then that can spark productivity, stimulate growth, stimulate consumption, right?
So because there were central government edict, pretty much every local government then came up with their corresponding AI action plan.
So every government wants to have an AI industry in the province or in their city, right?
And attached to this action plans, they have a target of growing an AI industry by X year.
And then attached to the target, they have subsidies, you know, probably cheap credit, cheap land, tax rebates to companies who claim to fit into this AI plus paradigm, right?
So overnight, then you have tens of thousands of Chinese companies just rush into this industry.
Some are real AI industries, real AI companies, some are not.
But nonetheless, they all claim to be this AI companies, AI plus companies to claim this subsidies and tax rebates, right?
And overnight, you have duplicated industries across the country, across provinces, and then you have supply overshooting demand.
I mean, that's stage one.
I suppose what you would expect to happen then is for these companies to compete against each other and then the bad ones to go bust.
Why doesn't that happen?
That is a very interesting question, because I think you're right that in any industry, any emerging industry, that at the initial kind of capital buildup stage, there will be what we call bubble, right?
Arguably we are seeing that in the West, in the US as well.
People have been arguing that the AI bubble has been building and building in the US.
There's overinvestment, and then there's not enough user case to justify the buildup.
I think that's part of the dynamic in China too.
But I think what's different in China is that because there's so much production, the supply stimulus that tends to obscure the demand signal and tends to delay the calling of the overcapacity, calling of unsuccessful companies through the market mechanisms.
So the market exit oftentimes are delayed, right?
So oftentimes you could see unprofitable companies kept alive by repeated capital injection, either through subsidies or through subsidized banking credit.
So they keep hanging on.
But I guess the question then is why do these local government authorities handing out these subsidies do this?
I mean, surely they've got an incentive to be less generous with their funds.
Right, because um, you know, winding up companies will cause uh job losses, potentially tax revenues, and then you have to write off your GDP and that impact their prospect for getting promoted.
Uh, so the political incentive for keeping the companies alive is high, and the political incentives to allow the market signals to call them is weak.
Okay, so we've got deflation, falling profit margins, some pretty mucked up incentives.
Tell me now about this term involution.
What's your interpretation of how this describes the problem?
This word is uh co-opted from the internet, right?
So initially it was kind of internet buzzword.
Typically, I think I saw it first used as say, imagine tiger moms in China, right?
Everybody competing to have their kids starting from very young age, are taking to all kinds of after-school activities.
And so that created this fear of falling behind and this fierce competition, but at the same time exhausting and self-consuming activities.
And that has been co-opted to describe this phenomenon of vicious competition among companies and industries, right?
So this idea of companies just cutting prices, sometimes below cost, in order to stay in the market, in order to gain market shares.
And so this try to capture this kind of self-consuming and uh exhausting aspect of this competition.
Are there any sectors where this problem is seen as particularly acute?
So officially, this anti-involution pressure has been mainly targeting three sectors.
Uh, they're the electric vehicles, silicon sector, and batteries, right?
But I think the phenomenon is widerspread than the three, because now we're seeing that uh there are warnings in Chinese state media that actually there can be overcapacity in humanoids, uh, in robotics, uh, in satellites.
Why?
Because they are now these emerging strategic industries that the government wants to focus on developing.
So unsurprisingly, because of the dynamic we described earlier, now we have companies just rushing into those industries trying to soak up uh the government largesse.
Just teasing out why the Chinese leadership thinks this is a problem, though.
I mean, you know, on the one hand, you've got, okay, well, lower profits, this is exhausting.
On the other, you've got, okay, well, all these subsidies are potentially a waste of money.
We're just, you know, building up debt to fund these companies that aren't really making a profit.
I suppose a more uh Western concern might be that, well, if you're not making any profit, that means you've got less cash to pour into research and development, and that could actually hamper innovation.
I wonder if that's so relevant here, given that the Chinese government is also subsidizing research, or am I wrong about that?
You're right that the classic Western worry of low profit leads to low RD is probably secondary concern here, because that has not really been happening, right?
So if we look at BYD, for example, the electric vehicle industry has been in price wars for three plus years.
Uh so BYD last year is market shares grew globally, revenues grew, profit margins declined, but its RD has increased.
Uh so I think that has a lot to do with state funding RD.
I think the RD write-off is as high as 100% for tax rebate.
And I think for a company like BYD, probably does not have to worry about access to banking credit.
Uh, so I think the concerns probably are more on the macroeconomic side about this deflation, particularly.
So tell me now about what the Chinese communist Party is trying to do to solve this involution problem.
Again, so most of the measures we're seeing so far are on the supply side.
So there are a couple of classic tools.
One is to delay or slow down entry of new companies, right?
So they can be slowing down of issuing production licenses, for example, in the polysilicon industry.
And then recently they're also slowing down issuance of new car models, so trying to slow down the production.
And also on the exit side, there has been a little bit more encouragement of industry consolidation, right?
