Silk Road Trap
How China’s Trade Ambitions Challenge Europe
For almost two decades, China has claimed that its expanding economy benefits Europe, stimulating European growth, exports, and employment. But the reality is not so clear-cut. Whilst individual companies may have profited from China’s economic rise, unbalanced trade with China has undermined its economy and its political influence. China’s monumental infrastructural project, the Belt and Road Initiative or New Silk Road as it has come to be known – is set to make this situation even worse.
The Silk Road Trap is the first book to expose just how risky this uneven partnership is for Europe. It argues that Europe must reduce its reliance on China and work on building a stronger and more sustainable European economic model. By revealing the political aspirations and economic strategy behind the new Silk Road, the book lays out its implications for specific European industries, from steel over aircraft to robots. The book does makes the case for a future made in Europe.
‘A smart and provocative analysis that deserves wide attention.’ François Godement, European Council on Foreign Relations
‘In this perceptive and pragmatic book, Jonathan Holslag awakens Europe to its romantic self-deception regarding China’s expansionist intentions and offensives. Europe must get realistic about China and this book may just be that wake-up call.’ Karel de Gucht former EU trade commissioner
‘A strong and thought-provoking argument about the implications of China’s rise for Europe.’ Alan Beattie, Financial Times
‘A powerful counterpoint to the increasingly complacent attitudes of European (and British) policymakers to a country that combines authoritarian politics with a state-directed economic system.’ Money Week
‘Enlightening’ FT Adviser
‘This well-documented book, which draws heavily on Chinese sources, shows how China ‘defied the expectations’ not just of Americans but also of Europeans, and argues that there is no reason to expect China to change its feathers any time soon.’ Hans Maull in Survival.
For many years, the European Union has hoped to build a balanced partnership with China and also expected the European institutions to engage China in regard to the trade deficit, market access and so forth. This book has found that this patient and constructive engagement has been unsuccessful. On its seven most important policy objectives, the European Union has made no meaningful progress and even lost in at least two cases. To be sure, more and more official dialogues have been set up. Europe has provided financial support to help China to create a level playing field. Europe has also granted China almost unhampered access to its market while access for European companies to the Chinese market remains limited. Europe has adhered to free trade, even while China has refused to reciprocate for over two decades.
The Chinese leadership has repeatedly vowed to build a win–win partnership. It has even presented itself as a new champion of free trade. But the reality remains different. First of all, there is no win–win partnership with China. For the vast majority of European countries, the impact of China on their economic growth has remained negative. It might be the case that individual European companies make a profit in China, but taking the general interest as a point of departure, which is what governments are meant to do, and evaluating the impact of China on the overall economy, it is just not appropriate to insist that China has been ‘good’ for growth in Europe. Most countries have a persistent deficit on the current account, which includes the trade balance. Altogether, the European Union has directly lost €1.4 trillion to China since 2006, as a result of that protracted deficit. European countries have also lost from China in third markets. Net technology transfer is usually not to their advantage either.
Ideals and reality
Whereas many liberal economists stress that a bilateral deficit is not a problem, this book urges realism. A free market remains an ideal; it cannot be taken for reality. As long as governments intervene and as long as economic shifts have political, social and security consequences, we cannot pretend that a bilateral deficit will be corrected by the functioning of a so-called free market. While a free market is the best way to allocate factors of production in theory, policy makers can strive towards that ideal, but they have to be aware that the reality is much more complicated. Moreover, even from a liberal viewpoint, it is difficult to maintain that China’s current economic manipulation is positive, that it encourages entrepreneurship in Europe and stimulates innovation. The contrary is true. Its industrial policy has led to massive overcapacity and excessively low prices that leads to a race to the bottom, instead of a race to the top, or the kind of competition that rewards societies properly for their innovation or their attempts to create a more sustainable economy.
This book also disputes that importing cheap Chinese products is good for European citizens. While it helps repress inflation in the short run, it threatens to render Europe vulnerable to destabilizing adjustment crises in the long run. This book also takes issue with the argument that bilateral deficits are not problematic as long as the overall current account is more or less balanced. Either way, a bilateral deficit remains a deficit and such trade partnerships, as has been asserted, have no positive impact on growth. In addition, many European countries have both a negative bilateral and total deficit on the current account.
