China’s industrial policy confronts fiscal reality

The active risk of deindustrialisation (Opens in new window) posed by a glut of Chinese exports is front of mind for policymakers across the developed world. Although Germany, South Korea and Japan are among the most exposed, China’s mercantilism will also impede (Opens in new window) the growth aspirations of emerging economies seeking to move beyond assembly-based production.

Arguments solely ascribing China’s manufacturing dominance to subsidies (Opens in new window) and intellectual property theft (Opens in new window) are deeply reductive. Beijing’s denials (Opens in new window) of these concerns are even more disingenuous.

The reality is that China spends – depending on the methodology in question – up to 5% of its GDP (Opens in new window) on industrial policy, or at least nine times (Opens in new window) more than the economies of the United States or Germany.

This latter estimate from the Kiel Institute covers tax concessions, government grants and below-market borrowing – excluding myriad other policy instruments, among them government procurement, export credits, subsidised land, utilities and inputs.

As economists such as Michael Pettis (Opens in new window) have argued (Opens in new window), China’s intricate system of subsidies diverts resources away from Chinese consumers and households. China’s parsimonious (Opens in new window) social safety net and financial repression (Opens in new window) are both cases in point.

Together, weak household consumption and industrial subsidies have played a major role in China’s prolonged deflationary (Opens in new window) malaise. The outward manifestation of this dynamic is China’s indomitable export machine taking market share from competitors without a commensurate increase (Opens in new window) in Chinese demand.

While Beijing parries complaints from aggrieved foreign competitors, it is local governments – acting with strategic direction from the central government – who execute and fund (Opens in new window) much of China’s industrial policy.

The finances of local governments have been facing acute strain since the steep collapse of China’s property market in 2021. Funding from land sales – which used to comprise around 40% of total (Opens in new window) revenue – has halved (Opens in new window) in the last five years.

This dynamic, and the growing burden of debt-servicing (Opens in new window), has left local governments reliant on transfer payments from the central government.

Theoretically, the central government is in a much better fiscal position (Opens in new window), with debt of around 30% of GDP. This figure obfuscates more than it reveals.

Beijing continues to play an essential role as a backstop in an economy where total non-financial sector debt exceeds (Opens in new window) 300% of GDP – and where defaults of local government financing vehicles and state-owned enterprises (SOEs) are a rarity.

A slowing economy and eroding (Opens in new window) corporate profitability has exacerbated the hit to fiscal revenue caused by declining land sales. In 2025, total fiscal revenue collected (Opens in new window) by central and local governments was 15% of GDP, down from 22% in 2014. Demographics are adding to the squeeze, with the central government spending (Opens in new window) 10% of its budget last year to plug the shortfall in local government’s social security funds.

The parlous state of China’s finances is, at the very least, forcing governments to make difficult trade-offs.

In Xi’an, local officials actually doubled (Opens in new window) down on subsidies for science and technology, opting instead to cut spending on courts, roads and schools. Perhaps unsurprisingly, local security forces also received additional funding.

At a more macro level, however, evidence is beginning to emerge that the spigot is being tightened. Government Guidance Funds (GGFs), act as a type of venture capital fund for local governments and have deployed at least US$500 billion (Opens in new window). Data available (Opens in new window) for 2024 shows that the establishment of new GGFs fell by 32%, while pledged capital decreased by 37%.

As well as being driven by explicit fiscal pressures, the decline (Opens in new window) in GGF activity reflects attempts by the central government to better align funding with overall national priorities. Grants to SMEs and listed companies also registered noticeable declines in 2024.

Given fiscal constraints, Beijing is now leaning on capital markets and China’s vast banking system to marshal capital towards companies in priority sectors.

But the banking sector can only do so much. Pressure on banks to provide local governments and ailing SOEs with cheap capital has led to a collapse (Opens in new window) in net interest margins over the last decade.

Some China watchers think Beijing is counting (Opens in new window) on a massive increase in productivity and corporate profitability, which will ultimately replenish state coffers. Barring that or other increases to revenue like taxation, fiscal reality demands that China be increasingly judicious in its use of industrial policy.

Will the rest of the world get a meaningful reprieve?

Probably in some sectors, but the picture is far from clear cut.

Titans such as BYD, CATL and Huawei lead global innovation in their sectors. Subsidies help (Opens in new window), but are not necessarily the driving force behind their competitive advantage.

China’s sheer economies of scale, huge STEM workforce (Opens in new window), growing dominance (Opens in new window) of industrial supply chains and ability to vertically integrate will all continue to confer their own potent advantages.

Tighter constraints on industrial policy might also help rationalise sectors experiencing intense overcapacity, to the benefit of industry leaders.

Economies in the industrialised world would do better than to hope for China Inc to collapse under the weight of its own contradictions.