• Involution occurs when industrial policy inflates an industry and then government support allows unprofitable firms to continue operating.
• Large-scale industrial policy helped spur China’s world-leading auto industry, but it is now mired in turmoil and beset with involution.
• Policymakers’ refusal to allow industries to restructure leads to wasted resources and firms that are less competitive.

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

According to state media and many analysts, competition is spiraling out of control in many Chinese industries. Sectors ranging from electric vehicles, batteries, and solar panels to machinery, steel, and copper now suffer from severe overcapacity and cut-throat price wars. In China, destructive competition that pits businesses against one another in a desperate race to the bottom is called “involution” (内卷). In involuted industries, firms continue to invest in capacity that far exceeds domestic demand, often dumping in foreign markets. Prices fall amid oversupply as rivals use scorched earth tactics to capture market share, and companies incur heavy losses. The market’s corrective mechanisms fail to take hold because cheap financing and government support allow unprofitable firms to avoid bankruptcy.

The spread of involution across multiple industries has prompted a strong response from Beijing, with Chinese officials sternly warning industries that there “are no winners in a price war.”¹ Chinese regulators have issued new rules to regulate “disorderly” business practices and threatened to investigate firms that do not comply. However, such measures treat the symptoms rather than the underlying disease: involution ultimately stems from the state’s ability to distort markets by channeling resources toward preferred industries.

The Cycle of Involution

It is important to distinguish involution from routine bursts of intense competition within an industry. Recently, the coffee, milk tea, and food delivery industries have engaged in price wars. These periods of intense competition can be disruptive, but they last only as long as private companies involved can afford to sustain them. For example, the fierce contest between Starbucks and Luckin Coffee made headlines but appears to be winding down as Starbucks considers selling off its China operations.²

Involution, in contrast, arises when the government distorts markets through subsidies, cheap credit, and preferential treatment for state firms. Such intervention allows destructive competition to persist for far longer and on a much larger scale than normal markets can sustain.

The cycle of involution begins when Beijing or local governments single out an industry for support. Once an industry is targeted for development, a surge of resources is unleashed that supercharges the industry’s growth.

Direct subsidies, tax incentives, cheap land, and discounted energy are directed to the industry by the government. State financial institutions complement this effort by channeling large amounts of lending into the sector. In addition, government investment funds shower startups in the industry with early-stage financing, and regulators fast-track public listings so firms can raise capital.³ Fanning the flames further, state enterprises pledge large investments in the industry. The flow of money and support acts as a steroid, letting industries expand at a speed and scale that market forces could never sustain.

Eventually, Beijing begins to taper the flood of resources, often in response to glaring signs of involution. Yet destructive competition may persist for an extended period before industry restructuring begins. This is because local governments in China seldom allow the restructuring to occur without their involvement. Localities are keen to intervene to keep local champions afloat and to protect jobs. They have resources of their own – such as local investment funds, local SOEs, and local banks – that allow them to provide lifelines to unprofitable firms. This slows the necessary adjustment of the market and allows involution to negatively impact an industry for far longer than they otherwise would. Thus the cycle of involution consists of the state inflating an industry and subsequently interfering to artificially delay the restructuring that must eventually occur.

How to Spot Involution

The key to spotting involution is to first look for industries targeted for support by the government. Within those industries, there are several common characteristics that indicate the onset of involution, including:

Low Margins: Industries experiencing involution see substantial declines in their margins (see Figure 1).

Source: Wind Information.

Selling Below Cost: Involuted industries often see firms selling products below their cost in an attempt to retain market share.

Deflation: A key indicator of involution is an extended period of deflation for firms as overcapacity puts downward pressure on prices (see Figure 2).

Source: CEIC.

Overcapacity: Involuted industries have investment in production that far outstrips demand, creating severe overcapacity problems.

Squeezing Suppliers: Companies in industries caught in involution often delay payments to their suppliers well beyond normal commercial terms to shore up their finances.

Zombie Firms: Industries mired in involution are littered with zombie firms, financially distressed companies that survive for long periods without being forced into bankruptcy.

Nothing New Under the Sun

Despite the recent media coverage, involution is not a new phenomenon in the Chinese economy. During the 2010s, industries such as coal, steel, cement, and aluminum were plagued with involution-like problems.⁴ Like now, the Chinese government mobilized new policies – referred to then as Supply Side Structural Reform – to address these problems.

Beijing’s approach to the problem was conveyed through a series of interviews by an unnamed “authoritative person” in state media between 2015–2016. Widely believed to be Liu He, Xi Jinping’s chief economic adviser at the time, the authoritative person opined that the root cause of these problems was that “the government intervened too much, causing the market to not clear.”⁵ The government created “zombie enterprises,” loss-making companies that kept operating indefinitely, through loans and subsidies. Therefore, the “most urgent task” was for the government to shut down these zombie companies, in the process reducing excess capacity and freeing up resources, capital, and room in markets for other competitors.

Did Beijing follow the advice of the “authoritative person”? In retrospect, the message appears to have been lost. Rather than reducing its interference as recommended, Beijing took an active role in reorganizing these industries. Officials relied on administrative orders, not market forces, to push firms to reduce excess inventory and shut down production capacity. Attempts to eliminate zombie companies, especially among state-owned enterprises, were frequently thwarted by vested interests such as local governments and state banks. In many cases Beijing responded by merging state firms into even larger conglomerates, as with Baowu Steel and Wuhan Iron, or Shenhua Group and Guodian, instead of closing them.

