Europe faces an economic war on two fronts

Telegraph

5 days ago

China's charm offensive in Europe did not last long. Xi Jinping has abandoned all pretence of a combined Sino-European front to defend world trade against Donald Trump.
It would be more accurate to say that he has joined the kill, sharpening his tools of coercion and activating China's rare-earth weapon against Europe just as aggressively as he has against his American nemesis.
'It was never that charming in the first place,' said Andrew Small, from the German Marshall Fund in Berlin. 'They were slightly more civil for a bit, but now almost everybody in Europe recognises that there isn't going to be any rapprochement. China has made that absolutely clear,' he said.
Mr Small said China has seized on the transatlantic rift to hit Europe while it is down, much as it did to Canada at the low point of US-Canada relations.
'Beijing treats this simply as a moment of vulnerability to exploit,' he said.
The slimmed down EU-China summit this week marks a 50-year nadir in bilateral relations, a charade of wooden smiles and gritted teeth. 'We have not always seen eye to eye,' was the warmest that Antonio Costa, the European council president, could come up with.
Europe now finds itself in an economic war on two fronts at once. The Trump ordeal is the lesser of the two. American tariffs on EU goods look likely to settle at 15pc, with a few carve-outs but also prohibitive tariffs on steel, aluminium, and (later) pharma.
Such a level is not as harmless as euphoric markets seem to imply. Citigroup's Giada Giani said the eurozone's growth spurt earlier this year was an illusion of 'tariff frontloading'. She expects zero growth for the next three quarters. It would not take much to push Europe into outright recession.
But the much greater long-term danger comes from the massive and systemic dumping of Chinese excess capacity on European markets. China's trade surplus with the EU hit €305bn (£265bn) last year. The monthly data shows that it is on an exploding trajectory this year.
Europe is suffering the brunt of the China shock 2.0.
The first China shock in the 1990s and early 2000s flooded the world with cheap goods and convulsed the global economy. It led to deflation, ultra-low interest rates, and debt bubbles. It rendered finance too proud and caused the worst inequality in a century.
Free capital flows and a globalised workforce allowed the owners of capital to exploit labour arbitrage, playing off Chinese wages against wages in the West. The politics were, and still are, toxic.
Goldman Sachs says the China shock 1.0 peaked at 0.6pc of global GDP in 2008. That was enough to destabilise our democracies. It is heading for 1pc this year as China remains mired in a post-bubble deflationary slump and as Chinese companies seek foreign markets to stay afloat.
'The China shock 2.0 is even worse than the first one. It is going to be slow torture for Europe,' said George Magnus, from Oxford University's China Centre.
The US political class has concluded that the trading relationship is unworkable on current terms and has taken drastic action to defend America.
The EU has allowed itself to become the market of last resort by default. The French grumble that German companies made a Faustian pact with China and long ago hijacked EU policy in their own interests.
'The Europeans are at last getting this, and there's been a shift even in Germany because the shock is really hitting home,' said Mr Magnus.
'It's reached a point where it threatens to destroy Europe's industrial capacity and know-how. It would be utterly myopic to ignore this for the sake of cheaper consumer goods,' he said.
Europe has imposed calibrated tariffs on Chinese electric vehicles and launched 18 trade defence measures of various kinds, but this ponderous pedantry is overwhelmed by larger forces. China has been suppressing the yuan via two disguised mechanisms: wage deflation and by linking the yuan to a weakening US dollar.
The combined effect has been a depreciation of China's 'real effective exchange rate' against the euro of almost 30pc since 2022.
We can argue over whether or not this is currency manipulation. Brad Setser, from the US Council on Foreign Relations, says Beijing is intervening surreptitiously and on a huge scale through the offshore dollar holdings of the state-owned banks.
Of course, China would slide into even deeper deflation if it revalued, but that only goes to show that the 'Leninist-capitalist' model of the Communist Party cannot coexist with the world's open trading system. One or the other has to go.
China's export surge is not happening because its products are better or because its economic model is more competitive. It is the result of a system that favours chronic over-investment, with warped incentives that defy market price signals. Policy is geared to the state-owned behemoths and honed to ensure absolute party control. The whole structure crushes consumption.
It is why Chinese households enjoy just 37pc of GDP, compared to 51pc in Germany, 62pc in the UK, and 68pc in the US. It is why China produces 32pc of the world's manufacturing goods but accounts for 13pc of world consumption. The rest of us have to absorb this surplus.
Chinese economists have been calling for deep change to boost welfare spending and move to a modern consumption economy, if only in China's own self-interest. That is how you get out of a deflation trap.
Xi Jinping will have none of it. Welfarism leads to 'lazy people' and wastes money needed for the techno-military Cold War against the West, and to sustain the national security state. 'Once welfare benefits go up, they never come down,' he says.
The evidence of the last year, from the third plenum onwards, is that China is doubling down on its deformed model of industrial over-capacity. This is what Europe is facing.
Any attempt to defend itself is met by Xi's coercive use of China's rare earth monopoly and its hold over critical choke points in the global supply chain.
At the same time, any attempt by Europe to defend itself against Donald Trump's tariff shakedown is met by veiled threats to throw Ukraine to the wolves, or to let gas-short Europe freeze in winter.
Europe is learning what it means to have no leverage in a Hobbesian world of lawless bruisers. But for all of Trump's pyrotechnics, China poses by far the greater menace.
Charles Parton from Germany's Mercator Institute says the Communist Party sees diplomacy as a zero-sum 'struggle against hostile forces'. Leaked internal documents leave no doubt that the Politburo thinks it is in an ideological knife-fight against liberal democratic values, economic freedoms, and the pluralist society. 'These elements add up to a geopolitical war. Many third countries fail to recognise this reality,' he said.
Europe has long been among the blind. The dependency now runs so deep that the EU cannot extract itself without serious damage. Its belated and half-hearted policy of 'de-risking' has failed from top to bottom.
Markets are talking up a European economic renaissance over the next three years. It is a bet on Nato rearmament and military-Keynesian growth. I can see the logic but there must be a very high risk that Europe will disappoint yet again and slip deeper into its second lost decade.
The tragedy for the West is that it stands divided in the critical civilisational battle of our time. Donald Trump is single-handedly to blame for this. He really is Xi Jinping's useful idiot.