So encouraging, say bigger companies, more successful companies to buy less successful ones.
Sometimes it's state managed and orchestrated, right?
So there would be, say, a local government vehicle set up to facilitate this kind of consolidation.
But this round, we are also seeing something different under the kind of the rubric of building in unified national market.
The central government is trying to take some of the investment policy autonomy from the local governments.
They're setting up red lines, setting up guidances, and local governments can only channel their investment subsidies within those boundaries.
And then just to show how serious they are, violation could be subject to anti-corruption investigation, right?
So it's this idea of local government has been investing repetitively and competing with each other and creating this overinvestment and overcapacity.
Hence, the central government wants to centralize some of the investment decision making.
Call me old-fashioned.
I don't believe that more state, more state intervention is the answer to a problem that's resulted from state intervention.
Right.
I mean, it sounds like they're trying to fix a problem of marked up incentives by just trying to manage the outcomes rather than fixing the underlying incentives.
I have a lot of sympathy for Chinese local cadres, right?
Imagine putting yourself in their shoes.
You still have to meet the growth target.
I think it's still around 5%.
And one of the engines is pretty much stopped.
The real estate is still in the dumpster.
So consumption is still pretty weak.
And how do you how do you generate enough GDP growth and investment is still a surefire avenue to tick that box?
My hunch is that to be politically safe, there will be more investment just channeled into this politically approved sectors.
So I think the next five-year plan will include uh commercial space technology as part of you know future strategic emerging industry.
And I think the AI-related, like humanoid will be one of the uh strategic industries.
So the safe thing for the local government to do to generate investment to meet the growth target while being politically safe is to channel the production into those sectors.
But hang on, it sounds like you're not going to avoid the problem of repetition if everyone's now challenging their resources into fewer and fewer sectors.
That's exactly right, right?
So, as we explained earlier, the example of the AI plus.
Now everybody wants to have an AI plus economy.
Uh, for example, inner Mongolia, which is a prairie state, agrarian prairie state, they want an AI economy tied to agriculture and Shanxi, which is a mining province.
Uh, they also want an AI economy, perhaps to turbocharge the mining industry.
Right.
So, yes, I think you're absolutely right that there will be a lot of repetitive buildup in those politically favored sectors.
One thing that has really struck me is that you know, historically there have been problems of overcapacity, um, say in steel, and the Chinese government had a pretty easy lever.
Lots of the companies involved were state-owned, and so it could just tell the managers don't produce so much, cut your capacity.
More recently, though, it seems like the issues of overcapacity have been much more concentrated in the private sector.
So, how is the approach different?
I'm glad you brought up that steel example, right?
So, I think you're talking about 2015, 2016, they were pretty bad overcapacity in steel and coal and a couple of other commoditized industries.
And you're right, uh, those industries were dominated by SOEs, and they were pretty responsive to kind of supply side management.
On one hand, consolidation of the existing capacity and preventing new capacity buildup.
And then that seemed to reflate prices in those sectors.
But then crucially back then, demand was on the upswing due to a combination of economic conditions and government stimulus in the property sector as well as infrastructure, demand for those sectors recovered pretty quickly.
Well, now this time, as you mentioned, the issue of deflation is not confined to a couple of those kind of state-dominant sectors.
It's economy-wide.
Why?
Because aggregate demand is really limp.
So companies doesn't matter if it's steel, coal or food delivery, they do not have pricing power.
But the government still is trying to do supply side management, right?
Trying to prevent companies from lowering prices, but then not really fundamentally solve this demand deficiency.
And hence I think we're not seeing the results so far.
What signs are you looking out for?
The all of these actions to try and tackle involution are working?
I think the probably most potent signs uh is price recovery, right?
So if we see reflation, that would be a very strong signal.
And then the then we can look for secondary signs, our factory utilization rate going up, our corporate profit margins rising, and those will be signs that reducers would have higher pricing powers.
What do you make of the official Chinese government data recently that described falling fixed asset investment?
That could be seen, I guess, as a sign that the government's efforts to curb investment have been working.
How much would you read into those numbers?
The short answer is I don't know.
I think because of the high pressure of the anti-involution campaign, and because of uh how politicized it is, right?
As we said earlier, uh, you know, violation can invite anti-corruption investigation.
So I think the political incentive for local officials to underreport investment is very high.
Okay, so a few asterisks around that one.
Let us go to a break now.
But when we get back, I want to ask how other countries should be responding to launch your business?
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We are back from the break.
So now I want to talk about another piece that you wrote recently, and it is associated with this problem of imbalances.
So you've got the involution issue in China.
One way that they're coping with that is by companies exporting a lot of manufactured goods elsewhere.
And that's coupled with this fear from the rest of the world that China is going to eat their manufacturing sectors, right?
China has risen up the value chain, it's now technologically excellent.
So you've got this wave of imports from China.
