The Bund in Shanghai, on the banks of the Huangpu River, is an exercise in contrasts. Once the center of European influence in the city, it is home to elegant neoclassical colonial-style buildings, testimony to the Western financial and commercial power of the past. Opposite, on the opposite bank of the river, is one of the most impressive skylines in the world, a fantasy of color, glass and steel, with the famous Oriental Pearl Tower in the center, testimony to the current Chinese financial and commercial power.
This present where China presents itself as a formidable economic power is the key to the fashionable debate on global imbalances. A confusing debate because it mixes macroeconomic concepts - the imbalances in the current account balance, derived from the dynamics between savings and investment - with sectoral concepts - Chinese competitive dominance in specific sectors such as electric vehicles or batteries - and national security concepts - control over the so-called rare earths and the increasingly frequent use of trade restrictions and sanctions -.
It is a debate that has metamorphosed over the years. In the 2000s, global imbalances were studied to assess each country's macroeconomic vulnerabilities: the enormous US current account deficit; the overheating of the economies of Great Britain or Spain or the current account surpluses, like that of Germany, which were presented as an example of macroeconomic virtue. The current debate no longer focuses on national imbalances – China's current account surplus, as a percentage of its GDP, is less than that of Germany, Holland, Sweden or Switzerland, for example – but on the implications of the Chinese surplus for the rest of the world economy.
Why this difference in approach? For two reasons. On the one hand, size matters. The Chinese economy has grown very rapidly—every five years, China adds the equivalent of India's GDP to the world—and is now the second largest economy in the world in terms of nominal GDP in dollars. This dimension implies that China dominates the global manufacturing sector, with a market share greater than the sum of the shares of the US, Germany and Japan, and makes it a world leader in a growing variety of sectors, many of them strategic.
On the other hand, the growing influence of geopolitics on economic policy – through the emphasis on resilience and national security – has increased the preference for protectionism and industrial policy, something that Financial Times columnist Martin Wolf has dubbed neo-mercantilism. This revival of protectionism is due, above all, to the exaggerated conviction that the decline in manufacturing employment in Western countries is the main cause of the rise of populism. To this has been added the conviction, also exaggerated, that China's success is due above all to its profuse use of subsidies, ignoring its detailed long-term investment plans and the existence of a huge internal market that allows Chinese companies to grow and adopt a global scale.
The problem with protectionist policies is that they are ineffective and often counterproductive. The United States has been increasing tariffs, applying sanctions and restrictions on imports for a decade, and has not managed to reduce its trade deficit or its dependence on the Chinese economy. It has reduced direct imports from China, but trade has been redirected and Chinese products enter through third countries.
The current debate confuses and mixes imbalances with competitiveness, macroeconomics with sectoral trends. Macroeconomic imbalances arise from the dynamics between savings and investment. In China, the current account surplus is the result of the collapse of its real estate sector, not of a specific trade policy—just as in the US the trade deficit is the result of its fiscal deficit. If China boosts domestic consumption or stabilizes its housing market, its current account surplus will decline, but its global dominance in manufacturing will remain intact. Its decades of investment with the aim of being a world leader in strategic sectors are bearing fruit and highlights the European error of focusing on savings instead of investment and, especially in the German case, of resting on the laurels of its past industrial dominance. The discrepancies are not macroeconomic, but sectoral: from an industrial point of view, China is the new Germany, but much larger in size.
The solution is not simple. Chance makes the macroeconomic context favor China: the collapse of its real estate bubble creates a deflationary force that increases the competitiveness of its real exchange rate at a time of rapid technological progress—a kind of “Dutch disease” in reverse—and, with zero inflation and interest rates and no fiscal space, China cannot afford a rapid appreciation of the nominal exchange rate. Europe could relax monetary policy to have a more depreciated exchange rate, but inflationary tensions prevent it, and since it is only a sectoral problem—the euro zone still has a trade surplus—the exchange rate has no tendency to depreciate.
If the problem is sectoral, the remedy must also be sectoral, and that is why the exchange rate is not part of the solution. It is true that China actively manages its exchange rate with a closed capital account, and it is undervalued relative to its long-term equilibrium. But it is also true that, if it opened its capital account and let the exchange rate float freely, it would surely depreciate even more, as happened in 2015.
Of course, there is an industrial decline to manage in the West that could potentially be irreversible, given the rapidity with which China has come to dominate the global manufacturing sector. But management must be based above all on offensive measures - investment in leading sectors and regional industrial policies that facilitate the transition to the new balance - and not only defensive measures such as tariffs and quotas. To face a possible trade war with China, as the European Union seems to propose, you must first strengthen yourself to be able to survive the responses.
Geopolitics dominates the debate on imbalances, which shows no signs of disappearing. Both China and the United States have decided to invest whatever is necessary to achieve technological leadership and, for reasons of national security, dominate as many strategic sectors as possible. China has been investing for a decade to become self-sufficient in natural resources, and the United States has now adopted a similar strategy, investing heavily in the Western Hemisphere to avoid dependence on China.
This leaves Europe in a weak situation, lagging behind in technology and dependent on natural resources—and with tremendous uncertainty about the future of Ukraine. Europe has one part of the Shanghai Bund, the colonial architecture of its glorious past, but it has to invest to generate the other part, that modern skyline that reflects current economic power. And, without that investment, protectionist defensive maneuvers will be neither effective nor credible and European geopolitical power will continue to decline. In the era of imbalances, reinforcement is the only alternative.
