Chartbook 454: China shock 2.0 and mercantilist-on-mercantilist violence.

At Premier Lǐ Qiáng addressed the plenary opening of “Summer Davos” in Dalian China last week, something unusual happened. There was laughter.

Even as it rang out, it took a moment for that fact to sink in.

For the Premier’s speech the venue is always packed - serried ranks of thousands of senior executives, politicians, a sprinkling of think-tankers, “experts”, some academics, seated in hierarchical blocks. Dark suits and regimented business casual - black polo shirts very much to the fore. Overwhelmingly male. Booms and cameramen swoop in for reaction shots. Hundreds of uniformed ushers hustle people to their places. Security in the background, along the walls of the room. Ear pieces in place. You can hear a pin drop. What you don’t expect, is laughter.

For non-Chinese speakers, the slight lag in translation made the guffaws even more surprising. The Premier, it seemed, was ad libbing. The audience reacted as he quipped that China is “too poor” to pay subsidies large enough to account for the blinding success of its export industries.

It was a nice, double-edged line, that conveyed a rather different message than that offered by the official text.

The Premier’s speech at “summer Davos” always carries a message. Two years ago it was China’s macroeconomic balance. Last year it was global trade. This year it was “China Shock 2.0”. In so many words.

The #2 of the People’s Republic of China directly addressed the term which, to my knowledge, we owe to Brad Setser, American economist, ex-Obama and Biden-administration official and macro commentator supreme.

Lǐ Qiáng’s answer to the “China shock 2.0” thesis had its moments. His points about the relentless energy of China’s entrepreneurs and engineering teams were well taken. I also liked his emphasis on “China opportunities”. These are real, especially with regard to “new energy”. But Beijing is going to have to do more if it wants to answer the kind of warnings delivered, for instance, by Tordoir and Setser in their recent CER paper or Setser and Shahin Vallée in Foreign Affairs.

China shock 2.0 has apparently made a deep impression not just in Beijing, but also in Berlin, where Chancellor Merz has taken up the accusation of an undervalued Chinese currency. Right on cue the announcement of massive job cuts at VW conveys the depth of the industrial problems.

The shift in China’s trade balance with Europe is truly dramatic. Cedric Gemehl’s data from Gavekal are useful here. The deficit has more or less doubled in the years since COVID.

Comparing “China shock 1.0” and “2.0” there are key differences. The first “China shock” back in the early 2000s was a straight-forward cost-of-production, market-access story. China’s exports overwhelmed western manufacturers in low-tech, low-wage sectors. Though opinions differ about how large the impact was, there is little doubt that it was most intense in the USA. China Shock 2.0, by contrast, is above all about Europe and it is above all about China’s progress up the industrial value chain. The shock is focused on a cluster of industrial sectors and, above all, as Setser and Tordoir highlight, on Germany and on cars. 60 percent of the $27 bn euro swing in Germany’s trade balance with China between 2021 and 2025 is accounted for by vehicles.

The car industry is decisive in German industrial politics. And Germany is decisive in Europe, so this is a disruptive shock. But focusing in this way on German manufacturing also changes the terms of the “China shock” conversation. After all, Germany is itself a chronic trade surplus country. So, China shock 2.0 is mercantilist-on-mercantilist violence. Indeed, even as the deficit with China widens, the EU’s manufacturing trade surplus with the rest of the world is at new highs.

This brings into focus some of the interesting conceptual and analytical lines that are crossed in the China shock 2.0 discourse - between macro, micro and “meso” levels, between economics and political economy.

As Guo Kai and Wang Jiankun of the Chinese think tank CF40 point out in a paper discussed on the Eastisread, if we ask why China’s trade with the EU has moved so sharply into surplus, the evidence suggests that this is not likely to be driven by macro forces. There is little evidence to suggest exchange-rate driven price dumping. The unit value of Chinese exports are on an upward trend and move closely with those of Japan and South Korea.

A large part of the Chinese export surge to Europe is accounted for by green energy goods which are heavily in demand for Europe’s energy transition. Another large element are chemicals, the production of which has been hit in Europe by high gas prices.

And, as for domestic market conditions in China itself, the sectors in which China’s trade balance with Europe has most dramatically shifted, are not sectors in which home demand in China is falling. What European firms are experiencing, both in markets in China and at home in Europe is the impact of a dramatic Chinese industrialization push heavily backed by policy.

Of course, this Chinese industrial policy is itself highly contentious. Premier Li may be right that subsidies alone do not account for China’s industrial breakthroughs. But there have been subsidies and they have been large. How large is not easy to quantify. But one estimate by a team at CSIS in the US, claims that for the EV industry the grand total over the period of 2009 to 2023 was $231 bn.

Accepting these numbers, or even larger estimates, it still seems to me perfectly possible to uphold the Chinese view, which is that such spending is in fact modest in proportion to the effects achieved. If anyone in the West had been able to transform an industry of comparable size and significance and one which is so vital to the green energy transformation, for an amount of subsidy spending that is in no way outsized compared to the European Green Deal or Biden’s IRA, we would be patting ourselves on the back. Job well done! As far as Germany and the car industry is concerned, comparable sums of money were available for reinvestment in the form of record-breaking profits. But rather than being plowed back into much needed new investment, they were paid out to shareholders in the form of dividends. In 2023 alone, as the Chinese EV avalanche was already upon them, Germany’s big three automakers, according to analysts at EY, paid out 31 billion euros in dividend. As Tordoir and Setser put it, complacency is, indeed, the besetting sin of European and particularly German industrial policy.

