Germany’s doomed China strategy

Most of the world’s economic policymakers are in Washington this week for the IMF/World Bank spring meetings. But one important meeting for the global economy took place on the other side of the globe, where German Chancellor Olaf Scholz met Chinese President Xi Jinping during a visit to Beijing, corporate executives in tow. It would probably have garnered more attention if those in charge of the global economy were not otherwise occupied. Even so, the visit has not escaped criticism for being more focused on business as usual than on promoting Europe’s “de-risking” agenda, and for being mealy mouthed about Chinese support for Russian President Vladimir Putin’s assault on Ukraine.

I think there are also some important points to make about the political economy of economic relations with China back home in Germany. Below are my thoughts about that.

It seems to have been a good visit — for Beijing. After a long period of funk, the recent pick-up in growth as well as the impressive production boom in green tech have left China with something to boast about. Not too surprising, then, that German big business wants to be in on the act. In the domestic debate, both the government and big corporations seem determined that any “de-risking” must go hand in hand with more trade and staying invested for the long haul. (The research, meanwhile, shows that even a full decoupling would come at a severe but bearable cost — look at the report from the Kiel Institute for the World Economy or this paper from the Bundesbank.)

In a recent tweet, Brad Setser rightly criticised the tendency to conflate what is good for German companies with what is good for Germany. It’s a point that bears highlighting. Much of the debate in Germany, and other countries’ debate about Germany’s China strategy, tends to start from the premise that the interests of German industry dominate the political strategy — and this leads to a strong bias to keep bilateral trade and investment flowing even at the cost of greater dependence.

That is not a bad characterisation of current policymaking dynamics — witness how Scholz was accompanied by chief executives of the biggest German industrials, earning a comparison by some with his predecessor Angela Merkel’s business-promoting visits. But dig into the details of Germany’s exposure to China and this particular political economy constellation looks increasingly brittle. Even within German industry itself, there are emerging faultlines that at some point will make the business-as-usual approach politically fraught. Moritz Schularick, president of the Kiel Institute, told me that while big manufacturers and carmakers see little need for soul-searching when it comes to China links, it’s different when you ask the Mittelstand of small and midsize companies.

The most striking developments in Germany’s economic ties with China in the past couple of years are captured in the chart below.

It shows the following three things. First, total German goods exports to China have been largely flat in nominal euros. Second, imports have gone up quite strongly since the pandemic, meaning that goods trade has moved from largely balanced to a bilateral trade deficit for Germany. This, however, is in large part a temporary anomaly caused by the price rises that came with the supply squeezes in the recovery from the pandemic, as I have written about in the larger European context. Those inflationary pressures have gone into reverse over the past year.

So it’s the third phenomenon that I find most interesting: the growth in German residents’ income from investments in China. (To be precise, the line measures primary income receipts in the current account.) While still a lot smaller than the shipment of goods produced in Germany, it has grown fast — I have charted below the same chart indexed to their 2018 values to show the relative changes more clearly.

Factory investments are made for the long run, and — in contrast to more skittish investors from elsewhere — German companies are still piling in (in large part by reinvesting the income charted above) in China. So it’s reasonable to expect investment income from local China production facilities to keep growing faster than earnings from Germany-produced exports to China.

Now it could be that making money from investing productive capacity in China is ephemeral, and that these loose-fisted executive-investors are deluding themselves and simply giving away technology and exposing trade secrets. Beijing’s goal is, after all, to build domestic — ie Chinese-controlled — high-quality production, and it is providing the subsidies to make it happen. (A recent study from the Kiel Institute estimates just “the more quantifiable” of Beijing’s industrial subsidies at more than €200bn a year, or nearly 2 per cent of Chinese national income.)

So the market share of German companies “in China for China” may not be easy to sustain. In a recent interview, Karl Haeusgen, president of the VDMA, which represents German machinery and equipment makers, pointed out that setting up production in China did not protect foreign wind turbine manufacturers from seeing their share of the Chinese market evaporate.

But let’s assume the returns on German FDI in China will indeed keep growing and remain lucrative for the long term. Even so, this has some profound implications at home. Not every German exporter is a big investor in China, even if some German exporters are among the biggest ones — Volkswagen, BMW, Daimler and BASF alone make up about one-third of it. This means the interests of the dominant German companies, heavily invested in China, are becoming quite different from the Mittelstand of midsize and smaller companies with a lighter investment footprint. The more Germany’s overall economic benefit from China derives from returns on investment in China rather than exports to it, the less aligned these two segments of German industry will be over what China policy they would prefer to see.

And even more importantly, income from China investments generates profits for German shareholders but not salaries for German workers. “CEOs will make arguments to politicians that this is about workers,” said Schularick, “but actually it’s about profits.”

With exports stagnant (and that’s in nominal terms), the scope for greater rewards for those who make the exported goods back in Germany is limited. Yet for shareholders, it scarcely matters whether the profit margin feeding dividends is harnessed in a German or Chinese plant. It is no surprise, then, if much of the lobbying related to Scholz’s trip was for building more German-owned productive capacity “in China for China”. Or even in China for imports back to the EU, which would presumably put German workers’ interests even more at odds with those of their owners’. Claims that profits in China help fund productivity enhancements back in Germany don’t sit easily with the fact that the bulk of German companies’ China profits are reinvested there.

In time, this must surely crack the monolith of German industry’s political influence. Until now, that influence has been based precisely on a view that what is good for German corporates is good for other parts of the German economy too. But that is no longer true, if there is, for example, a trade-off between promoting exports to China and encouraging investment into local production there or if production in China cannibalises export markets for domestic German production.

For now, German big business is still able to convince politicians that what is good for them is good for other segments of the German economy. But soon enough, the corporatist spell will surely break under the pressure of conflicting claims from labour and smaller businesses. That will shake the foundations of German politics, for Scholz’s own Social Democrats more than anyone.

Other readables

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IMF head Kristalina Georgieva foregrounded economic scarring from the pandemic — except in the US — in her launch speech for the institutions’ spring meetings.

Speaking of China, what has it been like to come of age during the dramatic changes of the past few decades?

Source: Economy - ft.com