Is the German economy about to be hit by the China shock?

Friedrich Merz didn't get much sleep last week. The CDU leader had barely been elected Chancellor in the second round of voting when he flew to France and Poland for inaugural visits. Germany has a special relationship with both countries for historical reasons. Both are also important trading partners for the Federal Republic. Good political relations are also good for the economy.

It would also be good for the economy if Merz were to fly to China soon. The Middle Kingdom is not only the second-largest economy in the world, but also Germany's second-most important trading partner after the USA. This is despite the fact that political tensions between China and the West have increased in recent years and politicians of all stripes have repeatedly called on companies to reduce their China exposure.

For most companies, however, withdrawing from the Middle Kingdom is out of the question. China has become too important as a sales and procurement market, and too important as a source of technical knowledge, for German companies to afford to ignore the country. However, the high dependence on business in China could become a problem for Germany as a business location – and lead to conflicts with the German government.

In light of the tough power politics of Chinese President Xi Jinping and the global expansion strategy of Chinese companies, supported by state subsidies, the "traffic light" government had already abandoned the notion that China was a liberal trading partner without political power ambitions. In its China strategy, the "traffic light" coalition maintained its goal of close trade relations with China. However, it also warned that it was important, especially in critical areas, to "reduce dependencies and diversify economic relations overall."

Critical voices against China are also likely to set the tone in the CDU-SPD coalition. The coalition agreement states: "We must acknowledge that the elements of systemic rivalry have now come to the forefront due to China's actions."

Rivalry instead of partnership, withdrawal instead of local presence? Many German companies operating in China see things differently. In a recent joint letter, more than 30 managers and entrepreneurs called on the German government to do more to promote the interests of German companies in their China business in the future. The letter states that there is a contradiction between the risk minimization (de-risking) demanded by politicians in doing business with the Middle Kingdom and the local presence considered necessary by companies. The demanded risk reduction must not result in a reduction of China's commitment.

Holger Klein, CEO of automotive supplier ZF Friedrichshafen, says companies need to have a presence in China to respond quickly to market changes and reduce costs. "China is a fitness center for us; it would be fatal for us not to have a presence there."

In fact, German companies have invested heavily in the construction of production facilities in China in recent years. From 2010 to 2024, a cumulative total of €90.5 billion flowed into the Middle Kingdom in the form of direct investments. Last year alone, despite all calls for de-risking, German companies invested €4.4 billion in the construction of factories and production facilities there. This was in addition to reinvested profits from local operations totaling €8.5 billion.

What makes economic sense could one day prove costly for German taxpayers. If a military conflict were to break out between China and Taiwan, resulting in the West's disengagement from China, Beijing could nationalize the production facilities of German companies. The companies would then have to write off their commitments to China.

If this puts them in trouble, it won't be long before politicians rush to their aid with taxpayers' money, just as they did with the banks during the financial crisis. "The moral temptation for companies is great to continue expanding their business in China in the hope that the government will bail them out in the event of a crisis," says Jürgen Matthes, China expert at the German Economic Institute (IW) in Cologne.

The German economy's dependence on China also remains high on the procurement side . Last year, Germany imported goods worth a total of 156.3 billion euros from China. As in previous years, the country remained by far the most important supplier for the German economy.

According to calculations by the Cologne Institute for Economic Research (IW), China accounted for over 50 percent of German imports in 2023 for 200 product groups. For 83 product groups, China's share even exceeded 75 percent. This is problematic when it comes to products that cannot be replaced by goods from other countries and therefore have the potential to slow down production in Germany, says Matthes.

One example of this is rare earths. According to IW calculations, in 2023, 91 percent of German imports of rare earths came from China. Rare earths are needed for the production of batteries for electric cars and wind turbines. China recognized the importance of rare earths decades ago and acquired extensive expertise in their processing. This knowledge is lacking in Europe.

