Why China’s Overproduction Won’t Stop: The Case for a “Fourth Option” in Trade Remedies

Key Poinst

1. In China, industrial policies that encourage aggressive market entry, combined with the high political costs of allowing loss-making firms to exit, have made overproduction a structural problem. The result is the persistence of “zombie firms” that continue producing despite sustained losses. This dynamic not only erodes industrial capacity abroad but also harms China’s own economy.
2. The WTO framework provides three principal trade remedies: anti-dumping duties to address injury caused by unfairly low-priced imports, countervailing duties to address injury caused by subsidized imports, and safeguards to respond to import surges even where no unfair practice by the exporter is involved.  None, however, directly addresses exports by firms that continue producing despite sustained losses.
3. A “scale tariff” should be introduced as a fourth trade remedy, designed to directly offset excess exports by loss-making firms. The CPTPP and the EU should also take the lead in developing a mechanism to coordinate tariff rates across importing countries.

Industrial Policy and Global Imbalances

China is engaged in fierce innovation competition with the United States in frontier fields such as AI and autonomous driving. At the same time, industries such as steel, solar panels, and EVs have become broadly loss-making in the domestic market, prompting firms to shift their focus from domestic sales to overseas markets. Both the “bright” and “dark” sides of China’s industrial development are products of intense competition driven by rapid entry and persistently delayed exit.

Over three decades, the Chinese government has developed increasingly effective ways of steering private investment through lists of encouraged industries and technologies. When the government seeks to develop a particular industry, building out supply chains from upstream inputs to downstream production can reduce costs across the industry as a whole. Given the scale of China’s economy and population, the positive externalities generated by such industrial linkages can be especially large. On the basis of such lists, investment from banks and private funds is induced, and local governments’ priorities for allocating land are determined. Rather than supporting specific state-owned enterprises by name, listing recommended “technologies” gives rise to inter-firm competition even in new industries, creating an environment in which capable firms hone their abilities.

The rapid development of the EV industry resulted from the combination of such policies and the efforts of capable entrepreneurs. Under the EV-promotion measures that began in 2016, consumers were eligible for EV purchase subsidies only if their vehicles used batteries from firms on a government-designated whitelist of 57 companies. BYD and CATL, which benefited from this policy support, are now leading EV-battery manufacturers. However, this first whitelist did not include the batteries of Panasonic, AESC, LG, or Samsung—the leading firms of the time— raising serious questions under WTO rules: as a subsidy effectively contingent on the use of domestically made batteries, it falls within the SCM Agreement’s prohibition on import-substitution subsidies and the national-treatment obligation. Moreover, it must be pointed out that the Japanese and Korean governments did not, at the time, mount an effective challenge to this. According to a study that analyzed the effects of industrial policy in the EV market within the framework of industrial organization, the exclusion of foreign firms at that point had a large effect and, in substance, resulted in substantial losses of market share for Japanese and Korean firms.

Why Overproduction Won’t Stop—the Structure of “Entry Without Exit”

Such industrial policies successfully encouraged firms to enter the market. On the other hand, China has a problem in which, even when firms become loss-making, they often continue production rather than exiting the market.

As Figure 1 shows, in the automotive industry, for example, the number of technology categories targeted for phase-out or restriction—centered on internal-combustion-related technologies—remained roughly unchanged from 2011 to 2024, while the number of categories encouraged, such as batteries and materials, more than doubled over the same period, from four to nine. The problem is that no mechanism exists to promptly facilitate market exit when excessive entry occurs in an encouraged industry.

Indeed, the 57 companies that entered the EV-battery industry in 2016 continue to produce today, even though the industry as a whole became loss-making in 2024. The same phenomenon occurred in the steel industry in the 2010s. In 2015, all but one of the publicly listed steel firms reported losses, yet subsidy support for these firms continued and overproduction persisted. In particular, where many state-owned enterprises operate in such markets, the high political costs make it difficult to encourage market exit. As a result, excessive entry and production are repeated across many industries.

Behind overproduction lie not the management decisions of individual firms so much as two structural factors: an industrial policy that pushes rapid entry, and political constraints that block loss-making firms from exiting. As a result, so-called “zombie firms” that keep producing while carrying losses come to be preserved across industries.

The Consequences of Overproduction: Damage Abroad and Denial at Home

Firms that would ordinarily be forced out through competition in the domestic market instead continue exporting at low prices, supported by government policy and the high cost competitiveness of the industry as a whole. This is the essence of overproduction—the dark side, one might say, of China’s industrial policy—and it has the power to erode industrial capacity abroad.

When an emerging economy pursues industrial-structure transformation and economic growth through its own industrial policy, and the resulting maturation of industrial linkages raises its cost competitiveness, the risk of damaging the industrial base of its export destinations grows, giving rise to economic friction. A similar dynamic was evident in U.S.–Japan trade friction. It is also one of the economic factors behind the rise of MAGA (Make America Great Again) as a political force in the United States in recent years. Centered on the Rust Belt, the discontent of workers who lost their jobs, or feared losing them, as a result of import competition from emerging economies helped fuel support for protectionist political movements.

