Stopping the Next China Shock

Twenty-five years after the beginning of the first so-called China shock, when a surge in Chinese exports disrupted manufacturing and industrial sectors worldwide, Beijing has again begun to flood global markets with a wave of heavily subsidized manufactured goods and materials—including everything from metals and textiles to more cutting-edge products such as electric vehicles, lithium batteries, and semiconductors. In more economically advanced countries, this influx threatens to upend emerging technology sectors and derail post-pandemic plans to “de-risk” economies by shifting supply chains away from China. In the developing world, a new tsunami of cheap imports could disrupt plans for industrialization and modernization.

According to the theories of economics and trade that are prevalent in the West, Chinese leader Xi Jinping has little choice but to pull back: China’s economy has become dangerously imbalanced. In 2022, according to the World Bank, the country accounted for 30 percent of global manufacturing value added but only 13 percent of global consumption. But it is a mistake to presume that Xi and the Chinese Communist Party (CCP) think about the Chinese economy the same way Western economists do. The key to understanding Xi’s economic policies is to recognize that they are principally about power, not prosperity. He will almost certainly forge ahead toward concentrating the world’s industrial power within China, even at the risk of provoking a cataclysmic trade conflict with other countries.

The emergence of a shared challenge has created an opportunity for enhanced cooperation among the advanced industrial democracies of the West and less developed countries in the global South. Beijing will push back hard against any attempt at policy coordination, seeking to divide, isolate, and overwhelm those who try to stand in its way. But the problems posed by the intensification of Chinese mercantilism are now so great that they cannot be addressed in an enduring way by any one country. Nor can they be solved merely by applying the usual assortment of stopgap remedies.

Only by banding together in a trade defense coalition—an idea I developed with an economist in Asia—can countries with market-based economies protect themselves against China’s predatory practices. Leading this effort will require the United States and its allies to set aside the post–Cold War dream of building a fully integrated, maximally efficient global economy. But rather than abandon the liberal principles that underpinned the free-trade vision, they must focus on constructing a core subsystem of countries that are genuinely committed to the concepts of openness, fairness, and reciprocity and are willing to defend and abide by them. This kind of coalition will be challenging to create, but the alternative is worse: a world in which democracies are dramatically divided and weakened as the Chinese party-state continues to privilege its interests and enhance its power at the expense of other nations—and the Chinese people.

SPEED DEMON

Over the past three decades, Beijing has adhered to a growth-target model that relied on net exports of manufactured goods and investments in infrastructure and real estate to drive economic growth and absorb China’s colossal national savings. The first flood of manufactured exports that the country unleashed into the global economy after joining the World Trade Organization in 2001 contributed to a loss of manufacturing capacity and jobs in other industrialized economies, especially that of the United States. At the time, these changes were not effectively resisted because they were widely seen as part of a mutually beneficial process of economic evolution: as older industries withered in the West, new ones would emerge to take their place. Western analysts expected that China would have to shed its statist, market-distorting policies to meet the commitments it made on entering the WTO. Democratic reforms, it was believed, would quickly follow China’s economic liberalization.

Needless to say, these expectations have not panned out. In the first decade of the twenty-first century, China sought to pursue more economically advanced nations up the value-added chain by continuing to use subsidies, market-access restrictions, currency manipulation, and other tools to expand its manufacturing capacity and win growing shares of global production in established industries such as steel and solar panels. Despite the initial success of this approach, CCP planners realized that they could not indefinitely sustain it without eventually swamping global markets, degrading domestic productivity, and generating dangerous financial bubbles. As early as 2007, Wen Jiabao, then the country’s premier, warned that China’s economy was becoming “unstable, unbalanced . . . and unsustainable.” Two years later, Beijing openly acknowledged that it had created overcapacity in six state-dominated heavy industries, including cement, steel, and wind turbines.

Yet even when export demand collapsed in the wake of the 2008–9 global financial crisis, Beijing doubled down on its familiar model, further diverting national savings into domestic infrastructure, building still more excess capacity in existing industries, driving down returns on investment, and ratcheting up debt. In 2015, Beijing unveiled its Made in China 2025 program, which aimed to capture growing shares of both the domestic and overseas markets for advanced products such as industrial robots and electric vehicles. According to an April 2024 South China Morning Post analysis based on government sources, this plan has already achieved 86 percent of its objectives.

