Europe Is Looking the Wrong Way on Trade

The real economic threat comes not from Washington, but from China’s industrial overcapacity and Europe’s political fragmentation 

More than a year after “Liberation Day”, when President Donald Trump announced tariffs against the rest of the world, most European politicians, business leaders and commentators still have not understood that the real challenge for the European economy comes from the other side of the world: China. 

The tensions that have developed with the United States should certainly not be underestimated. Nor are they easy to resolve. There is, however, an institutional framework — from Nato to the OECD and the G7 — within which at least some of the main problems can be addressed. 

With China, by contrast, imbalances continue to widen, while relations remain essentially bilateral, conducted mainly with individual countries. 

China’s trade surplus with the European Union exceeded €350bn last year, up from €160bn in 2019. According to European Commission estimates, it could reach €500bn in 2027. Chinese exports to Europe have been rising since the pre-Covid years, while European exports to China stagnated. 

Chinese industry’s capacity to penetrate markets now extends across a wide range of sectors, especially higher-technology ones, from cars to chemicals and renewable energy. This is displacing European production, not only in the domestic market but also in other global markets. Industrial production has been falling for more than two years, particularly in Germany and Italy. Millions of jobs across the continent are at risk. 

Given the global scale that China’s economy has now reached, around 20 per cent of world output, continuing to grow on the back of exports generates deflation, both domestically and for the rest of the world. 

The worrying aspect is the absence of any strategy to correct this imbalance. 

The classic adjustment mechanism would involve an appreciation of the Chinese currency against the euro, which would make European exports cheaper relative to Chinese ones. This, however, is countered by the exchange-rate policy pursued by the authorities in Beijing. Controls on inward capital movements further prevent the yuan from appreciating. 

In reality, the export surplus is the product of the industrial policy pursued for years by the Chinese government and local authorities, based on the provision of subsidies to sectors deemed strategic. This creates excess production capacity and keeps alive companies that compete with one another by cutting costs and prices. The excess output is dumped on foreign markets at bargain prices. There is extensive evidence of a negative relationship between the increase in public subsidies and the decline in the operating margins of the companies that receive them. 

This policy penalises domestic consumption, which suffers from pressure on employment and wages, and has a negative impact on imports from the rest of the world. It also produces substantial public-sector indebtedness, running at around 8 per cent of GDP a year. China’s public debt has reached 100 per cent of GDP, according to the IMF, more than double the level of 10 years ago. It is expected to rise to 120 per cent over the next five years. 

This debt is financed largely by the banking system, which benefits from zero-rate deposits. The absence of alternative opportunities for savers, especially after the collapse of the property market, which has not yet stabilised, pushes households to save even more. This comes at the expense of consumption and imports. 

Despite the unsustainability of this policy, reducing subsidies appears difficult, because it would trigger the failure of many uncompetitive companies, including state-owned ones, with severe repercussions for the banking sector and a recessionary effect on the economy. 

Europe has still failed to find a common position to address the problem, even though the European market is vital for the Chinese economy, especially after the restrictions imposed by the United States. 

The decision not to react a year ago, either to US tariffs or to Chinese restrictions on rare-earth exports, was interpreted by counterparts as a symptom of Europe’s political weakness. Beijing has also managed to convince European governments — from Spain to Germany, without exception — that bilateral relations are more effective than relations with the Union as a whole, as European Commissioner Stéphane Séjourné recalled in a recent interview with Le Monde. 

Political fragmentation, driven by the illusion among individual countries that they can negotiate with China on equal terms, has instead increased Europe’s economic dependence. 

The photograph of a handshake with Chinese President Xi Jinping may, perhaps, make it into the pages of national newspapers. But it does not help solve the problem.