And so you've got folks in Europe, even in the US saying, oh, actually, in some areas, we need the Chinese to invest to compete with them.
We need to learn from the best, and now they are the best in some areas.
And so there's this move to what you've described as a reverse dung.
Could you tell me about that?
So it's this idea that Deng Xiaoping invited foreign direct investment, uh, invited foreign multinational companies to China to invest, and then compel them to transfer their technology, train Chinese engineers, train Chinese workers, and then learn from their technology and the process, and then build up China's own manufacturing uh industry, right?
So that has been seen as a successful playbook, and now a number of Western economies want to replicate that as this moniker of reverse done.
Okay, so just look at what China did, repeat.
Is it gonna work?
I am pretty skeptical that it can work to the West, because one, I think there is quite a misunderstanding of how China applied it, right?
So China applied this idea through a combination and dynamic togling between competition and protection.
Uh so first, when China invited foreign companies to produce in China, they set up these special economic zones.
The idea is that they can produce in China utilizing cheap input from China as an attraction, but only for export.
So in the process, Chinese companies can learn from this foreign incumbents, uh, Chinese workers can be trained by them, but these Chinese kind of infant industries are not gonna be overwhelmed by this highly successful foreign giants.
They still have an opportunity to grow in the domestic market.
I remember when I was growing up, I often hear adults complaining that products you know made for exports are a lot better than products available in China.
Now I know that's part of the deliberate policy, deliberate infant industry policy, right?
So I think kind of the Western playbook hasn't internalized this adjusting between competition and protection part.
Okay, so you don't actually think that Western leaders have fully internalized what a true reverse dong would mean.
But I suppose assuming that they did and that they tried to replicate the China model exactly, would there be any other problems, any hurdles?
There will be, and it's pretty tough, right?
So when China invited foreign direct investment in, it was a low-cost producer.
It has lower cost labor, lower cost land, lower cost uh raw material.
Now Western economies are high cost producer, higher cost labor, higher cost energy, higher cost land.
So in theory, say a Western company can learn the full recipe from a Chinese competitor, it still will be producing at vastly higher prices than the Chinese rival.
So I oftentimes use this analogy of let's say the technology blueprint as the recipe.
But then if you have a kind of startup chef who has to pay higher salaries, higher electricity, higher rent, it's not gonna be able to compete with the master chef next door who pays everything at lower prices.
Can I ask about the reaction?
So I feel like when the Chinese did this, you know, other governments complained a bit, but they basically let it happen.
Do you think the Chinese are going to be so relaxed about other countries trying to get Chinese companies to share their technology?
No, they're not relaxed.
I think part of the Chinese export control they've set up in the past couple of years applies to technologies, right?
Applies to some of the battery technologies.
But however, interestingly, now I'm seeing some companies, Chinese companies arguing that the government should be a little bit more relaxed about this technology export because they are eager to escape the evolution in China, right?
They realize that part of the way out of this vicious price war in China is to produce and sell overseas.
And some of them feel that part of the entry price is for a technology transfer.
That's super interesting.
Do you have any examples?
The car industry.
So I think recently the Chinese regulators convened car industry executives to hear the problems and brainstorm solutions.
And then one of the advice from industry is that perhaps Chinese companies should be more collaborative on the technology front with the foreign investment destinations.
That will be music to many officials' ears, I'm sure.
How is President Donald Trump affecting any of this?
Is he making any of it worse?
Is he making any of it better?
I suspect that the conclusion from the Chinese leadership right now is that he's making no difference, right?
So if you look at the headline number, the Chinese exports are still growing very fast and reaching astronomical numbers.
And most US allies, despite pressure from the United States, have not really meaningfully put up trade barriers against Chinese exports, or the barriers they put up are ineffectual.
I also worry that they are overlooking perhaps some substantive damage, right?
So here's how I think.
I think partly because Chinese companies are not able to sell to the US directly as easily anymore, right?
We see the direct exports from China to the US plunged.
Now they have to look for alternative markets.
And in the alternative market, they just do not have the same pricing power as in the US.
So they have to sell their products cheaper in order to gain volume.
And I suspect that is deepening China's deflationary bust.
So we've got these two sources of tension internationally.
One, there's this sense that China is just exporting huge amounts to the rest of the world.
Two, there's a sense that it wants to eat up the whole of the value chain and not share its technology.
Do you see us resolving either of those two problems in the next five years?
I would say perhaps I'm seeing slight more willingness to relax on the supply stimulation and orient towards more attention on consumption, right, at a very high level.
So if I read the nitty-greeny of Party Speak in the last five-year plan, the 14th five-year plan, they were still saying to drive consumption, drive demand through supply.
Now this time they're saying that they have to you know put priority on both supply and consumption.
That's not much, but perhaps that's meaningful.
Okay.
So a hint there that the government's attitudes may be changing.
Yan Me, thank you so much for speaking to me.
Thank you for having me.
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I'm Samea Keynes.
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