China Shock 2.0: Why Europe's trade deficit with China keeps widening

By David Born

Last year, the EU ran a trade deficit with China of €1bn a day. If that figure is alarming, Chinese customs data for January to July offer even more cause for concern: in just seven months, exports to the EU grew by more than they did in the whole of 2025. The shift comes against the backdrop of steep US tariffs on Chinese imports introduced in 2025. The key question, therefore, is whether US tariffs have redirected Chinese trade. Are Chinese exporters shifting sales from the US to Europe, further widening the EU’s trade deficit with China?

This question is particularly relevant because Chinese exports to Europe are growing fastest in sectors in which European companies have traditionally been strong and previously exported substantial volumes to China, including electrical machinery and, most prominently, vehicles. This challenges European core industries and has triggered a debate about how Europe should react.

Trade redirection was real, but Europe was not the main destination

In this context, it is worth remembering that US tariffs on Chinese goods peaked at 125% in April 2025, before settling at an effective rate of around 34% by the end of the year. Chinese goods exports to the US fell by USD 105 billion, or 20 percent that year. Despite the sharp drop in US-bound exports, China’s overall exports grew by 5.5 percent, indicating a redirection of goods to other markets. Europe appeared to be the obvious destination, given its large market, strong consumer demand and relatively open access for Chinese goods.

The ECB tested this hypothesis by comparing 2025 imports of the same products across destination markets. Its analysis found statistically significant evidence of tariff-induced trade redirection towards ASEAN and Africa, but only a small and statistically insignificant effect for the euro area. This suggests that the recent increase in Chinese exports to Europe was not primarily driven by US tariffs.

The first half of 2026 shows that the results of the analysis also hold true for this year: Chinese exports to the United States did not decline further, which, if trade redirection were the main explanation, should have reduced the need to shift exports to other markets. Instead, exports to every other destination accelerated, with their growth rate to the EU doubling from 8.4 in 2025 to 16.8% in the first half of 2026 and total Chinese exports growing by 17.6 percent. The scope for further trade redirection had therefore narrowed, yet export values continued to rise. The main explanation therefore lies largely within China itself.

Structural factors outweigh tariff diversion effects

Evidence from 2026 increasingly points to domestic Chinese conditions as the main driver of export growth. A key factor is weak domestic demand. Since the Chinese property-sector downturn began in 2021, investment has increasingly shifted from real estate towards manufacturing.

Meanwhile, households and businesses have prioritized deleveraging over spending, creating dynamics often described as a balance sheet recession. At the same time, continued policy support for strategic industries such as electric vehicles, batteries and renewable energy equipment encouraged investment and production. The combination of weak domestic demand and expanding industrial capacity generated excess output that increasingly had to be absorbed by foreign markets.

The before-mentioned ECB analysis provides the details: Since 2022, sectors with weak domestic sales, including textiles, steel, machinery and automobiles, increased export volumes by around 75%, compared with roughly 30% in sectors where domestic demand remained stronger. The gap suggests that exports increasingly serve as an outlet for excess capacity in sectors where domestic demand is weak.

Export prices fell most strongly in sectors with the fastest export growth, suggesting that firms expanded market share by accepting shrinking margins or even operating at a loss. This gave Chinese producers a significant price advantage in international markets. In addition, advantages in scale, vertical integration and supply-chain depth enabled producers to sustain output despite weak domestic demand, reinforcing the shift towards foreign markets.

These effects are exacerbated by an undervalued currency. Overall, the IMF estimates that the renminbi remains 17% to 21% below fair value. Although the renminbi appreciated during 2026, export growth continued to accelerate, suggesting that structural factors currently outweigh exchange-rate effects.

On the other hand, China’s export success cannot be explained by subsidies alone. It also reflects a fundamentally lower-cost model: vertical integration, leaner organizations and lower overheads. The result is a remarkable ability to commoditize features once reserved for premium products, while moving at a pace few competitors can match. Two examples capture the scale of this advantage: China installed 354,000 industrial robots in 2025, almost three in five of all installations worldwide. Then there are lidar sensors: once priced at €44.000, they now cost Chinese suppliers around €180 a piece.

European countermeasures

The crucial question, then, is this: How can Europe not merely stop the downward spiral in its trade balance, but reverse it? And what options does the EU have?

Those looking to trade policy alone for the answer are likely to be disappointed. Chinese companies enjoy structural cost advantages that would persist even if they produced under European conditions: lean corporate structures, streamlined manufacturing and a high degree of vertical integration, generating substantial economies of scale.

For the EU, this points to two priorities. First, it must restore the conditions for fair competition, which are currently being undermined. Second, it must double down on its own capacity to innovate.

Five measures are particularly urgent:

1. Finally implement the Draghi plan.
   
   There is broad agreement on the reforms needed to restore Europe’s competitiveness. Implementation, however, remains the weak link. According to an analysis by the European Policy Innovation Council, only 15.7% of the 383 recommendations in the Draghi report had been fully implemented two years after its publication. In practice, that means three things: cheaper power, faster grid connections, one capital market. Europe's energy-intensive industry pays at least 50 per cent more for electricity than its Chinese rivals, six times more capacity is waiting for a grid connection than Europe built last year, and some €300bn of European savings leaves for foreign markets every year.
   
   
2. Reduce strategic dependencies — fast.
   
   Without diversifying supplies of critical inputs for machinery, electrical engineering, chemicals and the automotive industry, threats of trade defence will remain largely hollow. EU-wide reserves equivalent to 120 days of net imports, modelled on strategic oil stocks, could be one first step. So could a requirement to maintain at least three suppliers in critical areas, or offtake guarantees for refineries in other regions that currently lack the financial strength to invest.
   
   
3. Make better use of existing trade instruments.
   
   The problem is not a lack of anti-dumping or anti-subsidy tools. It is their insufficiently decisive application. Case-by-case investigations are slow and can be further delayed in court. Where macroeconomic evidence clearly points to systemic practices at sector level, why not reverse the burden of proof and apply measures across an entire industry?
   
   
4. Tie public support to clear value-creation criteria.
   
   The EU’s Industrial Accelerator Act (IAA) is the right idea, but the timeline is wrong. Until it takes effect in 2027/28, European taxpayers’ money will continue to support value creation outside Europe. EU member states should therefore act now and make public support conditional on clear value-creation criteria — including closing loopholes that allow imports or production in third countries to qualify.
   
   
5. Tighten the conditions for foreign direct investment.
   
   Chinese factories in Europe are not necessarily a problem; on the contrary, they should be part of the solution. But both sides must benefit from the partnership. Instead of soft commitments and a menu of options, Europe needs binding requirements. These could include joint ventures, IP licensing, R&D investment and the relocation of meaningful value creation — rather than simple final assembly. Thus, European companies can learn from Chinese innovation speed while Chinese firms can benefit from European expertise in return.
   

Europe does not need to choose between openness and industrial competitiveness. But it does need to be far more deliberate about the terms on which openness works.