A general view of buildings in the abandoned Qingquan Steel plant which closed in 2014 and became one of several so-called 'zombie factories' in Tangshan, China on Jan. 26, 2016. kevin frayer/getty images

SHANGHAI — Overcapacity in Chinese industry — mainly the result of easy loans and government subsidies — is having an “ever more destructive” effect on both China’s domestic and the global economy, according to a new report by the European Union Chamber of Commerce in China. The report says overcapacity has grown significantly since the government unveiled a stimulus package following the 2009 financial crisis — and is now leading to cutthroat competition within China, holding back the country’s ability to reform, and stoking trade tension with other countries.

As the Chinese government seeks to make its economy more competitive, following a slump in exports over the past year, and a slowdown in its construction and real estate industries, it has made tackling over-capacity a priority — vowing to wipe out unprofitable “zombie firms” in sectors from steel to coal. But the EU Chamber report is skeptical about the chance of success, saying protectionism by local governments has given rise to “serious concerns regarding the central government’s ability to effectively implement coherent and effective policies.” It calls for more radical measures, including greater privatization, to tackle the problem.

The report notes positive attempts in the past, including a pledge in 2013 to allow the market to play a “decisive role” in industries such as cement, steel and shipping. But with the exception of the wind power sector, it says there have been “few real breakthroughs” — with a 2014 budget law that pledged to reduce local government’s abilities to subsidize industry having had limited effect, while “loopholes” mean some local governments are still approving projects that should, in theory, be approved by the central government.

IMF China
A laborer works atop a construction site of a commercial building as residential complexes are pictured in the background, in Kunming, Yunnan province, China, Dec. 12, 2015. REUTERS/WONG CAMPION

It says the “competing and conflicting interests” of China’s different provinces and regions — and the tradition of officials’ promotions being based on GDP growth — mean that local governments tend to want to be self-sufficient, including in core industries such as steel. It notes that production of Chinese steel, the subject of an anti-dumping case in Europe, and of raised tariffs in the U.S., “has become completely untethered from real market demand, and is now more than double the combined production” of Japan, India, the U.S. and Russia, the next four biggest producers.

The report adds that local governments have frequently sought to avoid attempts to close unprofitable smaller companies in such industries, by encouraging them to expand or merge. It says fear of job losses and the costs of dealing with bankruptcies have fuelled this trend -- with companies often staying open simply in order to obtain more subsidies.

However, the report says this has led to damaging competition that has “seriously influenced the profitability of China’s industrial producers.” It notes that China’s producer price index has been declining for 45 straight months, suggesting shrinking profits for manufacturers. According to the report, this is damaging the economy by leading to slower wage growth, along with increasing disregard of environmental and labor standards, in order to save costs. It is also preventing many Chinese businesses from putting money into research and development and moving up value chain, as the government has called on them to do, the report says.

And it also expresses concern at the rise in non-performing loans at China’s banks, which it says rose by 35 percent in the first 10 months of last year. In China’s aluminum industry, for example, the report identifies “negative cash flow” in 60 percent of production capacity. It notes that China’s cement production last year was nine times that of its nearest rival India, but a “deluge of new capacity coming on-stream in recent years" meant that almost a third of the industry’s capacity was unused. A similar proportion of oil capacity is unutilized, in an industry where capacity almost doubled since 2008.

In the chemical industry, meanwhile, its importance to local governments as a source of tax revenues has watered down attempts to close unproductive factories in many areas, the report says. Glass and paper are other industries struggling to move up the value chain – with both having continued to expand in recent years, despite declining demand. Shipping is another problem area: China’s race to become the world’s biggest producer has now left some shipyards idle, with at least one state owned shipyard having filed for restructuring in an attempt to avoid bankruptcy this year.

China shipping
Containers are transported at a port in Lianyungang, eastern China's Jiangsu province, Jan. 19, 2016. STR/AFP/Getty Images

The E.U. Chamber, which represents some of the world’s largest industrial companies, has previously criticized the Chinese government for being slow in implementing market reforms it promised in 2013. The report calls for more “structural changes” to be included in the five-year plan that China’s legislature is due to approve at its annual session next month.

It says greater use of VAT would encourage local governments to focus more on consumption than on taxes paid by industry. It also calls for better enforcement of labor laws, to force less efficient companies to "leave the market," and for better welfare provisions, to encourage consumer spending.

In particular, it proposes deeper reforms of China’s state-owned enterprises, which it notes still employ 30 million people. It not only suggests more privatization of such firms, but calls for more progress in requiring them to pay dividends rather than hold on to their profits — since this would reduce their ability “to invest in unneeded expansions.” It also says reforms of China's financial system would allow easier access to funding for innovative small businesses, while better protection of intellectual property rights would encourage Chinese companies to spend more on research and development.

But the report acknowledges that changes will be painful. Many analysts say the Chinese leadership is ambivalent about reforming the state sector, both because it is such a large employer, and for ideological reasons too. The E.U. Chamber's call to "give market forces free rein," and for recognition that “the Chinese Government’s current role in the economy is part of the problem” may therefore be over-optimistic, at a time when some observers believe the leadership under President Xi Jinping is more focused on maintaining stability by emphasizing a return to traditional socialist values in many areas of life.