This impressive burst of technological and industrial upgrading came at a steep cost. China far outspent its foreign rivals on public subsidies, relaxed its environmental regulations, and spurred provincial and private debt-fueled investment into priority sectors. The approach created a free-for-all of domestic industrial competition that resulted in vast overcapacity—and helped drive China’s total debt to over 300 percent of GDP. In 2021, Beijing did throttle lending to construction firms and property developers out of concern for the oversupply in those sectors. Bursting the real estate bubble may have been necessary, but doing so then contributed to a dramatic post-pandemic slump in consumer demand and economic confidence in China and underscored the central question of how to sustain growth in both the near and longer term. The answer that Xi’s government has settled on has now become clear: yet more investment in manufacturing and another big export push, with a particular emphasis on high-tech sectors.

TRADE SECRET

Faced with a new wave of Chinese exports, U.S. and European officials have accused Beijing of deliberately cultivating industrial overcapacity. Chinese media outlets deride such allegations as a cover for a strategically motivated effort to contain their country’s rising power. Xi has flatly stated that “there is no such thing” as Chinese “overcapacity.”

The acute sensitivity to the term “overcapacity” reveals something essential about China’s political economy. In contrast to their liberal Western counterparts, Xi and his colleagues are not concerned primarily with the pursuit of efficiency or the enhancement of aggregate national welfare for its own sake. Neither market-loving capitalists nor true-believing Marxists, they can best be understood as mercantilist Leninists whose top priority is to acquire and exercise political power. Their economic policies are designed to preserve the CCP’s dominance and control at home while boosting the country’s industrial and technological capacities to transform China into the world’s most productive, innovative, and powerful state. These priorities help illuminate both what Beijing is doing and what it refuses to do.

Most Western experts, and some of their Chinese colleagues, have long believed that the only acceptable substitute for domestic investment is increased consumption. According to World Bank figures, household consumption in 2022 accounted for only 37 percent of China’s GDP compared with 68 percent in the United States, and the economist Michael Pettis has estimated that China would have to reallocate as much as ten to 15 percent of its GDP toward consumption to sustain healthy growth. This could be accomplished through greater wealth transfers to households in the form of higher wages, improved health care, and retirement pensions.

Xi’s economic policies are principally about power, not prosperity.

But China will not take that tack, because shifting a substantial portion of the country’s wealth into the hands of ordinary citizens would empower them at the CCP’s expense. And redirecting resources toward consumption and services, as developed countries eventually do, could diminish China’s industrial prowess and relative power, leaving it less capable of undertaking a military buildup or an emergency expansion of arms production. Losing its position as the irreplaceable link in many global supply chains would also reduce China’s geopolitical leverage.

This is why, rather than committing to liberalizing reforms, Xi is relying on China’s so-called new productive forces to turbocharge his country’s already outsize manufacturing base. As it has in the past, Beijing is now deploying massive subsidies (estimated to be three to nine times the levels found in the countries of the Organization for Economic Cooperation and Development, depending on the industry) and a shrewd predatory pricing strategy. The goal is to achieve an unrivaled position in fields such as semiconductors and biotechnology before competitors can react, as well as in the three vanguard sectors in which it already has a commanding lead: solar technology, batteries, and electric vehicles. And China shows no sign of relinquishing its hold on the sectors it has long dominated, including mining, textiles, and shipbuilding. On the contrary, Chinese officials now boast that theirs is the only country that produces goods in every one of the UN’s trade categories.

In the near term, Xi is counting on a surge of exports, especially to developing countries, to revive China’s growth. Based on July 2024 estimates from Bloomberg, this approach might temporarily alleviate China’s economic woes, but only on the optimistic assumption that other countries do not resist it. Beijing’s aims, however, are not purely or even primarily economic. By flooding global markets, China aims to drive foreign competitors out of business and tighten its grip over what officials in Beijing describe as “chokepoints,” including lower-end semiconductors and critical minerals. In these officials’ view, boosting manufacturing is part of an urgent “whole nation” effort to achieve self-reliance and reduce China’s vulnerability to technological blockades.

Even as Xi seeks to enhance China’s leverage over other countries, he is working to diminish their leverage over China. In the longer run, Beijing is betting that breakthroughs in artificial intelligence, robotics, and other emerging technologies will increase productivity, fuel growth, and permit Chinese companies to dominate global markets for new products. By supercharging science and technology, China aims to leapfrog ahead of current generations of military and intelligence systems to surpass even the capabilities of the United States.

