Hefei Model Successful but Hard to Replicate, Industrial Policy Can't Cure Supply-Demand Imbalance
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Hefei Model Successful but Hard to Replicate, Industrial Policy Can't Cure Supply-Demand Imbalance
Despite Hefei and other cities cultivating world-class industries through smart industrial policies, the fundamental contradiction between investment overheating driven by local government incentives and insufficient demand remains unresolved; relying solely on industrial policy or exports cannot reverse deflationary pressures.
- Hefei's success stems from timing, bold bets, and alignment with local industrial strengths, difficult to be simply replicated elsewhere.
- Even with better industrial policies, they only shift investment direction rather than reduce total investment, leaving the supply-demand gap unchanged.
- Strong exports help alleviate excess capacity, but their job and income multiplier effects are weakening, and they are vulnerable to global cyclicality and trade friction.
- China's economy is expected to exhibit a 'K-shaped' recovery in 2026-2027, with new economy sectors (AI, new energy) strong but old economy (consumer, real estate) weak.
- The ultimate solution lies in economic rebalancing reforms, including adjusting official evaluation criteria, reforming the fiscal system, and strengthening social safety nets to boost consumption.
Report interpretation
Overview
This report explores why, amid macro imbalances and deflationary pressures, relying solely on smart industrial policy (as exemplified by the renowned 'Hefei model') and strong exports cannot solve China's problems. Using Hefei as a case study, it argues that the city's success is specific and non-replicable, emphasizing that the local government incentives prioritizing output and investment are the root cause of excessive investment and insufficient demand. Therefore, the real solution lies in deep economic rebalancing reforms rather than merely optimizing investment allocation.
Core views
The report's core view is that while China's 'Hefei model' has achieved remarkable success in nurturing specific strategic emerging industries (like display panels, DRAM chips, and NEVs), it cannot address national-level macro imbalances. This success relied on fortuitous timing, bold early-stage capital commitment, and favorable demand cycles—conditions hard to replicate nationwide. Competitive imitation could lead to duplication and overcapacity in trendy sectors, worsening existing issues. Crucially, such industrial policies inherently redirect investment "where" (away from inefficient towards efficient areas) but do not change the "total" incentive for local governments to over-invest. As long as official evaluation prioritizes GDP and investment growth, and the VAT-heavy tax system rewards production, resources will keep flowing toward investment, squeezing consumption and household incomes, thus maintaining supply over demand. Meanwhile, the report sees strong exports driven by global AI and energy transitions as only a partial and temporary relief. Modern exports becoming more capital-intensive have lower employment multipliers, weakening income-spillover effects to the domestic economy. Over-boosting external demand also makes China more exposed to global volatility and trade protectionism, rendering exports a symptom-reliever rather than a cure.
Analysis framework
The report adopts a 'case study + macro deduction' framework. First, it uses Hefei as a prominent case study to dissect its 'ecosystem planner' industrial policy (including government-as-patient-capital, public-private co-investment, supply-chain building, and marketized exits with recycled gains), and affirms its micro-level success. Then, through comparative analysis, it uncovers the unique conditions behind Hefei's success (timing, boldness, local strengths), arguing for the difficulty and risks of nationwide replication (spurring new overcapacity). Next, the perspective shifts from micro to macro, applying 'incentive analysis' to explain the structural imbalance's root causes. Local government behavior is steered by performance evaluation ('cadre appraisal') and revenue structures (VAT tax system), resulting in a systemic investment bias. Against this backdrop, the report assesses why the two proposed solutions—better industrial policy and stronger exports—are palliative: neither modifies the underlying incentives.
Methodology notes
The dynamic balance between supply and demand is fundamental to gauging macroeconomic health. When supply persistently outpaces effective demand, inventories build, prices fall (deflation), and corporate profits compress.
Using the supply-demand framework, the report clearly identifies that China's issue is not mere industry-level overcapacity but a broader, prolonged economy-wide 'supply > demand' imbalance driven by local governments' investment bias. While investment expands supply, inadequate household consumption fails to match it, sustaining deflationary pressure.
Economic activity undergoes cyclical fluctuations driven by credit expansion and contraction. Investment vehicles (local government financing vehicles—LGFVs) underpin China's credit-fueled investment and growth patterns over the past decade.
Implicitly applying the credit-cycle lens, the report notes that robust industrial capex in 2021-2023 offset the then-slumping real estate investment to maintain growth targets. Local governments leverage financing channels (including LGFVs) to act counter-cyclically—a stability tool that also fuels structural distortions and debt accumulation.
Profitability is a critical gauge of economic health. Even with market share gains, intense price wars or high costs squeeze earnings.
Analyzing the Hefei case, the report observes that while local firms lead in market share, 'profitability is compressed,' reflecting macro-level deflationary pressures at the micro-enterprise level due to fierce competition and oversupply.
An industry's momentum transmits upward and downward along its supply chain; raw material cost hikes, for instance, often buffer mid/downstream manufacturers' profits.
The report cites that the PPI rebound surfaced mainly upstream (materials/energy) and AI-adjacent sectors, making frail transmission downward to consumption. This implies the price gains were driven by specific factors (such as energy costs and AI capex), not broad-based demand recovery.
Key data
- 2026 Real GDP Growth Forecast4.8%Driven by exports and manufacturing capex
- 2027 Real GDP Growth Forecast4.7%Moderately slower
- 2026 PPI Forecast1.5%First positive in four years, chiefly from energy and upstream costs
- 2027 PPI Forecast-0.4%Set to turn negative again amid fading energy shocks
- 2026 CPI Forecast0.8%Remains modest
- 2027 CPI Forecast0.6%Further moderation from 2026
- 2026 Export Growth Forecast10%Far above the 2023-2025 average, 2.2%
- 2030 China Export Share Target16.5%Current ~15%
- Precautionary Saving / Disposable Income~33%A key constraint on consumption
Impact & implications
This report warns investors and policymakers against over-optimism that China can quickly resolve its deep structural issues by copying the 'Hefei model' or relying on strong exports. Short-term GDP growth may appear robust but hides a fragile 'K-shaped' divergence and persistent deflation. Signals of substantive reforms in cadre evaluation, fiscal restructuring, and social safety nets are critical to breaking the investment-driven growth model and its cycles. Investment decisions should thus favor long-term winners from structural reforms (like consumption upgrades, import substitution), while guarding against cyclical downside risks in traditional sectors reliant on investment and exports.
Risks
- Unchanged local government incentives prolong investment overheating and overcapacity.
- Over-reliance on external demand exposes the economy to global cyclicality and trade protectionism.
- While boosting productivity, tech advances (like AI) risk job displacement and social divergence near-term.
- Geopolitical tensions could prompt Beijing to double-down on supply-side solutions, delaying rebalancing reforms.
What to watch
- Reforms to central government cadre evaluation criteria, shifting focus away from GDP/investment toward household income and consumption.
- Progress on fiscal reform, reducing VAT reliance and boosting direct taxation favorable to consumption.
- Strengthening social safety nets to address the ~33% precautionary saving ratio.
- Duration and strength of global AI/energy capex upcycle and spillover to exports.