A Dual Engine; a Demand Deficiency

How China's innovative excellence and dominance in exports and AI overshadows internal economic struggles. 

Source: CNN Business 

The Economic Reality

In the second quarter, China reported real GDP growth of 4.3% - missing its official target range of 4.5–5%. China is widely known for treating GDP as a target to hit rather than a metric to measure; the miss indicates there are struggles at hand. This is confirmed by independent estimates putting China’s real growth rate for the quarter closer to zero. When paired with a falling share of global GDP and growth that is slowing relative to the rest of the world, the figures expose a reality masked by the prevailing narrative of economic strength. 

This performance is a reflection of a number of economic difficulties. China has been suffering from a severe housing market downturn since 2021, with the crisis estimated to have reduced annual real GDP growth per year by 2% in 2024 and 2025, according to Goldman Sachs - a consequence of prolonged negative wealth effects and damaged consumer confidence.

China also faces one of the world’s fastest growing ageing populations, which drags on economic growth through shrinking the workforce and lowering labour supply. Whilst automation could ameliorate this demographic pressure, it also poses a threat to broader development. Despite its technological strength, China remains a middle income country with a large rural population that largely fails to benefit from the progress taking place in big cities.

A natural consequence is slowing consumer spending; taken all together, this picture evidences how the average Chinese citizen is struggling in a way concealed by the country’s impressive innovative capacity.

Innovation in China

China has long been the world’s dominant manufacturer; after all, it is production prowess and an export oriented strategy that has driven the country’s exponential growth. However, this story is evolving: an expertise in electric vehicles, robotics, renewable technology and AI has cemented China’s position as a global leader in high-technology sectors. This position has been reinforced through the country’s rare combination of manufacturing capacity and technological capability, allowing it to innovate at a scale, speed and efficiency that others simply cannot. It is perhaps the only true rival to the US on an innovation front - especially in AI, where the two are locked in a race so fast it has reduced the rest of the world to mere spectators.

A large part of this successful transition has been the active role of the state. Public funding - in the form of industrial subsidies - has accelerated the development of these high-tech sectors. For example, government funds invested an estimated $184 billion into AI firms between 2000 and 2023, illustrating the reliance on state-backed channels over private capital - which has been at the centre of America’s AI boom.

Beyond financial assistance, the Chinese government has shaped this trajectory through its intense drive to build and reinforce the nation’s technological strength. From the President “championing high-tech manufacturing”, to limits on offshore investment - an attempt to deploy private capital domestically - a top-down strategy has been imperative in guiding the shift towards advanced industries. This push is driven by a desire to solidify the nation’s already powerful standing, allowing it to transcend the ‘The World’s Factory’ legacy that initially propelled it onto the global stage.

However, in the pursuit of innovative excellence, the country’s attention has been diverted from an internal economy that is in dire need of support.

The Dual Engine

The external picture of China’s economy differs from the internal reality because of the dual engine driving it: exports and AI.

Last year, China hit a record $1trn trade surplus, a source of tension amongst trading partners. However, the value of its net trade balance is actually falling this year:

Source: Financial Times . China’s trade surplus was $576bn in the first half, down 4.7 per cent from a year earlier.

Standard analysis often interprets a narrowing trade surplus driven by rising imports as a signal of booming domestic demand and rising purchasing power. This argument fails to hold in the case of China. While imports jumped 36% and overall exports rose by 27% year-on-year in June, the surge in imports is not driven by consumers buying foreign goods - it is driven by the second arm of the dual engine: AI.

The world’s largest exporter has also become its second largest importer, as a need for chips boosts trade in the opposite direction. For example, imports of integrated circuits were up 70% year on year in May. Driven partly by soaring semiconductor prices, this surge demonstrates that the shift in trade is a function of supply-chain inputs and market value rather than domestic consumer appetite.

China has crafted a formidable reputation through its preeminence in these areas. However, most interesting is the relationship between the two: net exports now account for a third of a country’s growth, and this has been driven by mostly AI-related goods. The weak domestic economy is being propped up by this dual engine, foreshadowing China’s vulnerability if either motor was to sputter.

In the State’s Hands

An organic revival of the domestic economy is unlikely if exports and AI remain the primary drivers of growth. Because China is a centrally planned economy, domestic outcomes are heavily dictated by state priorities.

Beijing itself has begun to acknowledge this imbalance. In its five-year consumption plan released this year, Beijing set a target of $9 trillion in annual retail sales by 2030, pledging to "significantly" raise household incomes and boost household consumption’s share of GDP from its current level of roughly 40%.

However, current actions still reflect a treatment of symptoms rather than causes. While rising public spending on social security appears promising at first glance, it represents a mechanical response to the healthcare and pension demands of an aging population rather than a structural transfer of wealth. Meanwhile, interest rates remain constrained, and rising tax revenues point toward fiscal austerity rather than meaningful expansion.

Source: The Economist

The upcoming Politburo meeting in late July offers a direct test of Beijing’s commitment to rebalancing. To meaningfully address the root cause - the domestic demand deficiency - Beijing would need to pivot toward direct structural reforms, such as executing direct household cash transfers and issuing broad consumption vouchers, or expanding hukou-linked public service entitlements to rural migrants, freeing them from the necessity of defensive saving.

If the upcoming meeting yields these concrete wealth-redistribution policies, it will prove that Beijing has shifted its priorities towards the real economy. However, if the state relies on rhetoric, target-setting, and supply-side subsidies, it will confirm that Beijing will continue down the current path of neglect: soothing symptoms but leaving causes unchecked. China may remain an innovative superpower, but without a structural shift toward its consumer, it risks ceasing to be an economic one.