DANGER AHEAD

Should these plans succeed, China will be able to lock in enduring advantages, creating a perilous concentration of industrial power. Its manufacturing surplus—already approaching two percent of global GDP, a staggering figure—could balloon. The United States and its key allies would find themselves in a position of deepening dependence on China for goods essential to the manufacture of both commercial products and military systems.

The harm to other countries would extend well beyond those that are already industrialized. Beijing often claims that its economic development helps poorer nations, but Chinese firms are already feasting on demand that would otherwise be met by local manufacturers. The fact that China is trying to retain control of less advanced as well as advanced industrial sectors means that much of its gains will come at developing countries’ expense, closing off routes to industrialization and relegating them to exporting the raw materials to feed China’s manufacturing machine and then importing its finished products.

The first reaction of many economists, commentators, and government officials to China’s new export wave has been to try to persuade Beijing that it now has no choice but to reconfigure its economic strategy to rely more heavily on domestic demand. But such appeals are destined to fail because a wholesale rebalancing of China’s economy toward consumption would weaken the CCP’s power. In theory, Beijing could also diminish friction with other countries through a substantial exchange-rate appreciation, which would drive up the cost of China’s exports, drive down the cost of its imports, and reduce its trade surplus. But the CCP dismisses that option as a deflationary trap of the sort that it claims the United States sprung on Japan in 1985. That year, Washington pressured Tokyo to accept a drastic revaluation of its currency relative to the dollar, triggering an asset price bubble that eventually burst and ushered in a so-called lost decade of economic stagnation.

Other Western analysts, especially those in Europe, still cling to the hope that China’s schemes to subsidize overcapacity, the proximate cause of the current crisis, can be addressed through the WTO’s dispute resolution mechanisms. This approach has repeatedly failed, however, even when China was weaker and the trade organization was stronger. Donald Trump has promised that if he again wins the U.S. presidency in November, he will impose steep across-the-board tariffs on all Chinese imports, as well as lower tariffs on other countries, including American allies. But unilateral U.S. tariffs cannot solve the larger problems posed by Beijing’s distortionary trade and industrial policies. Building a dam solely around the American economy would reduce its competitiveness and deflect the impending flood of Chinese exports into other markets. The disputes between advanced democracies that would inevitably follow would merely create fresh opportunities for Beijing to play those countries off one another.

U.S. President Joe Biden’s administration has already begun to raise tariffs and use national security provisions in U.S. trade law to restrict certain Chinese imports such as electric vehicles. By carefully tailoring its restrictions to a limited set of products and sectors for which it can make a plausible environmental or national security argument, the administration is trying to avoid setting off another tit-for-tat trade war. Although some officials in Washington have emphasized the importance of coordinating with allies to respond to China’s export wave in a united way, they clearly hope to avoid taking concerted actions that could be seen as discriminatory toward China, violate the multilateral principles of the WTO, or further fragment the global economy. At this point, however, these are precisely the kinds of measures that are needed.

UNIFIED COMMAND

No country alone can forestall or contain the impending second China shock. The European Union’s competition czar, Margrethe Vestager, is one of the few world leaders to recognize this, openly acknowledging that China’s global trade surplus is a systemic problem that demands a systemic response. Anything less will yield what she aptly calls a “whack-a-mole” approach in which Beijing deflects complaints about particular industries and pursues endless dialogues to evade more serious pressure.

Avoiding this outcome will require the formation of a trade defense coalition modeled loosely on a collective security alliance. Its purpose would be to reduce its members’ dependence on China by encouraging the proliferation of productive capacity for a wide array of manufactured goods. As in the military domain, members would seek safety in numbers and through binding rules to reduce the risks of free-riding or defection. In democracies, joining the coalition would require formal legislation rather than executive orders, which can be overturned through a change of government. If key countries chose not to join, their markets would be swamped by underpriced imports from Chinese producers seeking a way through the coalition’s defensive armor, and possibly compel holdouts to reconsider. Although the coalition could grow, its inaugural members should include a core group of liberal democratic allies and an assortment of high-deficit industrializing countries that, regardless of regime type, share the objective of shielding their economies from Chinese mercantilism.

