China’s trade challenges

This is part 1 of a short series. In the next report we will consider three scenarios for trade relations between China and the West; what these scenarios mean for trade; and the impact on China’s growth outlook. We will argue that in the short to medium term (three years) a de-risking scenario remains most likely, but we see increasing risk of greater decoupling.

In May, Xi Jinping visited France, Serbia, and Hungary in his first post-pandemic visit to Europe. Earlier this year, several high-ranking EU officials visited China to discuss the many sensitive issues that characterize the changing relationship between China and the European Union. German Chancellor Scholtz and European Commission President Von der Leyen, for example, both went to China to discuss the war in Ukraine, China’s manufacturing (over)capacity, and – related to this – the bilateral trade relationship between China and the EU.

The deterioration in the trade relationship between China and the US had already started under the Trump administration. Many factors lie behind this deterioration between China and the West, which we will discuss below. While Europe and some other Western countries (South Korea and Japan) are still more reluctant than the US to start a full blown trade war with China, Europe’s patience with China’s trading practices is increasingly wearing thin.

We will start with a quick recap of how and when trade tensions between the West and China started. We will mainly focus on developments regarding the trade relationship between the US and the EU on one side and China on the other side.

In 2016, Trump’s campaign already singled out China as a country that engages in unfair trading practices and blamed China for manipulating its currency. Trump made good on his threats in July 2018 and imposed tariffs on goods imported from China. China, in turn, responded by levying higher tariffs on goods imported from the US. Thus a trade war started and tariffs gradually rose. This lasted until January 2020, when the so-called Phase One agreement was signed. Although this led to some adjustments, it left tariffs significantly higher on a large volume of traded goods. Looking at the share of US-China trade that is subject to tariffs, approximately 58% of US exports to China and about 66% of Chinese exports are still subject to tariffs under the Phase One agreement. [1]

[1] A detailed timeline of events can be found here.

Until recently, the EU generally adopted a different approach to its trade relationship with China. The EU has repeatedly expressed concerns regarding issues like fair competition, a level playing field, and an increased level of reciprocity. More recently, the EU has also addressed China’s manufacturing overcapacity in certain sectors. However, compared to the US, the EU is more divided about the appropriate policy response since its trade policies have to take into account the different interests of EU member states. Clearly, the trade relationship with China differs between EU member states.

This has not prevented the EU from taking the first steps to address what the EU sees as imbalances in the current trade relationship; which will be discussed in detail below. As the trade relationship between China and the West has become increasingly tense we can still observe differences between China’s export volumes to the US and the EU. While the amount of exports from China to the US have stabilized again since Trump imposed tariffs in 2018, the EU’s trade deficit with China has recently started to increase again and it is now significantly higher than in the pre-pandemic period (2018) and the initial post-Covid correction, which reflected a shift in consumer preferences from goods back to services.

As mentioned above, a distinction has to be made between the US’ approach and the EU’s stance towards trade with China. Clearly, the US adopted a significantly more assertive approach towards China compared to that of the EU. Below we will outline some of the more recent trade developments and argue that it is likely that more trade barriers will be raised in the near future. Taking all this into account we will assess the current trend.

Recent developments in China-US trade relations

The Biden administration has kept the vast majority of Trump’s trade measures in place. President Biden only made some minor modifications to the tariffs on steel, aluminium, and solar panels. He also allowed the tariff on washing machines to expire in 2023. Despite these adjustments, the amount of taxes collected under the Biden administration has increased significantly. Moreover, Biden recently levied additional tariffs on a range of goods – the majority of which already came into effect (see table 1).

Until now, China has responded to the imposed tariffs in a measured way in order to try to save an important export market for the country. However, in March, Xi Jinping called the current US strategy one of “containment, encirclement and suppression.” A fierce response to the newly imposed tariffs in the form of retaliatory trade measures has been absent so far, but China seems to be more assertive when it comes to the overall bilateral relationship. This is illustrated by, among other things, China’s reaction to US officials visiting Taiwan and US arms deliveries to Taiwan. As such, we expect China to respond in one way or another in the not too distant future. We will come back to this later.