In 2024, however, Chinese President Xi Jinping told European Commission President Ursula von der Leyen that there is no so-called “China overcapacity problem,” whether from the standpoint of comparative advantage or of global market demand—with the result that, in China’s policy arena, overproduction itself came to be treated as a problem that did not exist. As diplomatic discourse, this stance was unchanged in a document submitted by China’s Ministry of Commerce in July 2026.

As an economic problem, however, this issue has not vanished. In steel, for example, since 2024 domestic production has far exceeded demand and exports abroad have expanded rapidly; not only Europe but emerging economies such as Vietnam, India, and Turkey, and Japan as well, are responding through WTO challenges and trade remedies such as anti-dumping and countervailing duties.

Within China, too, excessive competition is regarded as a serious economic problem, and calls for action are strong. In 2025, the Chinese government itself rolled out an anti-“involution” policy, and as of August 2026 it continues to emphasize repeatedly the need to correct low-price involutionary competition.

Why the Existing Trade Remedies Don’t Work

Behind the way overproduction-driven exports generate economic friction lies not only the structural problem of China’s so-called “socialist market economy” but also a design flaw in the WTO’s trade remedies themselves.

WTO rules recognize the right of an importing country to respond with anti-dumping duties when its industry is harmed by dumped imports—goods sold for export below their normal value—that cause material injury to the domestic industry. Yet neither measure directly disciplines the act of continuing to export while running losses, or overproduction itself. The current method of calculating duty rates also overlooks important economic dynamics, so that, in reality, it fails to give domestic industry sufficient protection as a response to overproduction.

For import surges in which the exporting side is not at fault, the right to respond with safeguards (emergency import restrictions) is also recognized under certain conditions, but these measures are not designed to address structural problems in the exporting country.

Why are anti-dumping and countervailing-duty rates not enough to stop overproduction? Anti-dumping duties are based on the difference between the normal value and the export price (the dumping margin), while countervailing duties are intended to offset the ‘benefit’ conferred on the recipient firm of the subsidies. In economic terms, both can be understood as attempts to correct ‘excess exports,’ but their calculation methods have pitfalls.

First, the price decline caused by unfair low pricing or by the benefit of subsidies is no more than the initial trigger for the overproduction problem. For example, a temporary rescue subsidy may initially lower costs. Even after the subsidy ends, expanding production and exports can further reduce costs through learning effects generated by accumulated production experience, which in turn encourages still greater production. Current anti-dumping and countervailing-duty rates do not take this dynamic effect into account. Second, in a market that has already fallen into overproduction, even if exporting firms raise their prices somewhat, global supply and demand scarcely change. Unless sufficiently high duty rates that account for such economies-of-scale effects are set, neither anti-dumping nor countervailing duties will function sufficiently as a response to overproduction.

The “Scale Tariff” as a Fourth Option

For this reason, I propose a “scale tariff” that directly deters the excessive scale of production itself, as a fourth trade remedy. It is a method of calculating an additional duty rate that treats exports from firms recording losses domestically as “excess exports” and aims to offset those excess exports directly. In Watanabe (2026), for steel exports from China driven by the rescue of zombie firms in the latter half of the 2010s, I estimated the excess portion and conducted counterfactual simulations to assess the corrective effects of existing anti-dumping and countervailing duties and of a hypothetical “scale tariff.” Figure 2 compares the export-reduction effects of the two current trade remedies (excluding safeguards) and the hypothetical scale tariff. Under the current rate-calculation method, which does not consider economies-of-scale effects, exports arising from “overproduction” cannot be brought completely to zero.

There is another problem with the current trade remedies: for excess exports arising from the same cause, countries set widely varying additional duty rates. As a result, exports keep pouring into countries with lower duty rates, and loss-making producers in the exporting country have less incentive to cut production. To address this, a new instrument is needed that would allow importing countries to harmonize their duty rates on exports of the industry in question from the country where loss-making exports originate. As a first step, CPTPP members and the EU could coordinate their tariff responses to such loss-making exports.

In the first year of China’s EV-promotion measures, the failure to object to the discrimination against foreign firms—a clear WTO violation—resulted in Japanese and Korean EV-battery firms losing their markets. And even now, low-priced exports driven by overproduction with industry-wide deficits are displacing overseas competitors. The first should have been disciplined under existing WTO rules; the second requires rules that do not yet exist. Yet because the existing rules could not be operated effectively, or because appropriate means of discipline were lacking, the situation has worsened. The Japanese government should make active and effective use of WTO rules and respond in ways that secure the industrial base of Japanese firms.

(c)Alamy Stock Photo/amanaimages