Mr. Setser, what are the deeper reasons for the existential competition that Germany’s and Europe’s core industries such as the automotive sector, machinery, chemicals and aircraft are facing from China’s industrial and trade policies?
“The pressure on German industry reflects two distinct things: the technological catch up of Chinese industry across a range of sectors critical to the German economy, and the end of China’s property bubble, which led to a reorientation of China’s economy back toward exports.
Technological catch up has been a long-standing Chinese policy goal. And in the automotive sector, Chinese industrial policies worked in some deep sense – the transition from internal combustion engine cars to battery electric vehicles and plug in hybrids provided an opportunity for China’s “indigenous” auto companies to leapfrog the incumbent firms, be they German, Japanese or American. China now has the capacity to produce 50 to 55 million modern cars in on track to exports over 10 million cars this year after automotive export growth accelerated. With the domestic market down 5 million cars this thanks to lost incentives and ongoing investment in new EV capacity, this export wave won’t end on its own.
Yes, these are incredible numbers – Germany makes something like 4 million cars a year. China now makes somewhere over 30 million a year and could make another 20 million or so.
And China’s structural position in the battery industry is if anything even stronger than its position in the automotive industry – Chinese battery firms define the technological frontier for mass market batteries, and have the capacity to supply all global demand and then some.
The transition from internal combustion engine cars to battery electric vehicles and plug in hybrids provided an opportunity for China’s “indigenous” auto companies to leapfrog the incumbent firms, be they German, Japanese or American.
This same broad story applies across a range of sectors. China now produces high quality machinery at an attractive price. China’s chemical industry – which benefits from cheap capital and significant local government support – can more than meet China’s own domestic demand.
But there is a second factor at play, more macroeconomic than sectoral.
For the ten years after the global financial crisis Chinas property boom absorbed most of China’s expanding output at home. That boom has turned into a bust. And China hasn’t either proactively cleaned up the financial legacy of the burst bubble or taken strong policy steps to support household demand. As a result, China’s domestic economy has struggled over the last five years – and not primarily because of the legacy of COVID. The downturn in the property sector has subtracted something like five percentage points from China’s growth. I don’t think it is entirely an accident that net exports have added a cumulative six percentage points to China’s growth over the same period. Without a replacement for the demand that used to come from building out China’s cities, China has pivoted back to exports. A weak currency is of course in part a consequence of the housing crisis – but it is also a policy choice that has boosted exports. In many ways Xi has preferred relying on external demand for China’s expanding manufacturing base to finding new domestic growth engines.”
How should the measures of a defensive trade policy by the European Union be designed to robustly handle the China shock 2.0, as you and Sander Tordoir call it in your study?
“There is no sign that China is going to change of its own accord, unfortunately. Without policy action from China’s trading partners, President Xi seems happy to rely on a growing trade surplus to make up for the demand that China isn’t generating at home. China’s exports are now growing faster than global trade – squeezing other manufacturing powers across the board. And setting semiconductors and gold aside, Chinese imports have hardly grown at all over the past five years. That puts Europe – and Germany specifically – in a difficult position. China is a strong industrial competitor now, but not much of a market. Trade has become one way; Europe’s exports to China are falling while Europe’s imports keep rising.
I think though that the needed components for an effective European response to the second China shock are starting to be put in place.
One component of this is steps to insulate key parts of the European economy from the industrial distortions now coming out of China. Put simply, without tariffs, much of Europe’s auto industry could disappear in the next few years – with European demand flowing to China on a far bigger scale than Chinese demand ever flowed to Europe. In 2026 European imports of Chinese cars will exceed European exports to China by a factor of 10. That isn’t sustainable. The safeguards that the Commission is now working on are a sensible response – in autos, but also in other sectors where China’s excess capacity and undervalued currency threaten permanent damage to Europe’s industrial base.
Europe needs tools to support its own or friendly production in sectors where China now has a chokehold over inputs critical to Europe’s industry and defense.
Another component is a policy to reduce existing dependencies on China in strategic sectors. Europe needs tools to support its own or friendly production in sectors where China now has a chokehold over inputs critical to Europe’s industry and defense. Rare earths, including the heavy rare earths that aren’t important by volume but that are needed in certain defense applications, other minerals vital to advanced industrial production like gallium and permanent magnets are an obvious case. But I would include the chemical precursors to key life saving medicines and active pharmaceutical ingredients here, too. The diversification instrument now under consideration is a useful step – but there also needs to be a pool of money, likely at the European level, to make strategic investments in sectors where the return is more strategic than economic. Economic defense has a price.
Finally, Europe – ideally with help from the United States and others – needs to find ways to bring effective pressure to bear on China to change its growth model. China has been getting about half of its real growth from exports the last two years, and 2026 will be similar if the impact of the surge in China’s gold imports is removed from the data. China has already got a ton of its growth over the last five years from an expanding surplus – and it is too big an economy to be able to grow through exports without putting a ton of pressure on its trading partners. This means pressing China to allow a stronger Renminbi – I believe there is compelling evidence that the Renminbi is undervalued by 30 percent, which explains why European production has so much trouble competing with Chinese production. And in order to sustain a stronger Renminbi, China needs to strengthen its domestic drivers of growth. Put differently, China can no longer put its current savings of forty percent of GDP at work at home – and it needs to be clear that exporting those savings through an ever-rising trade surplus cannot substitute for needed reforms to raise domestic consumption.”
“I have been struck my how similarly most people in Berlin, Brussels, Paris, Rome and Washington, DC see the economic challenge posed by China’s current growth model. There is a common desire to resist further deindustrialization and limit and then reverse supply chain dependencies on China that can be weaponized. There is no real sense that anyone can grow through exporting to China. That is a significant shift from five or ten years ago.
But America’s current President doesn’t really believe in building enduring economic alliances, and believes that his bilateral deal making with China will deliver better results for the American people than forging a common transatlantic response to the very real challenges China’s current growth model poses to all the G-7 economies. I think that is a mistake – but Trump isn’t likely to change. He incorrectly thinks trade with Canada is tilted against the United States – and really does believe that Europe isn’t a better trade partner for the United States than China. Put differently, he is more inclined to raise than lower tariffs on Europe, and hasn’t shown any real sustained interest in building a coalition to limit China’s ability to weaponize supply and pressure China to pivot away from its export driven growth model.
President Trump is more inclined to raise than lower tariffs on Europe, and hasn’t shown any real sustained interest in building a coalition to limit China’s ability to weaponize supply.
I hope that will change over the next year. The traditional U.S. argument that Europe isn’t willing to take real action against China looks dated. Chancellor Merz has done far more than President Trump to draw attention to the negative spillovers from China’s undervalued currency. Europe has moved, and the U.S. hasn’t responded. There should be a united G-7 critique against China’s currency policies next year; China really is using state control over the banks and the PBOC’s central role in the market to block appreciation pressure from China’s rising trade surplus. But I don’t think Berlin or Brussels can count on Trump’s help on this or other issues. Europe needs to be ready to act on its own.
Over time, I do think the shared understanding of the challenge posed by China’s growth model should allow for more alignment on policy across the Atlantic. If the U.S. and Europe end up adopting similar tariffs on China that should allow for the restoration of relatively open trade across the Atlantic in a number of sectors where the U.S. now has substantial tariffs. And there are obvious gains from coordinating policies to reduce existing dependence on Chinese supply. But such a renewed economic alliance may need to wait a couple of years.”
Brad W. Setser is Whitney Shepardson Senior Fellow at the Council on Foreign Relations. Together with Sander Tordoir he has published the widely read trade paper “China shock 2.0: The cost of Germany’s complacency” for the Centre for European Reform.