Trade tensions between China and the US are not only confined to tariffs on goods, but also – and increasingly so – relate to China’s access to certain technologies. This is illustrated by remarks made by Foreign Minister spokesman Mao Ning that: “small yard and high fence [as US officials earlier described their trade policy] will not stop China’s innovation-driven development, nor will it do any good to US companies or the entire semiconductor industry.” That’s clearly a sneer at America’s attempts to contain China’s ambitions to become technologically on par with the US. With this in mind, it is telling that NVIDIA mentioned Huawei as a serious competitor regarding the supply of chips for AI.

Furthermore, with the continuous depreciation of the CNH vis-à-vis the US dollar, which we expect to continue gradually, new trade tensions seem to be on the horizon. Even more so given our base case scenario of a Trump victory in November.

Last but not least, Western accusations of China’s manufacturing overcapacity (see figure 4) in certain sectors add to this mix of recent developments that drive the deterioration of China-US trade relations.

Recent trade developments between China and the EU

Regarding trade it can be observed from figure 3 that the amount of EU imports measured in euros has declined significantly since the record month of august 2022. During this month, EU imports from China amounted to over EUR 57.5bn and the EU had a trade deficit in goods of almost EUR 38bn. Indeed, in 2022, the EU reported a record trade deficit with China amounting to no less than EUR 397bn. Since then, EU imports have dropped significantly despite a recent rise in April 2024 (compared to the average level of imports during the first quarter of this year) that brought imports to almost EUR 41.9bn. This resulted in a trade deficit of about EUR 22.6bn for April this year.

Declines in the imports of telecommunications equipment, automatic data processing machines and organo-inorganic and related compounds were most notable. Many of these trends reflect differences in economic growth, a change in post-pandemic consumer preferences (from goods to services) and higher energy prices in Europe that erode household spending for other goods and services. As such, the vast majority of declines in Europe’s imports from China is not related to EU policies. Still, this does not mean that the EU isn’t increasingly looking into imposing trade barriers in sectors in which China wants to grow and/or is growing. Certain categories of imports have shown a sharp rise, most notably Europe’s imports of electric vehicles (EVs) from China.

The EU has chosen a different approach regarding its trade relationship with China, showing more restraint in implementing trade barriers and export controls than the US. Still, a noticeable change has taken place in recent years. Indeed, rising imports of Chinese EVs have become one of the most pressing issues. The EU probe into unwarranted state subsidies for China’s EV sector have led the EU to propose additional tariffs on Chinese EVs. These tariffs came into provisional effect on July 4, 2024 and will become ‘definitive measures’ after four months, unless there is an alternative agreement between China and the EU. Chinese Commerce Ministry spokesperson He Yadong told reporters: “We hope that the European side will work with China to meet each other halfway, show sincerity, speed up the consultation process, and, on the basis of rules and reality, reach a mutually acceptable solution as soon as possible.”

These EV tariffs are still significantly lower than the tariffs imposed by the US. Furthermore, these tariffs will probably not materially impact the business case for Chinese EV manufacturers that export to the EU. However, it is indicative of the abovementioned change in this bilateral trade relationship, even though the proposed tariffs are met with opposition from some member states; most notably Germany, which made approximately a third of their car sales last year in China. As such, it is still uncertain if these tariffs will truly and definitively come into effect.

But there is more. Other probes have been launched into wind turbines, medical devices, (tin) plate steel, wood flooring and Chinese solar firms (see table 2). This resulted in the Chinese Chamber of Commerce stating to the EU that it was “gravely concerned about the consecutive in-depth investigations against Chinese enterprises”. China also seems to react slightly more assertively to the several probes that have been launched by the EU. When Germany’s minister of Economic Affairs visited China in June, Beijing warned that escalating frictions with the European Union over EV imports could trigger a trade war.

Germany’s view on Europe’s trade relationship with China is also illustrative of Europe’s internal divisions between several member states and Brussels. While the Hungarian president (who currently took over the helm of EU presidency) visited China for a ‘peace mission 3.0’, France and Brussels have shown considerably more willingness to address imbalances in Europe’s trade relationship with China. It should be clear that the main reason for these divisions are the different national interests between member states.

Needless to say that these differences further complicate Europe’s already challenging path towards strategic autonomy. As such, France has already been threatened with possible tariffs on it exports of brandy and China has launched an anti-dumping investigation against pork imported from Europe. Still, we do think that China will choose to show at least some restraint towards the EU since it would not benefit China to further alienate the EU, both from an economic and from a geopolitical angle.

