At the height of the 2008 financial crisis, as the world peered into an abyss, China earned global gratitude by pumping a record amount of stimulus into its economy. Ironically, continued stimulus has left the Chinese economy with mounting debt and a production glut threatening world trade.

Managing the asymmetry between leading markets and China as the world’s largest manufacturer is among the biggest economic challenges of our time. First and foremost the challenge is to Chinese leadership.

Writing for China Leadership Monitor, seasoned observer Barry Naughton asked whether the leadership had lost its compass. An underlying theme was that President Xi Jinping’s focus on party-state building and concentration of power had a damaging effect on management capacity and institutions. The handling of the stock market and currency reform has revealed serious leadership and policy shortcomings, but the management of the real economy over the last several years seems to be proof of nothing less than a system-generated overcapacity crisis.

While fortunate for the global economy, China’s response to the global financial crisis became an addiction leading to serious indebtedness and credit-driven development of overcapacity of monumental proportions in a number of key sectors. Urgent reforms were put on hold and debt more than doubled, today exceeding 250 percent of GDP and still growing. Corporate debt has risen more rapidly than in any other G20 country and in June the International Monetary Fund urged the Chinese government to address this issue or “risk dangerous detours during the country’s transition to a consumption-oriented economy.”

In a February report entitled “Overcapacity in China: An Impediment to the Party’s Reform Agenda,” the European Chamber of Commerce in China focused on eight sectors – steel, aluminum, cement, chemicals, refineries, shipbuilding, flat glass paper and paper board – and concluded that the stimulus packages supported industrial capacity that was ”disconnected from real market demand.”

The rapid expansion created an industrial sector that faces profound structural challenges. Rarely has so much capital been wasted in building capacity far beyond any reasonable future demand.

China’s government has long expressed concern about the buildup of overcapacity, but local officials have kept expanding, driven by growth targets and greed. Even today, additional capacity in cement, for example, is being added, despite close to a billion tons in overcapacity. While a serious issue, cement is not a globally traded commodity of great significance.

Steel is an entirely different matter, and China’s overcapacity poses grave consequences for the global steel industry. Today, China accounts for half of global output. According to the European Chamber of Commerce study, China’s installed capacity went from 644 million tons in 2008 to 1.14 billion tons in 2014. China is responsible for 91 percent of the increase in global capacity. In April, The Economist reported that China produced as much steel in two years as Britain has since 1900. Just 70 percent of installed capacity was utilized. In 2015 China’s surplus capacity was equal to the total production of the next four biggest steelmakers: Japan, India, the United States and Russia.

In northeast Liaoning Province, state-owned steelmakers are defaulting, and affected bond holders protesting. Li Keqiang, China’s prime minister, was provincial party secretary in 2005. The province was part of the rustbelt, and his priority was to reform lossmaking state-owned enterprises. Progress was made but, ironically, a new “rustbelt” has been created.

The Chinese government long has declared the prevailing development model as unsustainable, but the problem is now receiving attention in an explicit way. The government is taking measures, though these are modest and more is required. The key component of Xi’s “supply side” reforms this year is in fact about down-sizing industrial supply. In the steel sector, Beijing plans to cut capacity by 100 million to 150 million tonnes in the next five years, acknowledging that a cut of 200 million tonnes is closer to what’s necessary. Even this revised goal would leave China with huge excess capacity.

How to handle excess labor is the most sensitive domestic challenge of the painful transformation laying ahead. Labor unrest is increasingly common, as workers protest layoffs, and labor activists and protesting workers are detained. The 2016 budget recognizes the problem of excess labor: 1.8 million workers in steel and coal will be laid off, and RMB100 billion are allocated to compensate, reallocate and retrain workers affected by layoffs. Much more is required with analysts suggesting that China must lay off up to 6 million workers over the next two to three years in the country’s biggest retrenchment program since the drastic program carried out during the late 1990s by Premier Zhu Rongji. At that time, more than 30 million workers had to go.

An obvious solution, of course, is to export the oversupply and that has happened with Chinese steel. In the 1990s, China imported steel. Last year it exported 110 million tons, making China by far the world’s largest steel exporter.

Overcapacity adds to domestic challenges, and governments are responding. European steelworkers have protested in Brussels, and Tata Steel in the United Kingdom, in particular, has struggled to attract bids or tie up with Thyssen-Krupp. The entire European steel industry is in need of restructuring and technological shifts. When European Commission chairman Jean-Claude Juncker visited Beijing in July, Chinese overcapacity topped the agenda, and a joint working group on the Chinese surplus was set up. The United States also expressed grave concerns about Chinese overcapacity with steel during the annual US-China Strategic and Economic Dialogue in June. Both the US and the EU have imposed anti-dumping duties on steel imports from China.

US complaints have triggered a strong Chinese reaction. During the critical phase of the global financial crisis China had saved the global economy and now Chinese jobs are at stake.

In this sensitive situation, the question of market economic status, or MES, for China must be resolved. Beijing expects the status to be automatically granted as 15 years have passed since the country joined the World Trade Organization. But that is hardly in the cards.

The United States has warned China that it has not done enough to qualify for market economic status, especially in steel and aluminum, and the political climate in the US is hardly conducive to soft compromises. Already last May, the European Parliament, which has the last European word, took a preemptive negative decision. The commission does, however, want to avoid a direct confrontation with China, and according remarks by Vice Chairman Jyrki Katainen, the solution might be to grant China MES while setting up an entirely new line of defense in the form of a general anti-dumping rules that could be applied to any country, including China.

The G20 meeting in Hangzhou in early September offers an opportunity to deepen global cooperation on structural issues at a time of grave potential polarization. The imbalances between China and its markets in Europe and the United States are unsustainable, and steel is at the very epicenter of the biggest economic challenge of our time.

Börje Ljunggren is author of Den kinesiska drömmmen – utmaningar för Kina och världen (The Chinese Dream – Challenges for China and the World), 2015, and former Swedish ambassador to China and Vietnam. This was written for YaleGlobal, the website of the Yale University Center for the Study of Globalization.

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