By Zhu Tian

Over the past year, China’s economy has become strikingly divergent. On the one hand, breakthroughs in artificial intelligence, new energy, and high-end manufacturing have continued at a rapid pace, with innovation momentum building across key sectors. At the same time, consumption and investment have remained sluggish, general price levels have declined for the third consecutive year, and overall macroeconomic indicators point to persistent downward pressure.

How should we understand this “ice and fire” economy? And what are China’s real economic challenges, beyond the headlines? Here, CEIBS Professor of Economics Zhu Tian examines the state of China’s economy and its policy options for 2026.

Technological momentum amid macroeconomic pressure

China’s most exciting development in 2025 was perhaps the sudden emergence of DeepSeek at the start of the year, representing a major breakthrough in the country’s artificial intelligence capabilities. Despite US chip sanctions, the large language model achieved world-class performance at relatively low cost, accelerating the adoption of AI applications across China. China’s strengths in new energy and electric vehicles, as well as its near-absolute control over rare earth metals, also continued apace, drawing renewed attention from the global investment community. Against this backdrop, The Economist posed a striking question on the cover of its November 2025 issue: “Which industry will China dominate next?”

China’s achievements are not confined to a handful of sectors. In innovation and scientific research, the country has also moved to the global forefront. According to World Intellectual Property Indicators 2025, China accounted for nearly 50% of global patent applications in 2024, almost equal to the rest of the world combined. In the latest Nature Index China ranked first globally in papers published between October 2024 and September 2025 in 145 top natural science journals. Chinese authors published 35% more papers than their US counterparts and four times as many as Germany.

Yet, even as technological progress accelerates, the broader economy faces unmistakable downward pressure. In 2025, both consumption and investment growth were notably weak. Official data show that from January to November 2025, retail sales grew by only 1.3% year-on-year. Fixed-asset investment excluding real estate rose by just 0.9%; with real estate included, it fell by 2.6%.

By contrast, exports proved resilient despite renewed tariff pressures from the Trump administration. Over the same period, exports grew by 6.2%, while imports rose by only 0.2%. This stark contrast points to relatively strong external demand but unmistakably weak domestic demand. As a result, China’s merchandise trade surplus exceeded USD 1 trillion for the first time, up 21% year-on-year.

The picture that emerges is one of sharp divergence. Technology is surging ahead, while the macroeconomy struggles. This is an “ice and fire” economy, one half frozen, the other blazing. Across industries and enterprises, vitality and opportunity coexist with intense pressure and challenge.

From an industry perspective, sectors that are “on fire”, such as high-end manufacturing, new energy, the digital economy, and biopharmaceuticals, continue to expand rapidly. Meanwhile, many “frozen” sectors—especially real estate-related industries and traditional offline services—face falling demand, idle capacity, and shrinking margins.

At the firm level, leading companies, particularly innovative firms, have leveraged technology, scale, policy support, and global expansion to achieve growth in both revenue and profits, often gaining market share through industry consolidation. In contrast, many small and medium-sized enterprises in struggling industries, especially in catering, retail, and traditional manufacturing, are grappling with weak demand, declining profitability, and, in some cases, closure.

How should we make sense of this divided landscape? To begin with, it is useful to reflect on an overseas study trip I took in 2025.

In April 2025, I traveled to Egypt with a cohort of CEIBS EMBA students. Compared with China’s major cities, Cairo’s urban landscape appears markedly less developed. Some students concluded that Egypt’s current level of development roughly resembles China in the 1980s or 1990s. In fact, China’s economic status at that time was significantly lower; its per-capita GDP did not catch up with Egypt’s until 2003. Over the past four decades, Egypt’s growth has not been particularly slow by developing-country standards; it has simply been far slower than China’s.

What stood out even more was Egypt’s severe inflation. Inflation reached 25% in 2023 and 34% in 2024. For Chinese companies operating there, one of the biggest risks is currency depreciation driven by high inflation. Egypt is far from unique. Between 2022 and 2024, some 40 countries—almost all developing economies—experienced average inflation rates in the double digits. By contrast, countries experiencing deflation were extremely rare. China was one of these few exceptions.

From January to November 2025, China’s producer price index (PPI) fell by 2.6% year-on-year, while the consumer price index (CPI) was flat, well below the official target of around 2%. This marks the third consecutive year of declining overall price levels. This is extremely rare among major economies with comparable data since 1960, with Japan being the only notable precedent.

At the same time, industrial output and fixed-asset investment have grown slowly for several years. According to data from the National Bureau of Statistics, industrial revenue grew at an average annual rate of just 2% between 2022 and 2024, while fixed-asset investment rose by only 3.6%. From January to November 2025, industrial revenue increased by 1.8%, while fixed-asset investment declined by 2.6%. These figures clearly indicate that China’s core problem is not excessive production, but insufficient demand. What is often described as “involution” among firms is more likely the result of weak demand and economic slowdown, rather than the cause.

These observations raise two questions. First, why has China grown so much faster than countries like Egypt over the past four decades? Second, why has China faced deflationary pressure over the past three years, while much of the world has struggled with inflation?

Demand shortfall puts a drag on growth

To answer these questions, and to understand China’s “ice and fire” economy, we must distinguish between long-term economic growth and short-term economic fluctuations.