More than half of all imports into Germany of medications such as fever reducers, anesthetics, and painkillers also come from China. For laptops and keyboards, the import share is over 80 percent. "A core of almost five dozen product groups with a persistently high import dependence on China has emerged," says Matthes. A clear structural de-risking "cannot be identified."

Economists at the Kiel Institute for the World Economy (IfW) have calculated what this means in an extreme case in a study . If the EU were to decouple from China, causing trade between the regions to collapse by 97 percent, German economic output would be permanently reduced by one percent. In the short term, the damage would be even greater, the Kiel researchers warn. To ensure security of supply, they recommend diversifying the procurement of essential products, for example, through the conclusion of free trade agreements.

The German economy is not only vulnerable due to its high dependence on business with China, it is also coming under increasing pressure from competitors from the Far East in its most important European markets. As a recent study by KfW shows, the share of German products in imports from other EU countries has shrunk from 19.7 percent in 1999 to just 16.7 percent last year. China, on the other hand, has increased its share of imports from EU member states from around 2 to 8.4 percent over the same period.

The Chinese are particularly dominant in the core sectors of German industry. Germany's share of EU vehicle imports fell from 33 percent to 29 percent between 2012 and 2024. China's share, by contrast, increased from 1 percent to 4 percent during this period. For mechanical engineering products, Germany's share of imports from other EU countries fell from 30 percent to 28 percent, while China's share rose from 7 percent to 10 percent. And for chemical products, the import share of goods "Made in Germany" shrank from 22 percent to 18 percent. China, on the other hand, increased its share from 2 percent to 6 percent.

China's export structure to EU countries has "tends to be more similar to that of Germany," write the KfW economists. China has made significant progress in the quality of its products. The share of labor-intensive goods from China is declining, and "capital-intensive, technologically advanced goods are increasingly being exported," the KfW study states. While two decades ago, 55 percent of China's exports consisted of products that China simply assembled, last year their share was only 20 percent.

China now dominates research and production in key areas such as artificial intelligence. According to the Australian Strategic Policy Institute , a think tank specializing in strategic analysis of technological developments, China has taken the global lead in 37 of 44 technologies critical to future economic development. Chinese companies benefit from generous government subsidies and the cost advantages of mass production.

For companies in Germany, which are suffering from a shortage of skilled workers, high energy prices, rampant bureaucracy, and high government taxes, the air is becoming increasingly thin. In a survey conducted last year by the German Mechanical and Plant Engineering Association, 61 percent of member companies surveyed stated that they expect their own competitive position to be only average to poor vis-à-vis competitors from China in the future. In the chemical industry, 56 percent of companies are convinced that competition with China on European markets will intensify in the future.

US President Donald Trump's tariff policy, with which he aims to thwart China's rise to global economic power, is likely to contribute to this. Chinese companies, whose products are barely marketable in America due to high US tariffs, could soon shift more of their sales to Europe . The consequences would be falling prices and intensifying predatory competition to the detriment of German suppliers.

The advance of Chinese suppliers into core sectors of German industry, such as automotive, mechanical and plant engineering, and the chemical industry, has contributed to the decline in German exports to China for the past two years. Last year, they fell by 7.6 percent to €90 billion. "Chinese companies are now able to manufacture higher-quality and more technically complex products themselves and are therefore often no longer dependent on more expensive imports," says Andreas Glunz, Head of International Business at the auditing firm KPMG.

The malaise of German car manufacturers in the Chinese market is the most striking example of this. Glunz assumes that "the export volume from Germany to China is likely to continue to decline sustainably."

The question remains what can be done to prevent Germany from experiencing a China shock like the USA did about twenty years ago. Back then, China overran the American market with its cheaper products. American industrial companies were forced to close down and lay off workers. Once prosperous regions became areas of economic decline. This created the breeding ground for Trumpism.

KfW economists recommend not looking for the cause of the China problem in China, but rather improving the location factors in Germany so that investment and innovation can flourish again here. This suggests that the German government should focus its energy more on developing a Germany strategy than a China strategy.