Finally, this book challenges the optimistic assertion that members of the Eurozone do not have to worry about national deficits with China, because what matters is the combined current account of all the members, as the monetary union redistributes wealth internally. This might be true in theory for a perfectly functioning monetary union, but in practice, this redistribution is not so evident at all, especially when the persistent gap between deficit and surplus countries leads to political sensitivities. The baseline remains that China’s impact on growth is negative, that this could exacerbate the political tensions between the surplus and deficit countries inside the European Union and thus contribute to the weakening of cohesion. We can thus not simply approach the rise of China with rather constricted economic theories and need to bring the complexity of an imperfect monetary union and political sensitivities into the equation as well. Economics and politics are interrelated.
China’s future ambitions
We have probed China’s economic ambitions for the future and, by reviewing a large number of official documents and statements, found that there is no reason to expect China to change or rebalance its economy any time soon. The Communist Party is responsible for a colossal transfer of household savings into investment in the corporate sector, investment that has contributed to massive overcapacity. The Party leadership just cannot yet allow creative destruction do its work as it would have done in market economies, because that would evaporate hundreds of billions of household savings. It thus has to continue to invest, to roll over existing debt, to export some of the products that the domestic market cannot absorb and to try to make its companies more competitive. The objective is not to reduce capacity, but to modernize it. The idea is not to reduce exports, but to make them more competitive.
Even if Chinese leaders talk harmony when they travel abroad, economic policy documents are pervaded with economic realism, protectionism and economic nationalism. At the heart is always sovereignty, economic security, comprehensive national powers and also a clear linkage between economics and geopolitics. These are no mere slogans. The source of this realism is the Communist Party’s quest for survival as well as the assumption that China can only restore its dominant position if it reduces dependence of foreign companies, if it gains sovereign control over key industries, if it indigenizes technological progress and if it continues to generate enough growth to lift its population above the symbolical income threshold of US$12,000 per capita, which will officially make it a high-income country. These aspirations are not exceptional, but their consequences for Europe are immense, as they presage more competition and persistent political intervention to gain economic power.
Chapter 4 reviewed the instruments that China has deployed to advance its economic power. It became instantly clear that China’s economic policies are no longer exclusively characterized by defensive economic nationalism or protectionism. China is not on the defence: while it continues to protect its infant industries and reserves lucrative parts of its domestic economy to state-owned industries, its current economic policy is much more about the offense, about breaking open foreign markets so as to increase Chinese exports and so forth. The array of tools that China uses is impressive, if not intimidating. Most important has become the massive financial support. Part of the trade surplus that China runs is being converted on the financial account into export credit, concessional loans, etc. China disburses more of these loans than all other major economies combined and it refuses any meaningful cooperation to formulate international rules for such credit.
Crucial is that China’s advantage in exports is thus no longer limited to low prices. Those low prices are still important, but this advantage is now flanked by cheap credit, package deals, etc. Another source of strength concerns coordination. While China is no monolith and different interests exist, like in any other country, the benefits of a dictatorship, which China strictly speaking still is, are clear: by controlling the capital flows to domestic companies it can influence their behaviour at home and abroad, to make them fulfil political objectives. Whether they are state-owned or not plays less of a role, as they all borrow from state-owned banks and because those state-owned banks’ decisions to allocate capital does again depend to a large degree on political considerations, rather than the criteria that are common in a market economy.
This shift towards an offensive open-door policy instantly explains why China has started to preach ‘free trade’ in spite of persistent and growing state support. What China wants is ‘open’ markets, unrestrained access to other countries. But that is not the same as ‘free’ trade, where commercial exchanges happen predominantly on a private basis and without state intervention. While many liberals in European countries are enthusiastic about China’s pro-globalization discourse, its strategy is about manipulating globalization. China’s open-door policy threatens free trade and distorts markets as much as protectionism, but we have few conceptual and legal tools to deal with it.
The final chapter examined China’s economic policy through eleven important sectors, sectors that are all prominent in the Belt and Road Strategy as well as in the ‘Made in China 2025’ strategy. These sectors are about both services and manufacturing, high-end and basic industries. Again and again, it is striking how the thinking of China, despite the official discourse of harmony, is marked by realism and even zero-sum thinking, how political and economic considerations are intertwined and how everything is being integrated.
