Growing economic relations have characterized the global economy since the Second World War. In a first phase, increasing trade and investment was very concentrated in Western countries, especially between the US and Europe, which explains why today, the largest trade and investment exchanges still happen between these two regions. Japan also gained importance as another key pole of trade and investment globally, followed by the four Asian Tigers, Hong Kong, Singapore, South Korea, and Taiwan. Still, in this first phase, the Cold War and a self-centred China constrained the growth of economic relations more globally. This changed after the collapse of the Soviet Union, with a wave of new participants in the international trading system through its institutionalization with the creation of the World Trade Organization in 1995. China’s accession to the WTO in 2001 is a very important landmark, given the size of China’s population and the investment that China received as it stepped up its Reform and Opening-up strategy.
Since then, trade and investment between the West and China has ballooned. At first sight, this could be seen as the natural consequence of China’s growing economic size; but it goes well beyond that. China received very large amounts of foreign direct investment (FDI), not only from the West but also from other Asian economies, such as Japan and South Korea but notably Taiwan. A good share of this FDI into China is concentrated in the manufacturing sector. At the same time, China invested heavily in logistical and transport infrastructure, which (together with much lower trade tariffs and FDI from the rest of the world), made it possible for China to become the factory of the world.
While this tectonic shift was happening in the world, another important structural change took place in the corporate world. The sharp reduction in trade tariffs and transportation globally, as well as enhanced communications thanks to generalized access to the Internet, pushed the development of global supply chains. Parts and components of production started to be produced in locations with lower cost or higher technical specialization, massively increasing not only trade but also FDI to finance the plants needed for the growing economic globalization which followed suite. Offshoring of production to low wage economies, with China receiving the lion’s share of it, also created a transfer of income to developing economies and, thereby, created a new middle class with enough purchasing power to consume global brands. At the same time, China’s logistical and transportation capacity, as well as its sheer size and the related economies of scale, resulted in China’s increasingly central role in the global supply chain.
A review of the assumptions behind our model of economic interdependence
The model of increasing economic interdependence between the West and the emerging world, but specially China, was built on important assumptions, which did not hold for long. On the Western side, the assumption was that keeping only the highest value production at home would create enough wealth and that this wealth would be shared appropriately so as to keep a thriving middle class. While Western multinationals generally thrived in the era of growing globalization, the middle class in the developed world, and especially in the US, lost purchasing power as manufacturing jobs were shifted overseas. At the same time, the tax base in the developed world was carved out as multinationals shifted their tax elsewhere, generally to tax-heavens. This became much easier thanks to the shift towards supply chains which easily created loopholes in the allocation of profits to be taxed. The global financial crisis in 2008, which started as a sub-prime crisis in the US, clearly indicated that the West’s economic model was faulty and needed to be repaired. One of the unintended consequences of this crisis was a sudden collapse of global trade, initially due to financing reasons but which ended up being a more structural trend (Chart 1). In fact, the size of global value chains has never grown further since 2008 and, if anything, has shrunk. In other words, trade of intermediate goods, i.e. inputs of production shifted from one country to another, has decelerated since 2008 for an number of reasons, such as increasing geopolitical but also environmental risks (Chart 2). In the same vein, foreign direct investment has been trading down globally since the 2008 financial crisis (Chart 3). The trade war that President Trump initiated against China in 2018 was yet another blow to Sino-Western economic interdependence. Beyond the massive tariffs imposed on US imports from China, the Trump administration took an array of measures to contain China’s technological rise (Chart 4). This clearly had a bearing on multinationals’ perspectives and, thereby, the future of economic interdependence between China and the West. Europe has so far remained much more open in terms of its trade and investment relations with China but with a more negative tone since 2019 where rivalry – and not only cooperation – has been added to the definition of the relation between the two sides. In fact both the European Union (EU) but also the United Kingdom (UK) have become increasingly disenchanted with the gains to be made from accessing the Chinese market, given the perceived lack of equal treatment for foreign investors. In the same vein, both the EU and the UK have become wary of China’s influence in their economies, given the fast increase in acquisitions of high value added companies as well as critical infrastructure.