In economics, long-term growth refers to sustained increases in productive capacity and output, typically measured by average per-capita GDP growth over long periods such as 10, 20, or 40 years. Short-term fluctuations, by contrast, reflect year-to-year or quarter-to-quarter deviations in GDP growth around a long-run trend or potential growth rate.

Long-term growth is determined primarily by supply-side factors like investment, education, and technological progress. The familiar “three drivers” of economic growth that are often referred to - consumption, investment, and exports - are in fact demand-side factors that influence short-term growth. At any given moment, productive capacity is largely fixed; actual output is determined by demand, which fluctuates and drives short-term GDP growth.

China’s extraordinary growth over the past 40 years is precisely the result of its advantages in the three supply-side growth drivers of investment, education, and technology. It has maintained the world’s highest savings and investment rates, enabling rapid capital accumulation, while its strong basic education system has allowed its workforce to absorb advanced foreign technologies and develop indigenous innovation capabilities, driving rapid technological progress.

These strengths explain not only China’s long-term growth, but also the recent surge of high-tech industries. We tend to underestimate progress in the early reform years and overestimate progress in the past decade, but China’s technological rise is the result of decades of accumulation, not an overnight miracle. In fact, from 1985 to 2015, both economic growth and technological advancement were faster than from 2015 to 2025. The difference is that earlier gains were less visible because the starting point was so low. Today, progress feels more tangible because the gap with advanced economies has narrowed, not because progress has suddenly accelerated.

Short-term growth, however, is currently constrained by demand. China’s aggregate demand is below aggregate supply; both consumption and investment are weak, leading to deflation and slower growth. As I have argued elsewhere, the sharp downturn in real estate has been the primary driver of demand contraction over the past three years. This does not contradict the fact that some sectors and firms still experience supply shortages. Even in an economy with overall surplus capacity, certain industries can grow rapidly, while many more industries stagnate or decline.

Most developing countries, like Egypt, struggle with insufficient supply relative to demand, which is why inflation is common. China’s uniqueness lies in the opposite problem: supply is strong, but demand is weak. Compared with supply-side problems, demand-side problems are, in principle, easier to address and offer more policy tools.

Issuing large-scale consumption vouchers to stabilise growth

According to mainstream macroeconomic theory, when aggregate demand is insufficient, governments should adopt expansionary fiscal and monetary policies to stimulate consumption and investment. While China’s policy direction in recent years has been broadly correct, continued declines in consumption, investment, and prices suggest that policy strength has been insufficient.

One key reason is an overreliance on low-cost or no-cost measures like regulatory adjustments and scenario creation, to boost consumption structurally, rather than using fiscal tools to directly stimulate current demand, for example through large-scale issuance of consumption vouchers. As a result, the immediate impact on demand has been very limited.

China’s problem today is not that consumption’s share of GDP is too low, or investment’s share too high, but that the absolute levels of both consumption and investment are insufficient. World Bank data show that China’s relatively high investment rate and low consumption rate long coincided with rapid growth; they  cannot, therefore, explain the recent deflationary downturn. The issue is not the share of consumption, but the level of consumption today.

An analogy may help. Some diabetic patients maintain strict carbohydrate control, keeping their blood sugar well below the upper limit. This is beneficial. But, if meals are delayed, their blood sugar can drop too low, requiring immediate sugar intake rather than further restriction. Similarly, while China’s relatively low consumption ratio is a long-term strength, its current level of consumption is insufficient and needs policy support. The most direct and effective way to remedy this would be through large-scale issuance of consumption vouchers.

Because aggregate demand is below aggregate supply and actual growth is below potential, the policy objective should be to expand the total volume of consumption and investment, not to raise consumption’s share of GDP. Domestic consumption and investment together already account for more than 95% of China’s GDP. Raising the consumption share in the short term would necessarily suppress investment, leaving total demand little changed.

In reality, consumption and investment ratios are long-term variables and should not be short-term policy targets. Since 2015 (excluding the pandemic lockdown years), China’s consumption rate has been rising and its investment rate declining. As income levels rise and population aging deepens, this trend will continue naturally.

While China’s long-term growth fundamentals of investment, education, and technology remain strong, a high potential growth rate does not guarantee high actual growth. Persistent demand shortfalls can drag actual growth below potential year after year, eventually undermining long-term performance. Japan’s “lost decades” offer a cautionary lesson: without sufficient demand, technological progress does not automatically translate into growth. Slower growth, in turn, constrains innovation.

China’s central macroeconomic goal for 2026 should therefore be a swift end to deflation. A reasonable target would be nominal GDP growth of 7% (corresponding to around 5% real growth and 2% inflation). Economic policy should focus not only on “fueling the fire,” but also on “melting the ice.” Emerging industries must continue to grow, but they need support from demand in traditional sectors and households.

In boom times, controlling deficits and inflation is sound policy. In downturns marked by deflation, excessive fiscal and monetary conservatism can ultimately exacerbate risks. In the year ahead, China should issue larger volumes of special government bonds, pursue more expansionary fiscal and monetary policies, stabilise the property market, and distribute consumption vouchers on the scale of several trillion yuan to meaningfully boost household spending. Only then can pressure on struggling sectors be eased and a more balanced economic recovery take hold.

Zhu Tian is Vice President and Co-Dean, Professor of Economics, and Santander Chair in Economics at CEIBS.