Rising trade tensions unveil Europe’s China shock 2.0

The latest episode in the trade story, with China cutting off Europe for certain microchips, is yet another illustration of how the economic relationship between China and (industrial) Europe has changed. In the 2000s and 2010s, the so-called China shock was a positive surprise for industrial Europe and a negative one for low-cost and low-wage Europe as China entered the world stage with a large demand for European manufacturing goods. At the same time, China took over the role of an important workbench for both the global and European economy.

German industrial companies, in particular, benefited enormously from an ever-growing Chinese market. This positive China shock also helped Germany sugarcoat domestic reforms in the 2000s. Germany's strong economic performance is often exclusively attributed to the labour market reforms of the early 2000s. However, without Chinese demand for German manufacturing goods, even the most far-reaching labour market reforms would not have prompted the growth Germany experienced.

Since the early 2020s, however, the China factor has turned into a China shock 2.0. In fact, when the Chinese government announced its “strategy 2025” in 2018, Europe should have noticed that things were going to change. Unfortunately, many European policymakers and politicians did take these announcements lightly. And wrongfully so – far before the US-China tariff escalations, Europe had already noticed the impact of increased Chinese competition, both in its domestic market and the rest of the world. The China 2025 strategy is starting to bear fruit as China has become globally competitive in some key strategic markets.

Chart 1 below shows a crude measure of China's increased relevance in the European market for goods over time and illustrates the ratio of European imports of manufactured goods from China to European manufacturing. We use this for the benefit of the timeliness of data, as we can use quarterly figures to take the 2025 developments on board.

The trend is clear: from its accession to the World Trade Organisation in 2001 to 2010, China's share increased. In the US, this has come to be known as the 'China shock' following the publication of a famous paper led by David Autor, which showed that the Chinese accession to the WTO had negatively impacted US manufacturing in certain sectors and resulted in local job losses.

The ratio stabilised in the 2010s, but has since started to pick up once again. China’s exports to Europe have risen as a share of European manufacturing, essentially increasing European reliance on Chinese production and building competition in the European domestic market. If, indeed, the trade war is leading to an inflow of Chinese goods into the European market, we'll likely see an acceleration of a trend that started around the time of the pandemic.

An important reason for the accelerated exports to Europe is the so-called overcapacity in the Chinese industry, which comes after large investments in manufacturing capacity for key industries. This has resulted in involution – a term that originated in China to describe the overcapacity and resulting domestic competition, deflationary pressures and cutthroat labour market circumstances. This can be seen in sectors like the car industry, the chemical industry and non-metallic mineral products. But electrical machinery and electronics now also suffer more from declining capacity utilisation than they did in late 2019. The interpretation of the term ‘overcapacity’, however, remains controversial, with some observers suggesting that overcapacities are a very conscious attempt to gain global market shares.

With the US having already decreased its import reliance on China since 2017, the domestic market proving weak, and emerging markets unable to absorb the excess supply, the risk of a new China shock is mounting. This time, it would be more focused on the European market as the US increases its barriers.

The increasing reliance on China is not just a matter of preference or price. Dependence on China for critical inputs in the eurozone economy has also steadily grown over time. When it comes to critical raw materials, we see that dependence has risen most prominently in the last five years. For a significant number of rare earths, the eurozone industry is directly dependent on China, though strong indirect links also exist. This means that where China is dependent on Europe for demand for its products, the opposite is also true through critical inputs in the supply process.

The difference between a China shock for the US and for Europe is that both Europe and China are large global exporters with huge trade surpluses. The negative impact on the European economy of a new Chinese export surge is therefore also likely to be felt through slowing exports to third markets. Chart 3 shows that the Chinese share in total imports in most of the largest global economies has increased since late 2019, while the EU share has dropped slightly for the majority of the selected markets. Chinese gains in Africa and the BRICS nations (excluding China and the Middle East) stand out, while a small bit of market share has been gained for the EU in advanced economies. That has been mainly driven by the US importing less from China, but the UK has also seen increased imports from the EU, intriguingly.