As regards the emerging world, and notably China, as largest recipient of Western companies’ offshoring of production, the expectation was that China’s state-driven economic model would continue to evolve towards a market-driven model. In fact, the design of WTO membership hinged on this, with transition periods being granted to accommodate countries with different economic systems. China’s reform and opening-up agenda, though, stalled a few years after entering the WTO and, especially, after the global financial crisis. After a massive fiscal stimulus introduced in 2008 to insulate the Chinese economy from the West’s economic collapse, China embarked on a number of strategies that have made it even more state capitalist rather than less. The role of state-companies has not been reduced and the private sector is more subject to the state’s scrutiny than before. Foreign ownership in the production of goods increased right after China’s entry into the WTO but has stalled since and the service sector remains much more closed than the manufacturing sector. The recent opening-up of the financial sector could look like an exception but it is not so in reality —as the share of foreign participation in China’s banking sector has remained stagnant at barely 2% of bank assets. In addition, China’s push for self-reliance started as early as 2015, with the enactment of a massive industrial policy agenda, namely ‘Made in China 2025’, aiming at reducing technological dependence on the West. Even earlier, in 2013, the Belt and Road Initiative was introduced, as a hub and spoke approach, to promote China’s expansion overseas outside the Western-based multilateral framework. More recently, in 2020, China’s leadership introduced the concept of dual circulation to push further for China’s reliance on its own market and to cut dependence on the West, as a response to the US led trade and technological containment. At the same, a massive crackdown on China’s private companies started in 2020 and has only grown since, covering an increasing number of sectors.
Where is our economic interdependence heading?
When looking at trade and investment data, especially since the pandemic started, one could conclude that economic interdependence between the West and China has done nothing but increase as Chinese exports towards the US and Europe ballooned during the pandemic and also US and European FDI into China increased in 2020. This, however, masks important trends which clearly show reduced economic interdependence down the road, such as an increasingly obvious technological decoupling, divergent standards and other barriers pushing the reshuffling of the China-centric global supply chain, and even an embryonic financial decoupling as China pushes for the use of its international payments system (CIPS) and its digital currency overseas and the US restricts the access of Chinese corporates to its capital markets.
Beyond the above mentioned reasons for this trend, namely, the increasing Western disillusion with globalization and China’s doubling down on its state-driven economic model, two more important shocks in the last couple of years are pushing further towards reducing interdependence. The first is the Covid pandemic and the second is the War in Ukraine. The pandemic has marked a new low in the level of trust between the West and China, which clearly does not bode well for future co-existence. In addition, the pandemic has clearly shown the limits of the organisational model pushed by multinationals, namely global supply chains. This model — centred around reducing costs by increasing the efficiency of production — did not really include resilience or sustainability in the calculation. The cost of this model has become much more obvious during the pandemic as disruptions in the delivery of essential goods has hit the world and, certainly the West. Beyond the scarcity of medical and sanitary equipment, the more generalized supply chain bottlenecks have greatly contributed to inflationary pressures in the West. The result of it all is a clear push towards increasing resilience and sustainability of value chains, which cannot be achieved without some reshoring of production even at the cost of a less profitable/efficient business model. The ongoing Covid wave in China is rapidly reducing mobility, especially given China’s dynamic zero-covid policy. This is bound to affect China’s manufacturing capacity and may possibly produce renewed bottlenecks in the delivery of goods to the rest of the world. The ongoing reshuffling of part of the global supply chain away from China is bound to continue. This obviously implies reduced economic interdependence between the West and China.
If the pandemic has clearly been a tsunami for the direction of economic relations between China and the West, the war in Ukraine could actually be an even bigger one. In fact, both Russia’s aggression in Ukraine and the West’s response, with economic and financial sanctions, are creating new bottlenecks in supply chains, beyond the massive increase in energy prices. China’s position of neutrality in this conflict should, in principle help, as China remains the largest manufacturer of the world. However, there is a growing risk that China will be entangled in this conflict if it supports Russia in a way that the West considers to be against its objective of isolating Russia. In other words, China could be caught in the cross-fire either intentionally or unintentionally, with huge consequences for the global economy.
The economic global order introduced after the Second World War, which expanded after the collapse of the Soviet Union and China’s reform and opening up and accession to the WTO, is now moving towards reduced interdependence between the West and China.
There are a several reasons for this trend. First of all, the unintended consequences of such interdependence, and more generally globalization, have not been as favourable for the West as expected. Secondly, the West’s expectation that China’s state capitalism would increasingly look like a market economy has been proven wrong;China’s move towards self-reliance predates Trump’s trade war and technological containment of China. Third, China’s response to this containment has been to double down on the pursuit of self-reliance. Finally,as if this were not enough, the two major shocks which we have observed in the last two years or so, the Covid-19 pandemic and the war in Ukraine, do not bode well for increased interdependence between the West and China.
As a result, and even if trade and investment flows have not shrunk yet – if anything the opposite — one should expect a fast deceleration in economic interdependence between the West and China over coming years . This also includes Europe, as both the European Union and the United Kingdom have turned towards a much more defensive position regarding China. There are clear signs of this trend, such as the ongoing reshuffling of what is considered to be a too China-centric global supply chain but also the increasing bifurcation of technological standards as well as still targeted, but growing financial decoupling.