China should cut a deal with the United States and the European Union in order to solve its industrial overcapacity problem, according to a new report released Thursday.

The European Chamber of Commerce in China said the emerging Asian giant needs to figure out ways to reduce its excess domestic production capacity, but in ways that do not spur new trade wars.

"Beijing, Washington and Brussels should work out a multi-year plan in which China commits itself to rebalancing its economy and reducing its net exports," the group says in a study of capacity problems in the Chinese economy. "In exchange, the European Union and United States would commit themselves to boosting domestic investment to prevent demand slowing and to keep markets open for Chinese exports."

The chamber, which represents European businesses in China, said the Asian country has over-invested in obsolete plants and technology for years. When the global economy was growing, Chinese facilities could crank out new products without many commercial ill effects. But that's changed.

"The [current] crisis has throttled demand for exports from China at a time when even more investment, in the form of the Chinese government’s massive stimulus package, is being pumped into building new plants and adding unnecessary capacity," the 60-page study says.

The report notes that some Chinese sectors, such as aluminum and steel processing, are operating at about 70 per cent of capacity, considered to be a low level.

Overcapacity can lead a country to artificially lower prices for export, often attracting "dumping" charges from trading partners.

In most economies, excess capacity often leads to less investment by corporations. China, however, has continued to invest heavily in its industries, a situation that has resulted in low rates of innovation and a cash crunch for Chinese producers, the chamber said.

The way out of China's problem is to cut exports and boost domestic demand through a variety of measures, such as raising interest rates and reforming land ownership, the report says.

If nothing is done, however, the U.S. and EU are likely to deal with higher levels of Chinese exports through trade protectionism rather than getting Western countries to hike their investment rates.

China, however, has been fixated on boosting the country's export levels by keeping its currency low, other analysts have said.

To be fair, the Chinese government has enacted some reforms to improve domestic consumption, but more needs to be done, the chamber said.