So, first and foremost, China shock 2.0 is a sectoral story. But one cannot simply end the argument there. All macroeconomic dynamics, insofar as they involve any element of structural, “qualitative” change, are by definition, sectoral, industrial, or even corporate stories. What we have to ask is how those uneven development paths then interact and combine to form a larger macroeconomic ensemble and, then, how those “macro” variables - exchange rates and interest rates for example - reverberate back on sectoral developments. A sectoral surge in exports which raises the net flow across the currency exchanges “ought” - at least according to textbook logic - to unleash an adjustment in currency markets that has an offsetting effect. A large trade surplus appreciates the currency, producing an impact across other sectors, which reduces their competitiveness in export markets and increases the competitiveness of imports in sectors not benefiting from local structural change. The result is that sectoral success is offset by the force of comparative advantage. The macro aggregates are returned to something closer to balance. In a more malign form this is the much-feared “dutch disease”, where a single, hyper-competitive export sector squeezes the rest of the economy by way of the exchange rate and domestic overheating.

In the Chinese case, this broader adjustment is stifled. China’s foreign exchange markets do not operate freely. How flows would calibrate if there was free movement, is far from clear. A case can be made that the likely impact of a liberalization would not be appreciation, but capital flight and depreciation, a point I will return to in another post soon. In any case, under the prevailing system, China’s exchange rate is pegged by capital controls and intervention at an undervalued, overly competitive rate. Instead of driving an appreciation of the yuan, the proceeds from huge trade surpluses are absorbed into official and quasi-official reserve accumulation. To make matters worse, not only is the Chinese currency not permitted to appreciate, the real exchange rate is actually depreciating.

The real exchange rate is a measure of competitiveness that combines the exchange rate with relative prices. It measures how the prices of one country move in relation to those of a trading partner, given prevailing exchange rates. Since 2021, prices in the West have moved up, whereas in China, prices hover dangerously on the edge of deflation. With the exchange rate not compensating for this relative price movement, the effect is a real depreciation. Chinese goods are even more competitive as a result.

To redress these imbalances there are at least four options.

If Europe was the US and had a deficit not only with China but with much of the rest of the world, a policy of deflation might be called for. That, after all, is what the eurozone imposed on its own deficit countries, like Greece in the 2010s. The euphemism was “internal devaluation”. At the best of times, this is a punitive and risky macroeconomic maneuver. In the case of contemporary Europe it is irrelevant. Given its overall trade surplus, Europe actually should be aiming to raise, not lower aggregate demand. Running the economy hot may be the best hope of stimulating a much-needed acceleration of productivity growth. That however will not help to dampen the demand for Chinese imports.

The answer by way of macroeconomics, if there is such an answer, lies on the Chinese side.

One could recommend that China should allow its currency to appreciate. The risk of such an appreciation, however, is that by lowering import prices in China’s already amply-supplied markets, it compounds deflationary pressure in China. Again, the opposite of what is needed.

The obvious general prescription is to push demand growth in China. That is a general policy prescription long discussed. Long-time China watchers like Michael Pettis are highly skeptical that any such rebalancing is likely any time soon. It would require a fundamental reorientation of policy priorities. And Beijing, as Pettis admits, has important reasons to favor the current strategy. Industrial development is an end in itself and it also promises some relief of the problem of finding jobs for tens of millions of Chinese workers.

So, if there is no macro-solution on either side, the best policy is presumably to engage in some form of deliberate and conscious management of trade flows at the industrial and sectoral level. After all, this is where the origin of the problem lies. Setser and Tordoir suggest that the EU resort to a variety of trade defenses as a means of suasion. Various types of industrial and firm-level bargain may also address the issue.

In another post a few months ago, I listed four disrupters of the world economy in 2026.

• Trump’s trade policy rampage.

• The new and extraordinary incontinence of US fiscal policy.

• The AI boom, which has taken on global economic scale.

• The gear-shift in Chinese economic policy.

China Shock 2.0 reflects #4. If trade protection and international industrial bargaining are indeed the best solution, then that risks compounding the disorder in world trade hitherto personified by Donald Trump (#1). But doing nothing is potentially destabilizing as well. Spectacular and uncontrolled deindustrialization must count as a serious economic, social and political risk in Europe.

No one should underestimate either the ferocity of Chinese competition or the difficulty in getting Europe’s own industries up to speed. This will require a judicious combination of protection, incentives and discipline. If the EU is going to use government policy to shield the industry from the consequences not just of Chinese policy, but also its own technological short-sightedness, and if this protection comes at the expense of European consumers, is it acceptable for the European car industry to be still paying out ample dividends? Should there not be a requirement set for minimum investment levels? European industry needs saving from itself.

Returning to the scene at summer Davos and the ironic laughter of Li’s Chinese listeners, I was reminded that outside the conference center in Dalian one can see a Vegas-style reconstruction of what was once a Russian imperial town. European empire is now an oddball tourist attraction for Chinese honeymooners. Amongst Dalian’s districts is Lüshunkou, known at the start of the 20th century as the Port Arthur. In 1904 this fortified naval base was the scene of an incredibly violent encounter between Russia and the forces of Imperial Japan, then staking their own claim to mainland empire. In what was arguably the first modern battle of the 20th century, Japan and Russia employed massive howitzers, machine-guns, barbed wire, search lights, tactical radio and radio jamming, observation balloons and electric fences. Not for nothing, some have dubbed the Russo-Japanese war, World War O. Amidst general surprise in the West, the fighting both on land and at sea ended with a decisive, though bloody victory for Japan. This victory for the rising challenger from Asia, and the worrying implications of Japan’s ambition, delivered a shock that also helped to trigger the upsurge of modern Chinese nationalism. That bid for the great rejuvenation of the Chinese nation echoes all the way down to Lǐ Qiáng’s feisty address in 2026.

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