And the Chinese market itself is also a source of vulnerability for eurozone businesses. Over recent decades, Chinese demand for eurozone goods picked up significantly as the Chinese market advanced, resulting in many years of double-digit annual growth. But the combination of a more advanced manufacturing sector in China and more sluggish demand for goods in general has caused a turnaround in eurozone exports to China as well. Since the peak in February 2023, eurozone exports to China have fallen by more than 25%.

Ultimately, increased Chinese competition is a triple whammy for the eurozone industry as it experiences it both in the eurozone market itself, in the Chinese market and in other markets too.

So, while increased Chinese capacity and subsequent larger import penetration in the European and larger emerging markets are nothing new, we do note an acceleration since the start of the year. The new impulse to the trade war under the second Trump administration has boosted both American and Chinese competitiveness when looking at the real effective exchange rate, a common measure of cost competitiveness. This is in part driven by the weaker US dollar, which has also caused a devaluation of the renminbi against the euro (also keep in mind that many European imports from China are often paid in US dollars, which makes Chinese imports automatically more competitive due to the USD devaluation).

There are also large differences between European countries. Ireland is worst off, given its strong trade relationship with the US and the strong dollar devaluation, but Germany and the Netherlands are also harder hit. This means that the bigger surplus countries have seen their competitiveness hurt most within the EU.

Whether this is already affecting European imports from China this year is not easy to answer, as there's been a lot of noise surrounding the data on values and volumes of imports. Still, we do note a sharp decline in the value of total European imports from China since March, while volumes have held up.

When looking at the difference, it looks like import prices from China have roughly declined by 15% year-on-year, while average import prices decreased by just 2.2% year-on-year in July (latest available data). There are clear indications of price discounts, but this will also reflect the devaluation of the US dollar and Chinese renminbi compared to the euro.

Looking at the data by product group, we note that strong increases in volumes of Chinese imports are only happening for beverages and tobacco and for mineral fuels. The latter seems to be driven by lower global energy prices. Interestingly, exports from Europe to China have also surged for the same product group.

Other product groups have so far seen imports from China shrink since the trade war escalated in April. But while volumes aren’t up yet, we do note lower prices on a broad group of products, with manufactured goods on average seeing price declines of just over 5% since March.

It's not a full flooding of the European market, but the first tentative signs of Chinese products putting more pressure on European manufacturing are emerging – and this actually fits into a wider trend that materialised during Covid. For already vulnerable European sectors, this poses a concern. The European counterparts of some of the Chinese sectors that experience large and increasing overcapacity are themselves already experiencing weak demand.

From the Chinese sectors that had less than 75% capacity utilisation in the third quarter – auto, mining, chemicals, electrical machinery and equipment, food, pharma and non-metallic minerals – we note a particularly large jump in eurozone imports from China for auto, chemicals and pharma. The increase in auto and pharma is around 50% over the past five years. With the automobile and chemical sectors already struggling because of home-grown issues (e.g., energy competitiveness) and global competition, the most significant concerns seem to be focused on these classic manufacturing sectors.

That means that further weakening of domestic production and increased dependence on China for these sectors is a possibility. And for Germany – Europe's largest economy, where these sectors are more sizeable – this is a bigger problem than in other countries across the continent. With competitiveness more under pressure than in most other large European markets and with a much stronger link to China, Germany stands to lose out more from this perspective.

With the development of China's Strategy 2025, Europe is undoubtedly facing a second 'China shock' – only this time around, it's largely negative. Not so much, perhaps, if you're a central banker, and more inclined to embrace the disinflationary impact of cheap Chinese industrial goods – but definitely if you are a politician or industry employee witnessing key industries facing painful competition. And while this may ultimately lay the foundation for a move towards even more productive economic activity, geopolitical considerations around strategic autonomy are starting to play more of an important role in this discussion.