For such a coalition to be effective, the United States and the EU would need to take part, along with at least half the world’s 15 next-largest economies, excluding China—most likely, Australia, Canada, India, Japan, Mexico, South Korea, Turkey, and the United Kingdom. These states are already either close U.S. allies or strategically more aligned with the United States than with China. According to the International Monetary Fund, in 2022 these countries together accounted for 62 percent of global GDP and ran a collective deficit of $1 trillion with China and Hong Kong. Potential coalition members would also include other existing or aspiring members of the Organization for Economic Cooperation and Development, such as Argentina and Indonesia, as well as any other nations that seek to industrialize independently of China to safeguard their economic or military security.

The members of such a trade defense coalition could deploy a variety of tools to restrict access to their markets, including import quotas and regulatory measures such as bans imposed for the purpose of national security grounds or to protect industries endangered by unfairly priced imports. But the most important mechanism would be a system of import tariffs applied to specific product categories that are critical to national defense or essential to the functioning of modern economies and societies and are vulnerable to supply dominance by China. Most countries that would need to take part in the coalition have already developed such lists; these must be integrated.

It is critical that this coalition have a unified set of rules and target items; otherwise, trade circumvention or leakage would erode its effectiveness. The purpose of a tariff barrier would be genuinely protective: to buy time and create sufficient commercial incentives for new alternative suppliers to emerge both inside the coalition and beyond its perimeter. Tariffs shield existing producers from predatory pricing, but they might not be sufficient to induce new companies to enter markets. To encourage the latter, the coalition would also need to harmonize industrial policy tools, including members’ technology-sharing arrangements and capital, financial, environmental, and regulatory incentives, perhaps coordinating with aspiring manufacturers in other countries, as well.

Given the globalization of manufacturing, it will also be essential to devise a method for calculating the true origin of the value added to each product. Many of the world’s most important goods are now what the WTO defines as “complex products,” such as cellphones and vehicles, which cross at least two national borders before their final assembly. The economist Richard Baldwin has estimated that China now produces about 40 percent of the intermediate components incorporated in these goods, meaning that its actual dominance in many sectors is hidden.

Since the U.S.-Chinese trade war began in 2018, many Chinese firms have begun to offshore a fraction of their manufacturing processes to other countries to avoid the higher tariffs that would be imposed on their products if they were exported directly from China. To thwart such tactics and determine the appropriate tariffs on specific products, the trade defense coalition would need to create a much fuller supply chain accounting system. The higher the amount of Chinese-origin content in a final product that arrives at a coalition member’s borders, the higher the tariff should be. Such a system would have been impossible to implement a generation ago. But today’s information systems can track even the smallest of parts as they move through the production process.

DESTROY IT TO SAVE IT

The likely objections to this proposal are numerous. It cannot be denied that creating a defensive coalition would violate the WTO’s principle of nondiscrimination. Unfortunately, however, China has already warped and distorted the WTO’s principles and now uses the organization’s procedures to shield its own discriminatory practices from scrutiny and avoid compliance. The United States and its allies must not permanently abandon the WTO, but neither can they currently depend on it to protect their economies.

The creation of a trade defense coalition would also further fragment the global economy into at least partly separated trading blocs. But the alternative is not the renewal of a march toward a fully integrated, balanced global economy based on the principle of comparative advantage. Xi likes to present himself as the great defender of globalization. What he has in mind, however, is a very lopsided version of it, in which China protects its own market and uses subsidies to expand its already overgrown industrial base while other countries remain open, providing it with the markets, technology, resources, and capital it needs to grow even as their own industrial capacities erode and their dependence on China deepens.

Learning from China’s experience so as to better counter its policies need not mean that, through some perverse process of convergence, “we” will become more like “them.” A decade after Beijing unveiled its Made in China 2025 program, other industrialized countries are slowly grasping the reality that Chinese leaders indeed intend to make almost everything in China. Other major economies now have little choice but to adopt trade and industrial policies that mirror some of China’s own successful efforts. In addition to walling off infant or embattled industries, these policies may include offering subsidies, mandating locally made inputs, and requiring technology transfers from any Chinese company permitted to operate inside the coalition’s defensive barriers.

No country alone can forestall or contain the impending second China shock.

