When China’s domestic imbalances become Europe’s challenge

Speaking with business executives there is a justified fear of a rupture in the Europe-China relationship. Chinese overcapacity is threatening European industry, Brussels and member states have taken a tougher line. But there is widespread fear of the nuclear option: that China may completely withhold rare earths and other critical raw materials, and factories come to a standstill. There is a tendency to then say, ‘let’s just focus on our own strengths’ or – in the parlance of Brussels – focus on ‘Promote’ and not ‘Protect’. My argument is that we have come to the point that the former cannot succeed without the latter and we need a new floor in our trading relation with firm and broad trade defenses. 

The EU is now moving in that direction, after the successful hybrid vehicle deal and its search for a new diversification instrument. However, a fracture in this surprising unity of a more assertive EU is lurking dangerously whenever Beijing decides to push back firmly. They have signaled resistance to any further concessions or changes in the bilateral relation, regardless of how desperately the Chinese economy itself needs rebalancing.

To understand why China’s powerful industry and export strength is the exact flipside of domestic stagnation, one needs to go back to the foundations of its economic model. China’s economic growth miracle was created by increasing the domestic savings rate by suppressing consumption to rally financing for investment and development. Suppression of household incomes (and therefore consumption) has occurred through various channels: a systemically weak currency (favors exports), financial repression (transfers wealth from savers, i.e. households, to borrowers, i.e. businesses), excessive infrastructure spending, labor repression, state directed credit and direct subsidies. No wonder China has by far the lowest consumption as share of GDP at around 55 percent where all other big economies average 75 percent. It has been successful in the sense that China dominates industries like EVs, chemicals, robotics, shipbuilding, batteries, steel and others. 

However, this growth model has become unsustainable. Investment is increasingly allocated less efficiently, evidenced by the fact that total non-financial debt in the economy reached 300 percent in 2026 according to the Bank of International Settlement. Furthermore, the rupture of the housing bubble in 2021 has fundamentally weakened the domestic economy and broken the financial system and fiscal system that undergirded Chinese growth. 

In China, local governments are the powerhouses of fiscal policy implementation, nearly 80 percent of expenditure (including investment) occurs at the local level. Whether it is via local state-owned enterprises (SOEs) or as a shareholder in private corporations. However, the 1994 fiscal reform reduced the local government’s fiscal autonomy by allowing them a smaller share of the taxes they collect vis-à-vis the central government, without significantly adjusting spending obligations. In their search for alternative funds, they turned to selling land-use rights to developers. By the time of the housing crash in 2021 local governments got 40 percent of their revenue from selling land, at around 8,7 trillion RMB. That number has since dropped to 4,2 trillion RMB and created an enormous fiscal hole in local government budgets. Their total debt via opaque local government financing vehicles (LGFVs) is the biggest mystery in China, but the IMF estimates it to be 70 trillion RMB. Anecdotally we hear that many officials in local governments haven’t been paid in months, while we can observe in official statistics that fixed-asset investment is down 7,2 percent in the first nine months of 2026, and may be worse, due to local governments pullback from investment. 

One might say that almost all the debt is held domestically, which is true, so it is not a problem. However, a financial system choking on bad debt that is continually being rolled over cannot extend credit for future growth in new industries. It requires a fundamental overhaul of the tax and fiscal system and rebalancing towards giving households a greater share of the economic pie. 

In the short term that will be little comfort for the Chinese economy. Rhodium Group estimates that instead of the reported 4.5 percent growth, actual economic growth is closer to 0. When fixed-asset investment is deeply negative, the real estate sector (which was 25 percent of GDP) is still shrinking five years after the crash and consumption is stagnant with 10 percent of the Chinese population behind on debt payments, such reported growth is simply not credible. High tech industries cannot make up for that. Again, Rhodium estimates that it represents only around 6 percent of China’s GDP. What is clear is that whatever growth there is, is vastly more reliable on exports than healthy for China and the global economy. 

The EU is right to take an assertive stance and should seek partners across the globe. The more pressure China feels from its external environment, the more untenable their growth model that displaces other countries’ investments and exports due to internal imbalances, becomes. 

evofenedex is pushing the EU to promote supply-chain diversification by strengthening ties with partner countries and leveraging the EU’s common buying power. Where alternatives are scarce the EU should support businesses to offset the competitive disadvantages. Lastly, the European Union must be able to intervene swiftly and predictably to unilaterally rebalance the relationship where it is most strategically urgent. The problem with the Commission’s current approach is its focus on product-specific investigations, which makes it impossible to capture the systemic nature of distortions. Its full arsenal, with the Anti Coercion Instrument, Foreign Subsidy Regulation, fast-track safeguard investigations and duties at the full level of the dumping margin, should be deployed. 

Only when the EU establishes credible deterrence in terms of creating a new trading relation with China, will Beijing be pushed to change its economic model.  Businesses will have to proactively adapt to a new economic relationship and rough months ahead.