China's economy in Q2: Domestic woes dampen growth as imbalances intensify

This analysis is part of the Q2/2026 MERICS China Economic Indicators, our quarterly analysis of China’s economic data. You can find the most recent data here.

China’s economy cooled considerably in the second quarter of this year. GDP growth slowed to just 4.3 percent, dropping from 5.0 percent in Q1, on a sharp fall in investment and sluggish consumption. China’s exports continued to grow, delivering crucial momentum for an otherwise flagging economy. As China’s structural imbalances intensify, China’s leadership will need to act if it wants to keep its annual growth target of 4.5-5.0 percent in sight. Overall growth in the first six months was 4.7 percent and is trending downwards, so some form of additional fiscal support is almost guaranteed. But so is continued growth in exports, implying EU-China trade tensions will remain high.

Cash-strapped local authorities and households spend less 

The main factor dragging down GDP growth was nosediving fixed-asset investment (FAI). It dried up as the state-led push in Q1 to promote spending on infrastructure, and by state-owned enterprises, fizzled out. Overall FAI declined by 5.7 percent in H1, with impacts across many sectors. Real estate investment dropped by 18.0 percent, the largest contraction for a half-year on record. But FAI also fell in road building, education, healthcare, and construction. This suggests the funds of already cash-strapped local governments, which would normally shoulder a hefty share of infrastructure spending, have dried up. 

Ominously, China’s multi-faceted economic imbalances are becoming more entrenched. Domestic car sales collapsed by 16.1 percent in June year on year, reflecting weak consumer confidence and suppressing headline growth. Excluding car sales, consumption grew by 3 percent, nothing to cheer about, but better than June’s aggregate increase in retail sales of 1.0 percent. The 4.1 percent increase in producer prices recorded in June does not signal improving domestic demand, but rather higher global prices linked to the AI boom and upheaval in the Middle East. Energy-intensive sectors, suffering from higher input prices due to the war in Iran, showed significant price hikes, while prices in other areas kept declining.

Though manufacturing output is holding up overall, regional disparity is increasing. Some provinces like Jiangsu and Zhejiang – hotspots for flourishing sectors such as semiconductors, biotech and robotics – have recorded substantial growth in manufacturing value-added. By contrast, China’s northeast saw manufacturing decline. Growth is thus becoming narrower in terms of sectors and regions and entrenching inequality, something policymakers know but have not yet addressed.

Foreign demand for Chinese goods shows no limits

Although China’s domestic economy is in the doldrums, its international trade remains strong. Exports increased by 27.0 percent in June and imports by 36.0 percent on a USD value basis. High-tech products performed particularly well, suggesting China’s export boom still has significant room for growth:  mobile phone exports rose 21.2 percent in June and automotive exports surged by 70 percent. While export volumes have grown, import volumes have remained largely flat. Rather than importing significantly more goods, China is simply paying more for them due to rising prices for commodities and high-tech products.

Recent months have delivered important foreign policy wins for Beijing that bode well for China’s exporters. Firstly, the meeting between presidents Donald Trump and Xi Jinping in May provided some relief in the US-China trade conflict, delivering some tariff reductions and deals signed on Boeing aircraft and agricultural trade. Although the summit fell far short of any breakthrough, it calmed the waters and gave China space to continue its drive for self-reliance.

Second, China has successfully navigated the shockwaves from the turmoil in the Middle East. Its energy system has shown remarkable resilience. The secure positioning of China’s oil supply was evident from the drop in oil imports in May. Earlier stockpiling and high inventories enabled China to curb its oil purchases to avoid high prices on global markets. Still, China is not completely immune and is far more exposed to the secondary shock on oil and natural gas related goods. For instance, Beijing recently suspended exports of helium – a crucial input for semiconductors – to safeguard domestic supply. Given the fact that hostilities between the United States and Iran reignited in early July, shipping disruptions could still lead to further price increases in China and dampen global demand for Chinese goods.

China is too reliant on exports to budge in EU trade negotiations

If recent patterns hold true, Beijing will announce new measures to support growth before the year’s end, in response to the downturn in Q2 and international uncertainties. We can expect additional funding for major projects, channeled via local governments, such as the extra 500 billion CNY announced in September last year that supported projects covering the digital economy, AI, urban renewal efforts, etc. This would help generate additional short-term growth and cushion the decline in fixed asset investment. But doing so would add to government debt, which policymakers have been striving to keep in check. A Politburo meeting in late July will likely provide clues on Beijing’s plans.

Even with the surge of exports, Beijing will need to aim for at least moderate growth in consumption and investment to avoid a broad-based slowdown and keep its growth target within reach. Net exports accounted for 20.9 percent of GDP growth in Q2. As imports are also at elevated levels, exports will struggle to make up a continued shortfall in investment and consumption. And yet serious steps to boost consumption are not on the cards. Beijing’s professed commitment to raising household spending is a long-term goal which would require difficult structural reforms. Even substantive reforms would take several years to have an impact.

Consequently, while the government will continue to pay lip service to boosting consumption, its main goal will be supporting exports for the rest of the year. This can generate an immediate economic boost, without expanding debt – a win-win for China. Industries in foreign countries are left to bear the cost. The growing inflow of Chinese goods to Europe has catalyzed a review of the EU’s trade defense toolbox. Even the German government has dropped its usual caution about criticizing distortions generated by Beijing’s industrial policy to speak more candidly on China’s unfair trade practices. However, EU policymakers should not expect any concessions from Beijing during discussions on trade and investment. Given the economic pressures it faces at home, China is likely to be as intransigent as ever.