The essence of China’s economic policies in all these sectors and throughout the many policy documents remains to bend is weaknesses – overinvestment and overcapacity – into strength. It generates surpluses on the current account. These surpluses have created large foreign exchange reserves, which in turn are being sterilized by the Chinese Central Bank and sent back out of the country on the financial account in the form of foreign investments. This serialization contributes to the suppressing of Chinese domestic demand and is therefore often considered a financial sacrifice: the money is, after all spent abroad and not at home. But those foreign investments allow China first of all to continue to export, by pre-financing consumption through export credits and so forth. But it is also to enhance the competitiveness of its economy by acquiring natural resources, technology and strategic infrastructure, as well as to support backbone industries to gain ground on their foreign rivals. In the short term, sterilization and government-induced foreign investment are thus, so to say, a sacrifice, but in the long term it is expected to defend Chinese exports and also to create additional investment incomes on the current account. Investing abroad is done to earn money abroad and these incomes can flow back to China on the current account and thus in the long run contribute to domestic demand.
Besides these economic gains, there are also political benefits. Even if China’s acquisitions of, for instance, foreign government debt can be stated to be a consequence of its weakness, namely its dependence on exports, it allows China to enhance its political influence. In the past, most of its investment was channelled into US treasury bonds, to the extent that even China’s exposure to US debt became an additional vulnerability. But now that the investment portfolio is diversified, China has built itself a very strong position as creditor to a large number of smaller countries. So, even if Chinese factories remain an important competitor to the industries of those smaller countries, and even if those countries are often incurring protracted trade deficits, China in the end emerges as a saviour, a lender of last resort. Besides prestige, the spreading of Chinese trade and investment flows also enlarge its military footprint. The flag follows the trade. The navy is being deployed to protect maritime lifelines, the People’s Liberation Army is increasingly present along strategic choke points and the ambition for China is to become a resident military power all around Europe: in the Mediterranean, in the Atlantic and in the Arctic.
Consequences for Europe
What does all this mean for Europe? First of all, we have to stop claiming that China’s rise has been beneficial to our growth. This is not the case. Second, governments must take the general interest as the point of departure for their engagement with China. In that regard, they might actually learn from China. The success of individual companies is important but has to be put in a broader perspective. They need to understand that the prosperity of their national economy is linked to the prosperity of the EU economy as a whole, that these prosperities are often being eroded, and that China deliberately complicates the cohesion and the survival of the European Union. Third, European leaders have to ask themselves what certainty they have that the situation will improve, with or without the cooperation of China, for instance because of the promises related to the Belt and Road. Europe has tried for over twenty years and repeatedly China has promised to rebalance the partnership, but nothing has happened and the result of over two decades of engagement has been a direct loss on the current account of €1.4 trillion. This is an immense amount of capital that could otherwise have been used to boost internal demand for European producers or for investment in our own new industries. For this study, dozens of Chinese policy documents were reviewed and there is no indication that China will work to a more balanced partnership, whatever it promises publicly.
This raises the question of how European countries can respond. The emphasis on European countries is not accidental, because European Member States first of all have to understand that they cannot outsource the problem to the European institutions or hide behind them. The first condition to rebalance the partnership with China and to build an equitable relationship is for national governments to show economic leadership and responsibility. It is not sufficient for European politicians to praise China for its so-called long-term vision; European politicians should develop a joint EU long-term vision for themselves. This starts with taking the national economic interests and the prosperity of future generations seriously, and by realizing that these national economic interests are better served within the EU than on their own. Serious economic policy is about more than attracting as much investment as possible from China or the gains of a few domestic companies; it is about strengthening the national and EU economies at large, about creating a good environment for positive entrepreneurship and about avoiding a sustained drain on the current account.
National interests do not have to be at loggerheads with a common European approach. The problem today is not that the capitals are much too focused on their national interests with regard to China; the problem is that they are not doing that enough and are often too short-sighted. As the impact of China on growth is negative for almost all Member States, an unambiguous economic reaction towards China could actually be one of the foremost policy issues on which national interests converge in a common EU-wide approach, leveraging the full weight of some hundreds of millions of European consumers. To reach that point, the surplus countries of the European Union, like Germany and the Netherlands, need to understand that their future still depends much more on the weaker countries in Europe, which still absorb over 60 per cent of their exports, than on China. Those surplus countries must also ask themselves what they have gained out of several years of efforts to build a special partnership with China and what has been the loss and cost for the EU as a whole. The weaker countries, those with deficits, in turn should understand that it makes no sense to duplicate the uncomfortably unbalanced partnership they have with surplus countries inside the European Union with yet another unbalanced partnership with China. That is, so to say, a double loss.