A trade defense coalition would not leave Beijing free to commercially dominate the global South. Nor would it compel developing nations to choose between China and the West. On the contrary, by promoting the broad diffusion of industrial capacity and know-how, a coalition would offer these countries a better deal than the extractive one they currently get from China. It would be in the interests of the coalition to cultivate alternative suppliers in a variety of nations, from Malaysia to Morocco. Everyone outside the coalition would be free to continue buying low-cost goods from China; if they incorporated targeted items into their exports, however, the coalition would levy appropriately weighted tariffs. That would pressure Chinese companies to add more value to products in other countries, permitting companies in those countries to manufacture more components and do more of the work. Meanwhile, multinational companies based in coalition countries would be incentivized to transfer skills and capacity to countries other than China, preferably friendly ones with market economies and a dedication to the rule of law.

Although penalizing China’s underpriced exports could slow the world’s shift toward renewable energy, environmental considerations must be appropriately weighed against security concerns. Aided by cheap electricity, much of it generated by coal-fired plants, China’s oversize solar power industry has already driven prices so low that foreign competitors have largely been eliminated from the market. This is not the case yet for wind turbines, however, or even batteries, for which the chemistries are evolving. As the world’s energy systems slowly tilt away from fossil-fuel-dependent grids and internal combustion engines and toward renewable energy technology and distributed storage, most industrialized nations will seek to control the manufacturing, installation, and operation of substantial portions of these critical networks.

Beijing will no doubt retaliate against the formation of a defensive coalition, whether by cutting imports from member countries or threatening to limit their access to the supply chains it dominates. But because the countries that would make up the coalition will continue to be the major source of global demand, they will not lack for leverage. Provided that they work together, a 
group of like-minded countries should have the scale, technology, and resources needed to resist Chinese pressure and sustain their own prosperity.

BETTER TOGETHER

Rather than simply accepting an outcome in which industrial and technological power inexorably gravitate toward China, this kind of trade defense coalition would shore up the position and protect the autonomy of the United States, as well as other advanced nations. It would also accelerate globalization in the truest sense by encouraging a wider dispersion of production, knowledge, and income. In the United States and other developed countries, however, this kind of coalition will be a tough political sell. Although it would generate good new jobs, its creation would likely spur inflation, and major multinational corporations would feel the pain of China’s retaliation. To ease the path, the coalition’s purview could be established incrementally, starting with just a few industries. This was the approach that ultimately led to the creation of the European Union, which began with a more modest 1951 agreement to form the European Coal and Steel Community.

Today, the automotive sector would be a logical place to start. Chinese planners recognized the promise of electric vehicles early on. But because auto industries provide millions of jobs and have direct links to manufacturing sectors critical to national defense, most major economies still want to retain them. Preserving them in the face of cheap Chinese imports will be impossible, however, without tariffs and incentives for alternative suppliers of batteries and components. These methods will be more effective if they are applied in a coordinated fashion. Cars and car parts produced under the policies of a trade defense coalition would likely be more expensive than those imported from China. But the data they collect would be more secure, and they would be built by better-paid workers in liberal, transparent economies. Consumers would have more opportunities to bypass Chinese brands and thereby avoid rewarding the CCP for its mercantilist policies.

Ultimately, the strongest argument in favor of a trade coalition is that it is vital for the security of advanced democracies. The world is already dangerously reliant on China for an astounding assortment of essential goods and intermediate components, as the COVID-19 pandemic laid bare. The war in Ukraine has driven home how central manufacturing capacity still is to modern warfare. It takes little imagination to foresee a future crisis or conflict in which China could inflict sudden and potentially paralyzing supply chain shocks on its adversaries. Democracies understand that they must pay a premium to preserve their freedom of action by at times increasing their defense budgets. They must also learn to take steps to defend their economies, even if these are costly.

Although Beijing will claim otherwise, a trade defense coalition need not hold China back or stifle its growth. Instead, it would prevent the country from exercising its self-proclaimed right to development in ways that deindustrialize the economies, limit the autonomy, and endanger the security of other countries, rich and poor alike. Ultimately, a trade coalition could even be good for China. Limiting Beijing’s ability to externalize its domestic economic imbalances and use other countries as outlets for its overproduction would increase the odds that the Chinese government will finally abandon its mercantilist model in favor of genuine, liberalizing reforms. Then, China could take its proper place in the open, integrated, and mutually beneficial global trading system that democratic countries envisioned when the Cold War ended three decades ago.