Can Europe Do a "Reverse Deng" With China?

Europe is in a trade quandary. But China is also likely to face growing obstacles to its international economic expansion.

Let’s start with Europe.

Trade barriers are going up in the United States, with likely discrimination between different types of partners. Even if Europe was not to incur the steepest increases in custom duties and other restrictions, it will suffer indirectly as trade is diverted from the United States to our market. This is going to be particularly severe since the U.S. effectively decouples from China in some categories of exports - automobiles, greening technologies, telecom and possibly others. High tariffs, or alternatively a trade deal implying restrictions, will also discourage other Chinese exports to the U.S., as was the case after 2018. Between 2019 and 2024, China’s trade surplus with the United States went down from euro 295 billion to euro 273 billion (at average yearly exchange rate with the usd), while it nearly doubled with the European Union, from euro 164 billion to euro 305 billion. Trade diversion and price dumping on the European market are likely to happen again. In fact, they are already happening, from a combination of producer price deflation in China and marginally lower yuan exchange rate. By volume, Chinese exports to Europe are growing much faster than by value.

The new Trump tariff strategy is the flip side of China’s export drive. Both are win/lose strategies. Through control of its capital markets, China is able to prevent monetary readjustment to its ever-growing trade surplus. In 5 years - from end 2019 (last pre-Covid year) to end 2024, China’s trade surplus with the world rose from euro 352 billion to euro 918 billion - a near tripling. In the same time span, the yuan moved up only 1% relative to the usd, and 5% relative to the euro.
 

Europe will therefore face a hard choice. It could move in two directions.

Europe May Resort to its Own Protectionism

One is to match U.S. restrictions or duties, including on imports from third parties to avoid becoming the market of last resort for Chinese exports that find other markets closed. This is already happening for aluminum, where additional U.S. duties have provoked a flow towards Europe, largely from Chinese makers. A Commission enquiry is likely to result in additional import duties. So, Chinese producers and investors, think twice before directing FDI to proxies - from South-east Asia to North Africa and Mideast or even Turkey.

Ironically, this would be a de facto negative trade alliance with the United States, the result of a conjunction of protectionist measures rather than the former promotion of free trade agreements. It runs counter to the fundamental basis and interests of the European Union, which remains globally the first promoter of these agreements. But in a fragmenting trade world, this choice can become an unavoidable outcome. It is a fact that the world’s two economies that benefited most from WTO rules - China and the United States - are destroying the trading system. China did it in practice by abusing its developing economic status long after it had become obsolete. The United States is now doing it both as a matter of principle and in a return to a mercantilist and isolationist era.

The consequence of these policies is going to come back to China. It will create a rising challenge for China, with more and more obstacles to its economic expansion abroad.

Challenged simultaneously by its two main trade partners, Europe is more likely to adopt its own protectionist shield. This protectionist agenda may include tit-for-tat measures across the Atlantic. But it will surely focus on the huge trade imbalance with China and at that country’s goal of conquering industry sectors, one after the other.

Instead, a "Reverse Deng" Investment Policy from China?

There is another possible direction for Europe and China. It does require a paradigm shift for China in its trade and investment strategy towards Europe, and a compromise from Europe as well. This presupposes a realistic political understanding by China, something that is difficult to this day. Many Chinese producers are achieving an unprecedented level of competitiveness in advanced technologies, and Chinese leaders may believe that this success, along with and China’s Ricardian advantage, trumps politics. Compromise through negotiation may be easier to accept from the European point of view, because this is always what it has sought with China - usually in vain.

Some 45 years ago, China successfully started its reform and opening policy with Deng Xiaoping’s endorsement of Special Economic Zones and joint ventures drawing in foreign capital and technology. These policies led to China’s economic miracle. Its economic surge is unparalleled in history, even considering the post WW2 success of Japan and the Four Dragons.

All of that is well known. Less known is that the window for foreign investors has been closing in China over the last decade, through Xi Jinping’s strategy of self-reliance and indigenization of foreign technologies. In 2024 (first ten months), FIEs (foreign invested enterprises) made up only 22,7% of China’s exports, against 58% in 2005. Chinese private firms - or considered as such - reached that same 58% landmark figure in 2024. That last figure is as important as the other two. In that same interval, an advanced and diversified economy has appeared in China. 

