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China News: Trade and Debt in Balance: China’s Economic Situation in 2026
As trade tensions between China and the EU head toward a critical deadline this fall, the domestic economic landscape is splitting into two camps. While global demand for AI is fueling a massive surge in profits in the upstream technology sector, traditional downstream sectors are facing a sharp decline in margins due to rising energy costs and subdued consumer spending. Meanwhile, a comprehensive national audit has uncovered data manipulation in local government debt reduction efforts—forcing Beijing to crack down on high-interest offshore loans.As trade tensions between China and the EU head toward a critical deadline this fall, the domestic economic landscape is splitting into two camps. While global demand for AI is fueling a massive surge in profits in the upstream technology sector, traditional downstream sectors are facing a sharp decline in margins due to rising energy costs and subdued consumer spending. Meanwhile, a comprehensive national audit has uncovered data manipulation in local government debt reduction efforts—forcing Beijing to crack down on high-interest offshore loans.
1. EU-China Relations: Tensions and Ongoing Dialogue
Growing Tensions and Risk Mitigation: While relations between China and the U.S. are showing signs of stabilization, trade tensions between China and the EU threaten to escalate. The EU is pursuing a clear “risk mitigation” agenda and is pushing forward with the EU Industrial Accelerator Act to strengthen its domestic production capabilities.
Trade Under Pressure: Since 2023, the EU has launched trade remedy investigations and measures targeting Chinese chemicals, steel, machinery, electrical equipment, and electric vehicles (EVs). China’s exports to the EU consist of intermediate goods (40%), capital goods (28%), and consumer goods (25%).
Channels of Dialogue: Despite the tensions, channels for pragmatic compromises remain open. On June 29, a joint statement outlined four key areas for discussion: trade and investment, export controls, intellectual property rights, and WTO reform. A ministerial-level meeting is scheduled for the fall, with a strict deadline of October to achieve tangible results.
China’s Response: China is expanding its own countermeasures, drawing on its recently enacted Supply Chain Security Law as well as regulations on outbound direct investment (ODI), which took effect on July 1, 2026.
2. Industrial Profits: AI and Energy Exceed Expectations Despite Downstream Pressure
Slowing Momentum: Growth in Chinese industrial profits slowed to 21.1% year-over-year (y-o-y) despite a lower base, indicating a loss of momentum.
Mixed Performance: Profitability remains concentrated in the upstream sectors (energy, non-ferrous metals) and the electronics industry, driven by global investment in artificial intelligence. In contrast, midstream and downstream sectors faced significant margin pressure due to high input and energy costs as well as subdued selling prices.
Sector-Specific Profit Declines (Jan.–May):
Apparel and Fashion: Decline of ~11%
Leather and fur goods: Decline of ~19%
Rubber and plastics: Decline of ~1%
Electrical machinery: Decline of 14% (affected by cuts to VAT refunds for solar and battery exports)
Cautious consumer sentiment: Subdued domestic demand weighed heavily on retail-related sectors. Year-over-year profits for the first five months plummeted by ~58% for furniture, by 20% for motor vehicles, and by ~7% for sports and leisure goods. Weakness in real estate and infrastructure investments further reduced overall profit growth by 1.2 percentage points.
3. Local Government Debt: Accelerated Risk Mitigation and Audit Notes
Early Issuances: To manage budgetary constraints and mitigate debt risks, local governments brought forward their refinancing bond issuances and issued over 2 trillion RMB by the end of the first half of the year (equivalent to 73% of the annual quota of 2.8 trillion RMB). However, issuance of special municipal bonds for projects lagged behind expectations through the end of June, accounting for 47% of the annual quota.
Progress on LGFVs and Warning Signs: According to estimates, the debt of local government financing vehicles (LGFVs) as a percentage of GDP fell slightly to 46.8% in 2025 (from 47.2% in 2024), and 82% of LGFVs were delisted in 2025.
Data Falsification: China’s National Audit Office (NAO) highlighted significant problems on June 24, reporting that 6% of LGFVs had falsified data during spot checks in order to be removed from the regulatory watchlists. Some local governments concealed debt through state-owned enterprises (SOEs) or deleted system data to artificially lower debt figures. As a result, the NDRC is actively discouraging LGFVs from taking out high-interest offshore loans.
Revenue Constraints: The ongoing downturn in the real estate market has severely constrained the recovery of local budgets, with revenue from land sales falling by 28.7% year-over-year from January through May. Although non-tax revenues rose by 2.2%, more comprehensive reforms of the budget and consumption tax are considered necessary to correct the structural distribution of revenues between the central government and local authorities.