Production shifts have not reduced dependence on China

guest post

Jeroen Bell Production transfers did not reduce dependence on China

Experts in international diplomacy may have noticed that the Biden administration has recently reformulated its approach to dealing with trade with China: from “disengagement” to “restore support,” and from “supporting friends” to “reducing risks.” One might be tempted to dismiss this as another exercise in geopolitical jargon, but it may also signal a long-overdue recognition that previous attempts to exclude China from international trade have been unrealistic.

The basic political idea behind decoupling efforts may seem simple. After the pandemic-related lockdowns in China, which led to shortages in supplies of basic goods, and increased tensions between China and the West, the United States wanted to reduce its trade dependence on China and shift its supply chains to other countries. In a way, these policies are a result of the tariffs the Trump administration imposed in 2018 and has maintained ever since. In fact, US imports from China are currently at their lowest level in ten years, while the bilateral trade deficit with China has fallen to its lowest level since late 2019.

So, is the case closed and is there scope for broader implementation of the separation policy by the G7? Not at all, as a look at the data reveals. First, the total volume of Chinese exports has not fallen from its post-lockdown peak. Moreover, since the volume of global imports generally declined over the same period, this means that China’s share of global exports has actually increased.

deficit with China

How does this fit with reports of increased export penetration, i.e. the relocation of supply chains to countries such as Mexico and Vietnam? Well, these countries imported much more from China – their higher trade surpluses with the United States were largely offset by higher trade deficits with China. In the case of Mexico, the growth in the deficit with China is higher than the increase in the trade surplus with the United States.

Of course, such trade U-turns come with efficiency costs – the same goods that would have come directly from China now take an expensive and time-consuming detour. And economists wouldn’t be surprised. They have long emphasized the difference between trade creation and trade diversion and the associated greater efficiency gains through multilateral trade liberalization (that is, treating all trading partners equally) than through narrower free trade areas that exclude non-member countries. Despite the reduced risks, China remains the “factory of the world” and the logistics center with large overcapacity, while Vietnam and Mexico have reached capacity limits.

In addition, removing risks creates new risks. The “friends” to whom supply chains are transferred bring with them their own social and geopolitical risks. Without wanting to judge the resilience of the supply chains that have been transferred to these countries, it should be noted that the Vietnamese economy resembles that of China before 2012, while investors in Mexico often point to concerns about the rule of law. However, the importance of Chinese investments in these countries has increased, shifting dependence on China to more countries.

With this in mind, rebranding the de-risking process as de-risking may hold a lot of truth – an insight into the high costs of trying to de-risk in earnest.

However, while decoupling from China seems less of a goal, a decoupling of economic policy from past practices, such as the widespread adoption of industrial policy and state-directed investment in the US and Europe, is gaining momentum. As with de-risking, there is ample evidence of the costs associated with it. Because when there are trade constraints, governments’ allocation of capital to sectors they have chosen as winners does not usually lead to good results. The evidence ranges from Germany’s failed investment in maglev trains, to China’s overinvestment in real estate, to Northern Ireland’s attempt to become the car capital (although we deserve credit for the DeLorean train).

Keep expectations in check

While current investor confidence that the economy will see a soft landing after a period of high inflation and rising central bank interest rates may ease these concerns, the question is whether this new consensus on trade and industrial policy will survive the next recession.

Will policymakers then seize the opportunity to restore basic efficiency and growth by returning to open trade and abandoning restrictive policies? Or will they make greater efforts to protect jobs from foreign competition? The answer to this question will determine whether the world ends up in a low-growth, high-inflation environment, as was the case between 1990 and 2020.

What does all this mean for US allies who clearly fall into the “friends” category? Optimists may see scope to welcome industrial diversification and exports, but the reality may be less optimistic. Above all, any production that is outsourced is likely to be less efficient and ultimately worsen the situation in the labor and real estate markets (as in Mexico). Moreover, any reorientation of commodity exports will likely come at the expense of lower exports to China, and will remain dependent on the (currently declining) global aggregate demand for commodities. So it’s best to keep expectations under control.