There are sensitive areas where security is an issue - say, automotive software and more generally digital technologies where data syphoning, cyber hacking and denial of service are seen as risks. Chinese firms could do in Europe exactly what some European firms are consenting to in China. Daimler and BMW, for example, are turning to Chinese software for their cars produced in China. It would be a major security issue, however, if that cooperation extends to their global production and sales. For security reasons, the digital world is fragmenting, and this is no longer preventable. That reality is also recognized vis-à-vis the United States for the European weapon industry and for data storage.

More generally, China’s guiding motto for FDI in China - "in China for China" could be matched by a "in Europe for Europe" policy. The United States' IRA policy, along with the more direct measures proposed by the Trump administration, have established a policy of "in America for America." To compete with the United States, the European Union must also have inclusive industry policies, and Chinese - as well as American - companies could be part of these if they observe our rules and fit with our interests.

Matching European Economic Realism with Chinese Political Realism

The conversion could be easier from the European side. The European Union is not committed to decoupling in a targeted China perspective, but only to derisking in a global perspective. This distinction has not been publicly recognized by Chinese officials, who focus instead on new European economic security measures: inward investment screening, possible export controls at EU level, prevention of cyber risks and deterring Chinese trade coercion have indeed entered the European agenda.

Europe itself needs to make its own self-assessment. Yes, state support in every form is the original sin of China’s economic policies, and we are right to call to take defensive measures. But it is also a fact that nearly five decades of building a technology base through policies inherited from Deng and accelerated by Xi have succeeded. Asymmetric rules remain in China regarding international trade and investment, and we should oppose this. But it is likely that many Chinese firms, large or small, could now do without these props.

European trade defense measures are in order because of China’s overall industry policies. But they will not suffice - unless we adopt a decoupling policy.

Another assumption from the major market economies of the West emerged, once trade perspectives began to sour. It was that domination by the Party-state, support for state enterprises, rising subsidies, as well as China’s enduring privilege as a "developing economy" since its 2001 WTO admission, explained the reversal of fortune for foreign firms in China. And indeed, the absence of a level-playing field, massive state subsidies at central and local levels, coercion over technology transfers and foul play regarding intellectual property have played a key role. Ergo, negotiating with China for a level-playing field inChina became the top priority for its Western partners, often over geopolitically strategic issues. The accent should be maintained, including with defensive trade measures. But seeking a level-playing field will not suffice either, as this would require major political changes in China which are nowhere on the horizon.

The financial benefits are accruing less and less to other countries and companies, apart from producers of energy and raw materials for which China has a deficit. Ergo also, the turn towards industry policies and protectionism, America leading the way.

China Should Accept the Political Realities of International Trade, Which it Practices for Itself

In a nutshell, China, which crafted after 1978 rules and incentives to attract the largest FDI flow in history should understand it is now time to perform with Europe what could be called a reverse Deng. The time is ripe, because the only alternative for Europe will be to follow the protectionist route and to finance its own industry policies on a large scale, whatever the initial cost. China’s search for 100% wins in successive industrial sectors is politically unachievable. This may work with smaller economies with a limited industrial base, but they represent only a sliver of the global market. In the short term, China’s industry export strategy is contradictory with the need to diversify financial holdings beyond China and away from the United States. You cannot simultaneously bankrupt and buy the same economies, which is what a 100% win strategy seems to be aiming for. And you cannot become the absentee landlord of the global economy if you don’t deliver global goods. For the United States, it was a combination of security guarantees and shared rules. China has no similar appeal, nor does it seek to carry on what America now sees as its own former burden.

Some 50 years ago, China might have been better off with Japanese cars and appliances: in fact, there was a short time between 1978 and 1980 when these imports increased massively, legally or not. The country then turned to encouraging - and regulating - foreign direct investment instead. This was import substitution in practice, which later turned into an export drive. Today, out of 25 million cars sold in China, 800.000 are imported.

Similarly, European consumers might seem better off in terms of buying power today if they drove Chinese cars. That is indeed what is basically happening in much smaller markets devoid of national producers. It’s not politically likely to happen over a 450 million customer market, where there would be devastating consequences from deindustrialization.

Wash and repeat the same argument for other industry sectors where, if one puts in the time and effort, producers are indeed replaceable. Chinese officials, who put politics in command of economic policies, should be well placed to recognize this political reality.

