China's Keynesian Model Is Crumbling. It Needs a Trade Deal, Fast…

Authored by Daniel Lacalle,

In the past decade, the Chinese economy has expanded its central-planned neo-Keynesian model that simply cannot survive without a trade deal. The Chinese manufacturing sector has followed a running-to-stand-still strategy that simply cannot subsist without the enormous trade surplus with the United States.

The Chinese manufacturing sector overcapacity is not an anecdote. It is the norm. China produces 30% of the world’s manufacturing goods but consumes less than 18%, according to CKGSB. Additionally, China’s industrial capacity utilization rate fell to 74.1% in the first quarter of 2025.

China’s Keynesian central planning model aims to maximise employment and maintain strong economic growth, despite financial constraints and excessive indebtedness. Thus, it needs to sell its excess production to avoid a massive problem of working capital. Even the government has recognised the problem in a roundabout way, noting that “involution”-style competition (wasteful competition) is a major focus for the 2025 economic policy, and steps are being taken to reduce unnecessary investments and control growth in some industries. However, overcapacity in China is not a fatality; it was created by political design, with local and national authorities trying to boost GDP at any cost.

The model is aimed at keeping full employment and economic growth even with economic returns below the cost of capital, and it almost works if the excess capacity can be sold globally, receiving reserve currency and maintaining low costs by passing the working capital cost to global consumers and maintaining low production expenditure with currency controls and exchange rate fixing. However, the combination of rising debt, a constantly weakening currency, and the escalating bankruptcy and working capital issues could potentially bring this model to a collapse, even in the absence of an official recession.

China has learnt that it cannot endure a trade war and cannot substitute the US consumer, the richest and largest market, with European or Latin American consumers. Therefore, it needs a trade deal quickly before the domino of bankruptcies that has plagued the Chinese economy since 2021 erupts into a full-blown financial crisis.

China is officially in deflation for the third consecutive month in April. Business insolvencies are projected to increase by 7% in 2025 and by 10% in 2026, according to Allianz, even as the government implements additional fiscal stimulus.

Small and medium-sized enterprises, particularly exporters, are facing mounting bankruptcies due to declining cash flow and the elimination of US tariff exemptions. Job losses are rising in export-dependent regions, and the urban unemployment rate is expected to average 5.7% in 2025, above the official target, according to CNBC.

The official NBS Manufacturing PMI fell sharply to 49.0 in April 2025, the steepest decline since December 2023, reflecting a drop in output, new orders, and employment, with foreign orders shrinking to their lowest in at least eleven months.

The collapse of the real estate sector, which once accounted for up to 30% of GDP, has weakened banks, reduced household wealth, and led to a negative wealth effect, further depressing consumption and credit demand.

China’s economic strengths are well known, but the weaknesses are too important to ignore. The situation serves as a reminder that central planning never works. Everything that is weak in China comes from previous years of government policies aimed at boosting economic growth by building stuff and hoping it would sell at some point. Furthermore, rising bankruptcies, an imploding property market, and mounting local government debt strain the financial system just as non-performing loans from the Belt and Road Initiative (BRI) soar. Several BRI countries have defaulted on their debts or required IMF bailouts, including Sri Lanka, Zambia, Ghana, and Pakistan, while the BRI generated $385 billion in off-the-books debt.

Keynesian policies always lead to high debt and stagnation. However, when combined with a centralised planning system, a closed financial system, and capital controls, Keynesian policies create a dangerous mix of overcapacity, poverty, and economic slack. China can only begin to address its enormous working capital problem through a quick and successful trade deal with the United States. It will benefit China enormously if the government opens its economy, lifts capital controls, and allows the private sector to breathe. An implosion of the overcapacity problem hidden from the media, offset by even more central planning and stimulus spending, is only going to weaken China in the long run.