Since China joined the WTO in 2001, China’s trade with the rest of the world increased from USD 55.4bn to USD 481.5bn. During this time of hyper-globalization and free trade, many Western firms relocated their manufacturing capacity to countries where labor costs were low. China offered Western firms cheap labor, and great potential for foreign firms to sell their goods in the country’s domestic market.

However, over time, China developed its own (state-owned) companies and brands that started to compete with Western brands; both domestically and abroad. Initially these were goods with relatively low added value, like consumer electronics and textiles, but over time China has developed the capacity to produce high value-added goods, such as smart phones, electric vehicles, and even 5nm semiconductors. The latter is regarded as a major breakthrough. To summarize, China quickly developed to become the world’s largest producer of manufactured goods and as such also became the number one exporting country.

Therefore China’s industrial policy is part and parcel of its trade strategy that is aimed at becoming an essential part of global value chains, and exporting its surpluses to the rest of the world.

The second pillar has been to remove as many trade barriers as possible. While accession to the WTO was a crucial step, it is certainly not the only factor in China’s trade strategy. China has negotiated Free Trade Agreements (FTAs) with many of its trading partners. The Regional Comprehensive Economic Partnership (RCEP), which includes 15 Asia-Pacific countries including all members of the Association of Southeast Asian Nations is one of the most important one.

Related to that is a third pillar: the Belt One Road initiative (BOR), which over time developed from a Eurasian transit corridor to a global trade strategy involving 154 countries. This has enabled China to find new markets on top of its key trade partners in the West. The BOR is also a way to ensure China’s access to those raw materials that are needed as inputs for producing goods.

China and the broader West

Although our main focus is on the EU and the US, some trade issues apply to the broader West in general. Firstly, the pandemic exposed clear vulnerabilities in Western supply chains in crucial (medical) goods. Secondly, the increasing geopolitical tensions are amplifying concerns that a potential conflict would lead to the West imposing heavy sanctions on China. That, in turn, adds to worries about supply chain vulnerabilities and the risks of manufacturing capacity being concentrated in China. Last year, we wrote a paper about how this has led to the so-called China plus one strategy.

These concerns are mainly driven by China’s stance towards Taiwan, but there are other geopolitical risks. These are mainly concentrated around the South-China Sea. Japan and the Philippines, among others, have territorial disputes with China and especially in case of the Philippines those tensions are on the rise. Very recently, China and the Philippines held talks to try to reduce the tensions. Last but certainly not least, China’s relationship with Russia is increasingly worrying the broader West. Both Europe and the US have warned China to not provide Russia with so-called lethal aid. For now – and unlike Iran and North Korea – China seems to stop short of this, but there is no guarantee that this will remain the case. Indeed, both the US and the EU have already put some Chinese banks and companies on the sanctions list. However, trade tensions between South Korea and China might also rise because of these global trends.

Trade tensions between China and the West have been steadily increasing and this trend is likely to continue in the foreseeable future. While the US already started a trade war in 2018, the EU has been, and still is, more hesitant to adopt a similar hawkish stance. Given our base case scenario of a Trump victory later this year, it is likely that US-China trade relations will deteriorate further. However, the EU is slowly becoming more assertive as well.

While the EU follows a different approach, it is clear that the EU also seeks a more equitable trade relationship with China. So far however, China has not taken tangible steps to address the concerns of both the US and the EU. A lack of demand from China - due to several economic challenges that plague China’s economy - is an important factor for China’s rising trade surplus with the West, but other factors continue to play an important role. China’s ambitions to move up in the value added chain also results in the West aiming its trade barriers towards specific sectors. Indeed these are sectors that add high value like EVs, semiconductors, chips, and AI.

This becomes clear when looking at goods that are being targeted. Here we see some similarities between the EU and the US. Both look(ed) at EVs, goods related to the energy transition like wind turbines, steel imports, and medical devices. China for its part will try to prevent a further deterioration of its trade relationship with the West, while at the same time deepening its trade relationships with emerging markets and the pacific region. For China, FTAs are an important tool to increase trade relationships with the rest of the world and the BOR is an extra tool to ensure stable trade relationships and a stable supply of raw materials.