Up to now, the European Union has stuck to its mandate of carefully considered and justified measures, rather than sudden, escalating decisions, or linkage with issues other than involving public security, or at the member state level national security. China may have seen this moderation as a persistent sign of weakness, and looks first at its main strategic competitor, the United States. Today, Europe’s adhesion to a multilateral system of rules is challenged from both ends. China has used its outdated status as a "developing economy" and its central party state control to rig the playing field. The United States is breaking away from the multilateral trading system and seeks to leverage its strengths against all trading partners. Both have moved from a win/win to a win/lose perspective.

China cannot be comfortable with the ultimate results of this change. It has become the most export-dependent economy in the world (excluding smaller economies which are essentially trading posts). It will face a closed door or a very expensive half-open door in the United States. China should not believe at this point that singing empty praises of multilateralism while simultaneously swamping the European market with goods and reducing its own imports is going to work at the political level.

China was never an idealist believer or practitioner of free trade. It is well placed to recognize that free trade, never without rules in any case, endures when it is profitable to all parties, or at least when the balance of benefits and costs is not lastingly unfavorable to one party. Of course, the argument from liberal trade economists has always been about balancing in the long run, largely through monetary adjustment. That view is challenged by reality. China has resisted the monetary reevaluation that its massive current account surplus would seem to require. The Trump administration’s new stance on international trade is based on a win/lose assumption, rather than on the old win/win argument.

A Balanced Deal

We need solutions that match the interests of both parties. For China, they include financial diversification and direct investment abroad as the continuation of its industry and innovation successes. For Europe, it means the preservation of economic and national security, which implies limits on Chinese investment, and genuine localization in Europe for Chinese companies, with rules that guarantee technology sharing or, alternatively, a high percentage of locally sourced supplies and components. Those rules cannot be set directly by member states, which would result in undercutting each other’s interests. For China, given the impact of its competition on the world’s largest market, it needs to keep that door open, especially in today’s global context.

This writer is fully conscious of the objections that can be made to a "reverse Deng". It would go much farther than the Comprehensive Investment Deal of 2020 between China and the EU, which never reached a conclusion.

The first objection is that we make a judgement on where China’s interests lie. This is often a mistake, as geopolitical strategy may trump all other considerations. It takes two to tango, and this proposal supposes a shift in China’s estimate of its own interests.

The second it that it presupposes a European-wide agreement on the rules and limits of joint-ventures or even wholly owned subsidiaries in several industrial sectors. Most likely, the automotive sector would be a test. Not only does that imply basement sales such as that made by Hungary are excluded, but it raises complex issues of implementation, and of resolving the diverse interests of different categories of producers.

There must also be careful consideration to the legality of new binding rules on foreign direct investment, and singularly China’s, with EU law and WTO rules. This is a complex issue which cannot be dealt with in a limited space and time.

Let’s first note that the recent proposal by the Commission of a Clean Industrial Deal explicitly recognizes that "Member States could collectively consider conditions such as ownership of the equipment, EU sourced inputs, EU-based staff recruitment, the need for joint ventures or intellectual property transfers, starting with some strategic sectors, such as for example, the automotive or renewable manufacturing".

Foreign investment is now an exclusive EU competence, although poorly spelled out. Member States would clearly have a major say at the Council for such a major innovation. This is an area of Qualified Majority Vote (QMV). WTO rules would make it highly preferable to work out an agreement with China, in order to avoid obvious legal challenge. Both TRIMS ( the Agreement on Trade-Related Investment Measures ) and GATS (the General Agreement on Trade in Services) prohibit discriminations in national treatment, with TRIMS also banning quotas. Previously signed Bilateral Investment Agreements signed by member states with China may also stand in the way. In general, the spirit of WTO - and the EU’s former approach - lean towards less conditionality for investment, rather than more.

However, China might take note of three facts. It gets away with many restrictions under its outdated status as a "developing" economy. The United States has been making broader use of national security considerations in its actions on foreign trade and investment, and this is likely to expand further. The EU itself, starting with its investment screening regulation, has a "public security" clause that is not wholly defined at this point, and which could also be expanded in a conflictual context. A complete refusal by China to move would undoubtedly push Europe towards the new American way, again as a measure of self-protection. It is even possible that Europe adopts new general rules for foreign investment in specific sectors, rather than a differentiated approach, making these rules consistent with WTO. There are sticks as well as carrots that can be used towards the adoption of a reverse Deng strategy. In a context of global tension, China might see its own advantage in cooperating.

In other words, a reverse Deng deal between China and the European Union may be the worst of prospects, except any other course.

Copyright image : AFP