Economic leadership also means that the focus of economic policy is not to generate as much trade as possible, for trade is a means to stimulate progress, not an end. The objective of economic policy is to organize the domestic marketplace in such a way that positive entrepreneurship becomes possible. China is organizing its economy in a way that companies grow better and more competitive in fulfilling China’s basic needs: combating poverty, developing infrastructure and allowing an urbanizing society to live in comfort. Most European countries have passed that stage. Their challenge is to organize the domestic economy as part of the single European market so that entrepreneurs still remain able to fulfil these basic needs, but at the same time move higher up the pyramid of needs, and also organize their economy in a way that it contributes to a better environment, social cohesion, self-fulfilment, respect and identity. That is the true definition of progress, and the job of governments is to allow entrepreneurs to work towards this as efficiently as possible and to permit consumers to judge to what extent the products they buy directly or indirectly contribute to their personal development. Progress thus does not inevitably require abolishing basic industries, from steel to food for instance, but stimulating them to produce and serve in a better, more sustainable way and, besides that, nurturing new industries.
The primary recommendation, then, is for European governments to show strategic leadership, and secondly they also need to invest in their economic intelligence to properly assess the economic reality and act with economic realism. Too often, governments are not aware of the motivations of China and the possible impact of Chinese policies, even if most of that information is readily available, in Chinese, on official websites. Member States’ administrations should therefore not only be instructed to collect information about so-called Chinese opportunities, like possible Chinese investments, but also about the challenges.
Tackling the negative impacts of China’s offensive nationalism requires European countries to go to the core of the problem: China’s immense trade surplus. It is this trade surplus, that China converts on the financial account into massive financial support for its industries, into loans with which it buys political influence, and into credit lines with which it permits companies to buy European technology or strategic infrastructure. As long as European countries tolerate the trade deficit, China will continue to garner the resources to undermine their position economically and politically.
To address this deficit, anti-dumping policies are not sufficient, because, as revealed throughout this book, China’s strength today is about much more than low prices. It is the combination of different trade-distorting policies that permits China to continuously gain markets and market share and influence. Europe needs to address all at once: trade credit, technological nationalism, support for strategic industries, package deals, etc. Several of those aspects of China’s economic nationalism are not even covered by international rules, so that China remains completely sovereign in its decisions. Even though it would be desirable, international rules and multilaterals will thus not allow the full scope of China’s power politics to be addressed, which leads us to the final question: Is Europe ready to go political? Is Europe ready to explain to China that the deficit is untenable, that Europe needs a binding roadmap with clear benchmarks to reduce it, and that Europe is ready to act ourselves in all fairness by reciprocating the way China treats the EU collectively and its Member States individually? Europe can have that conversation respectfully with China, understanding its difficulties, but China must also understand Europe’s internal challenges and become aware that after twenty-five years of cooperation, real action producing real results is needed.
So, if Europe continues to allow China to predate on Europe’s internal market and to run large surpluses driven by unfair trade and investment practices and by active industrial policies massively distorting international competition, Europe would be continuing to give China the financial resources to expand its political influence and thus also to keep European countries in such unequal partnerships. This awareness should really be at the heart of any future strategy towards China.
The condition is not to be satisfied with mere process; Europe must make progress and must do so quickly. Europe needs to draw conclusions from the past two decades during which China selectively made compromises, usually only at the point when it became confident and strong and when discussions over many technical matters had dragged on for years and years, a period during which European interests continued to be damaged. Strategic patience works if it does not weaken Europe further nor undermines Europe’s bargaining power. Another precondition for Europe to be successful, and this cannot be stated enough, is to continue to elevate the playing field of the internal market. The European countries need stronger, yet probably fewer, standards to spearhead a new economic revolution that makes their companies and societies more competitive, more sustainable, more creative, more cohesive, more beautiful and more humane. Positive entrepreneurship remains the key. The focus should be on strengthening Europe internally, but this requires preventing other countries from turning dictatorship, social dumping and pollution into a competitive advantage. Europe’s future should be made in Europe.