With the growing political tensions between China, Russia, and Europe and the United States, it seems only a matter of time before protectionist policies lead to the disconnection of global value chains.
At the latest in February 2022, when the situation between Russia and Ukraine suddenly changed, economists began to predict and simulate the future direction of China's and the West's economy and trade under the pessimistic attitude of global trade and globalization. According to a study released by the Kiel Institute for the World Economy (IfW) in March 2022, with the increasing political tensions between China, Russia, Europe and the United States, it seems only a matter of time before protectionist policies lead to the disconnection of global value chains.
The Kiele Institute has simulated five decoupling scenarios: decoupling between the EU and China, the US alliance and China, the Russia-US alliance, the BRICS and the EU, and the BRICS and the US alliance, each of which includes three scenarios: one-way and two-way decoupling. In this model, decoupling is achieved by doubling down on non-tariff barriers to a particular trading partner, i.e., through a sharp reduction in trade, rather than a complete cut-off. In the first scenario, the EU's decoupling scenario from China would be a direct consequence of the almost complete elimination of bilateral imports. Specifically, Europe's imports from China decreased by 95.82%, while China's exports to the rest of the world increased by 8.22% due to the increase in export costs to Europe and China's search for alternative markets, but because alternative markets could not fully offset the losses caused by the decrease in exports to the EU, China's overall exports decreased by 8.49%, resulting in a 0.55% loss of economic welfare (real income). In this scenario, the EU's exports to China also decreased by 15.92%, exports to other countries and regions decreased by 5.3%, and imports from other regions increased by 6.43%, resulting in a loss of economic welfare of 0.58%. In the two-way decoupling scenario between China and the EU, that is, a trade war in which both China and the EU have non-tariff barriers, the economic welfare losses of China and the EU are 0.92% and 0.78%, respectively. However, in the event of a trade war between China and the U.S. alliance (including the EU), the cost of China's economic welfare would be 3.55 percent, compared to 0.95 percent. The study concludes that simulations show that deliberately dividing the world with non-tariff barriers will reduce the economic well-being of all countries involved in conflict and should never be done lightly.
In Germany, an exporting economy, concerns about a divergent world seem to be even deeper. In 2022, China was Germany's largest trading partner, the largest source of imports and one of the five most important export target markets. Economists are focused on what this export-oriented German economic model means in the event of a trade war or even decoupling with China? In August 2022, the Institute for Economic Research (IFO) published a study that sought to answer this question. The study speculates on five trade scenarios, namely, the return of production to Germany or neighboring countries, the decoupling of the EU from China, the decoupling of Western countries from China, the decoupling of Western countries from China and the conclusion of a free trade agreement between Europe and the United States, and the decoupling of the EU from authoritarian states. The study concludes that, in the long run, the consequences of decoupling to China will be smaller than the losses caused by reshoring production, if firms can gradually replace their economic and trade ties with China under diversification strategies. However, in the event of a trade war between the EU and China, the resulting economic losses for Germany are six times greater than those caused by Brexit. The study also points out that raising trade barriers to China, while reducing dependence on China, may increase dependence on other countries. The study suggests that "China+X" may be a more precise route, as firms can reduce their dependence on a particular market by spreading their supply of intermediate goods to more countries. The study focuses on "dependency", not just "dependence on China", because reducing or moving away from dependence on China could mean leading to new dependencies on other countries. The study concludes that if trade barriers are set up against China, it will make exporting country Germany uncompetitive.
However, recently published studies by economists from the Kiel Institute for the World Economy and the London School of Economics and Political Science have come to a different conclusion: the damage to the German economy caused by Sino-German decoupling is severe in the short term and manageable in the long term. The study simulates hard decoupling, i.e., a scenario similar to Cold War 2.0, in which the world economy is divided or split into three blocs: the G7 or Western economies, China and its allies, and neutral countries. Within this framework, the study simulates the extreme scenario of a complete trade shutdown between China and Germany, i.e., a simulation of the worst-case scenario. The study concludes that the cost of a sudden hard decoupling between China and Germany would cost the German economy 5% of gross national expenditure in the short term and 1.5% in the long term.
The study also provides a detailed analysis from the level of import and export trade. Economic and trade exchanges between China and Germany have undergone tremendous changes over the past 30 years. According to the data of the German Federal Statistical Office, Germany's exports to China increased from 1.5 billion euros in 1990 to 100 billion euros in 2022, and Germany's imports from China increased from 1 billion euros to 200 billion euros during the same period.
In terms of imports, Germany's imports from China accounted for 7.15% of Germany's total imports, and imports from China accounted for 2.29% of Germany's total national expenditure. Taking the machinery and electrical and electronic equipment industry as an example, this industry accounts for the highest proportion of Germany's total national expenditure in Germany's import industry, at 8.2%, while the industry's import from China accounts for about 14% of the industry's total imports and 1.14% of Germany's total national expenditure. In terms of exports, German exports to China accounted for 6.7% of Germany's total exports and 2.56% of total national expenditure.
However, the model does not take into account factors such as strategic raw materials, economic cycles and FDI by German companies in China. According to the study, Germany is highly dependent on Chinese supply for 9 of the 16 key raw materials (imports account for more than 65%), 5 of the 9 have alternative supplies, and the other 4 raw materials, including gallium and rare earths, are difficult to find potential substitutes from third countries in the short term. The supply of rare earths from China has been one of the biggest concerns at EU level and in Germany. Citing China's export controls on rare earths from Japan as an example, the study said that Japanese companies that needed rare earths at the time responded by using raw materials more efficiently, and that the export ban at that time caused relatively limited damage to Japan.
In terms of FDI by German companies in China, the study points out that although some industries have made significant investments in China, these investments are not as important as the overall German economy. In 2019, for example, direct investment in the automotive and parts industry in China accounted for 23.5% of the industry's total FDI, but the sector's investment in China accounted for 0.79% of Germany's total national expenditure.
After comparing the different routes of sudden hard decoupling, gradual decoupling and gradual de-risking, the study said that the consequences of hard decoupling are serious in the short term, but if adjusted over time, the loss will be reduced, but the loss will not disappear, and will persist for a long time and remain at the level of 1.3%. Gradual decoupling will reach a state of hard decoupling after a period of time, but it will not bring about the consequences of hard decoupling in the short term. Gradual de-risking, on the other hand, is limited to selected specific areas and causes very little long-term economic damage. The study also points out that the short-term impact on GDP under hard decoupling is comparable to the impact of the global financial crisis and the pandemic, and the consequences are severe but manageable. Of course, the gradual de-risking route is far less costly than hard decoupling.
Hard decoupling is probably not just the worst-case scenario for the world economy, but also the world for the worse.