China makes more cars than it needs. Now, it’s shakeout time.

Overall, car sales in China rose 5.5% last year to 22.9 million vehicles, the China Passenger Car Association said Thursday. Yet that demand is far short of the capacity companies have built up, leading them to cut prices and push into overseas markets to stay in the game.

“The period from 2025 to 2027 marks the elimination round in the automotive industry," wrote He Xiaopeng, the chief executive of electric-vehicle maker Xpeng, in an internal letter dated Dec. 31 that was seen by The Wall Street Journal. “Competition in 2025 will be fiercer than ever."

Among the early losers are foreign brands. General Motors, Volkswagen and Toyota have been bleeding market share to homegrown rivals. Domestic brands accounted for 61% of the local market last year, up 8.6 percentage points from a year earlier, the China car association said.

But local brands face a reckoning too.

Last year, 23 EV brands either exited China or were consolidated into other brands, while a dozen new brands came to market, according to Stephen Dyer, managing director at AlixPartners. He said 112 brands sold at least one EV in the first nine months of last year.

Dyer estimated carmakers in China last year used only about half their capacity.

“State-owned companies and large privately owned companies can survive, but there’ll be a lot of consolidation and attrition among smaller companies, especially ones that don’t have an export footprint," said Sam Fiorani, who makes global vehicle production and sales forecasts for AutoForecast Solutions.

The shakeout is a familiar outcome of Beijing’s industrial policy. Central and regional governments first encourage favored industries with subsidies and policy support, then—once a critical mass is achieved—let loose a Darwinian struggle. Similar dynamics have played out recently in solar panels and wind turbines, as well as steel and electronics in the past.

The companies that survive the fight often emerge as global champions and sources of national pride. Already, Chinese carmakers such as BYD are in the top ranks of global EV producers.

More than half the new cars sold in China are either full EVs or plug-in hybrids. In his New Year’s speech, Chinese leader Xi Jinping highlighted the milestone that production of those types of vehicles hit 10 million in 2024.

The number of EVs and plug-in hybrids sold in China is now approaching the size of the entire car market in the U.S., where around 15.9 million vehicles were sold last year, according to Wards Intelligence.

In 2024, as many as 227 car models reduced prices, compared with 148 models the year before, according to Cui Dongshu, the car association’s general secretary. Tesla China has been offering zero interest for five years on its car loans and has discounted the Model Y to the equivalent of less than $33,000.

Tesla has been holding up better than many of its Western and Japanese counterparts. It sold about 662,000 cars in China last year, an 8% rise, according to GlobalData. Still, it has fallen behind local rivals led by BYD, which sold almost four million vehicles in China last year.

Sales by GM’s joint ventures in China fell by more than half between 2018 and last year. AutoForecast Solutions’ Fiorani said GM’s six plants in China were more than it needed. Last month, the company said it expected to take more than $5 billion in noncash charges because of weakness in its China business. GM didn’t reply to a request for comment.

Having deep-pocketed backers doesn’t ensure a company’s future. In December, videos surfaced on Chinese social media showing angry staffers at a Chinese EV startup surrounding their boss and expressing concern about whether they would receive their salaries and other payments. The startup’s owners, tech giant Baidu and Geely, said its operations were facing challenges and departing employees would be treated fairly.

William Li, the CEO of premium EV maker NIO, said last month that “car companies cannot afford to have any shortcomings," adding that the industry has entered “the most fierce and brutal phase of competition."

In 2025, China’s auto sales are likely to decline because of weakness in the overall economy, according to Bernstein analyst Eunice Lee. Some incentives offered last year, including a cash-for-clunkers program to subsidize purchases, created one-time demand that isn’t likely to be matched this year, although Beijing extended the subsidy program on Wednesday.

Chinese carmakers are looking overseas to absorb their production. That is getting harder because of rising trade barriers.

The European Union in October imposed tariffs of up to 45% on made-in-China EVs, and the Biden administration last year imposed a 100% tariff on Chinese EVs. Data from the Chinese car association show China’s EV exports are still rising but at a slower pace in recent months.

Chinese carmakers have set up factories abroad to avoid tariffs, but one of the most prominent of these efforts—a BYD factory in Brazil—has run into trouble. Brazil’s government said in late December that it has halted construction as it investigates what it said were conditions analogous to slavery for some of the workers. BYD said it has fired a subcontractor at the site and doesn’t tolerate violations of human rights and labor laws.

Write to Clarence Leong at clarence.leong@wsj.com