China: Hope for the best but prepare for the worst

Following Russia’s invasion of Ukraine, Europe was utterly unprepared, as its energy dependence quickly became an economic weapon for President Vladimir Putin. 

Compared to what’s at stake if relations with China soured, however, this looks like child’s play. Recent events in the Taiwan Strait should be taken as a warning: It’s necessary to get ready for a future of uncertainty, where things can quickly spiral out of control. 

Globalization is not yet dead, but it’s entering a new era marked by geopolitical risks. And before those risks can spoil its profitable benefits that we’ve taken for granted over the past 30 years, Europe’s economic security must be improved. To be better prepared, Europe needs to step up its game — before a new crisis unfolds. 

In this regard, the response to the 2007-08 global financial crisis might serve as a good model. After a shock that undermined trust in the business practices of vital banking institutions, financial regulators mandated stress tests to be better prepared for the next crisis. A similar solution should be applied in dealing with the complex economic interlinkages with China, as an annual stress test examining the exposure of companies to Beijing could help mitigate the economic fallout, should relations deteriorate. 

While the current fallout is mainly affecting the energy supply in the case of Russia, nearly every aspect of economic life would be affected during a crisis with China. The European Union’s economy is deeply engaged with the country — exports amounted to €224 billion to China in 2021, and the bloc’s investment stock in the People’s Republic is around €400 billion. In the case of a major escalation, both would inevitably get caught up in the political crossfire.  

Deeply integrated value chains could disintegrate, and supply chains could break down. GDP growth would collapse, and with companies losing China as a production base and market, inflation and unemployment would increase. In the longer term, wealth and living standards would drop dramatically, as Europe’s economy faced scarcity of supply. 

Europe’s complex global value chains, ranging from intermediary products — such as metals or active pharmaceutical ingredients — to more complex assemblies, would break down without Chinese inputs. For example, around 70 percent of printed circuit boards and over 90 percent of some types of antibiotics are imported from China. 

On top of that, a new form of dependence would undermine the Continent’s energy transition, as China dominates the global production of solar panels, batteries, as well as the processing of critical metals needed for cleaner energy production, including cobalt, lithium or rare earths. 

Any major disruption to the €473-billion worth of goods the EU imported from China in 2021 wouldn’t only affect companies with direct links to Beijing, but it would also have ripple effects throughout the economy. Due to its unrivaled price competitiveness, the vast majority of Europe’s consumer goods are produced in China, and its manufacturing prowess has made the country a major sourcing hub for large retailers: 95 percent of imported laptops and 70 percent of mobile phones originated from China; nearly 98 percent of baby carriages and 75 percent of paper cups that the EU imports are made in China. If Europe’s supply were to be disrupted, the impact on businesses and people’s everyday lives would be severe.  

Faced with all this, a mandatory stress test can be a vital tool to identify the bloc’s economic vulnerabilities and set priorities to improve resilience, as it can help ensure that corporates are able to cope with the economic shock of their operations being partially or totally, cut off from China. 

Such a test should focus on both financial and supply chain resilience to ensure that risk management includes the company’s ability to absorb the loss of revenue and profits, written-off investment, as well as its ability to keep its business up and running, should supply from China be disrupted.  

Governments, business associations and shareholders would be best placed to define the profiles of companies for which a stress test should be mandatory. Such criteria could include thresholds for revenue and procurement — for example, for businesses that generate over 10 percent of sales in China, or source over 40 percent of goods from China — and it could also focus on systemically relevant companies due to their overall weight in the economy, or their role in the supply of basic health care. 

Either way, it should be in the interest of any company that their suppliers are primed for a crisis. 

The fact that risks are growing doesn’t mean companies have to sever business ties with China, but they do need to improve operational robustness. This can be achieved by increasing diversification and inventory levels — and by accepting the higher costs that come with this.  

China still offers many economic opportunities, but disruption can come in many forms – and it’s best to be prepared. 

As Chinese President Xi Jinping tightens his grip on power, China has domestically become far less pragmatic and more ideological. Thus, more conflict with Europe over political and human rights issues should be anticipated as a result. And with the tensions between the United States and China over Taiwan looking like it could easily escalate further on the international stage, Europe cannot afford to just stumble into a crisis with a major authoritarian trading partner — especially after its experience with Russia. 

Europe needs to be ready for a crisis in relations with China, even as we all hope it will never become a reality.

Politico