As a testament to the limits of Beijing’s approach, overcapacity re-emerged in several industries only a few years later. The authoritative person’s diagnosis proved correct: state intervention in the market created overcapacity and involution. However, because Beijing had not abandoned its proclivity towards industrial planning, the same problems were bound to return.

China’s Auto Industry: Exceptional or Involuted?

China’s auto industry serves as a live example of how involution continues to occur. The meteoric rise of Chinese electric vehicles has generated worldwide attention. Beijing was early and aggressive in drafting industrial policies to support the growth of EVs. Driven by EV sales, domestic automakers have rapidly displaced foreign brands as the largest portion of China’s domestic auto market.⁶ Even more impressive, China is now the world’s largest auto exporter, surpassing Japan, Germany, and the United States.⁷ Foreign automakers now speak of their fear that Chinese EVs could wipe them out in their home markets without trade restrictions. At face value, it seems like an unqualified success for Beijing’s industrial policies which have targeted the creation of a domestic EV industry.

Despite its seeming success, the auto industry is mired in turmoil and many firms are teetering on the brink of financial distress. The industry is awash in overcapacity, with dozens of different automakers all competing for market share. Goldman Sachs estimated that by 2026, Chinese EV manufacturers would have capacity to produce 25 million vehicles per year, an amount equal to the entirety of projected global demand.⁸ Meanwhile, traditional gas car makers have been reluctant to reduce their capacity despite tepid sales.

Overcapacity in the auto industry has worsened amid the ongoing phase-out of EV subsidies. This has led to the outbreak of price wars and automaker profit margins have fallen precipitously (see Figure 1). Competitors are accusing each other of selling below cost to drive out competition. Excess inventory problems are so bad that dealerships are taking brand new cars and marking them as “used” in order to circumvent price floors imposed by manufacturers.⁹ Suppliers are complaining that they are being squeezed by automakers who have forced them to accept egregious payment terms. The industry’s accounts payable have skyrocketed due to this abuse of suppliers (see Figure 3). The government and industry associations have called on automakers to rectify their destructive business practices and issued new regulations requiring automakers to pay their suppliers within 60 days.

Source: Wind Information.

The problems plaguing the auto industry are hangover effects of China’s large-scale industrial policies. Through direct subsidies, preferential tax breaks, cheap credit, and other support, the government channeled massive resources into the sector, fueling an unsustainable boom that produced almost five hundred EV makers at its peak.¹⁰ Grappling with excess supply and dwindling subsidies, automakers have slashed prices and battled for market share to survive. Beijing and local governments, however, have refused to let the industry restructuring run its course. Instead, they have sought to guide consolidation, protect favored firms, and delay production cuts to avoid mass layoffs. As a result, excess capacity and unprofitable companies have persisted far longer than they otherwise would have.

The auto industry in China is paradoxical in that it is simultaneously a successful example of industrial policy and a cautionary tale for involution. The industry’s long-term fate will be decided by how Beijing chooses to allow restructuring to play out.

Conclusion

As analyzed in China’s Models of Competition, industrial policy can supercharge the growth of industries. However, the flood of resources must eventually come to an end. When that occurs, Beijing faces a key dilemma. Does it allow a market-based restructuring of the industry where the best and most efficient firms (usually private) consolidate market share? If so, an industry may avoid an extended period of involution and emerge on a more sustainable trajectory. Having survived the shakeout, the remaining firms are likely to be quite strong, perhaps even globally competitive.

Beijing and especially local governments often refuse to allow this restructuring to occur naturally. Government intervention creates a protracted adjustment that extends the duration of involution. When the long process of rationalization is finally complete, the resulting industry is less competitive than it could be because many inefficient firms were not forced to close.

The irony is that while Beijing is currently heaping blame on companies for engaging in destructive competition, its own policies have created an environment where involution can occur. Even more confounding is that the Chinese government identified the causes of involution a decade ago but has failed to follow through on its own policy prescriptions to prevent it.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of June 30, 2025, the Seafarer Funds did not own shares in the securities referenced in this commentary.

1. “China Vows to Tackle ‘involution-style’ Competition in Auto Sector.” The State Council Information Office of the People’s Republic of China, June 3, 2025.
2. Feng, Yiming, Yunxu Qu, and Wei Han. “Starbucks Courts Buyers as It Weighs Sale of China Business.” Caixin Global, June 24, 2025.
3. Zhang, Erchi, Min Tan, Peilin Liu, Yunxu Qu, and Denise Jia. “A New Gold Rush Begins in China’s Hard Tech Sector.” Caixin Global, July 21, 2025.
4. Boulter, John. “China’s Supply-side Structural Reform.” Reserve Bank of Australia, December 2018.
5. “7 Questions About Supply-Side Structural Reform (Interview with the authoritative person) 七问供给侧结构性改革 (权威访谈).” People’s Daily, January 4, 2016.
6. Waldersee, Victoria, and Joseph White. “Volkswagen is Reeling in China. Can EVs Help it Grow in the US?.” Reuters, July 23, 2024.
7. Chang, Agnes, and Keith Bradsher. “How China Became the World’s Largest Car Exporter.” The New York Times, December 3, 2024.
8. Trina Chen, “China’s Capacity—Imbalances, Inflections, and Beyond Cycles.” Goldman Sachs, August 6, 2024.
9. Yu, Cong, and Yi Dong. “Chinese Dealerships Pass off New Cars as Used Amid Auto Glut.” Caixin Global, June 10, 2025.
10. Moss, Tefor. “China Has 487 Electric-Car Makers, and Local Governments Are Clamoring for More.” The Wall Street Journal, July 19, 2018.