Cost of decoupling from China for German economy severe but not devastating

Bundeskanzler Olaf Scholz (l.) und Xi Jinping, Präsident Chinas (r.), bei der Begrüßung in der Großen Halle des Volkes

"Trade with China brings us prosperity and is practically irreplaceable in the short term. A break would have high costs for Germany, yet our country has enough resilience to manage even such an extreme scenario," says Moritz Schularick, President of the Kiel Institute for the World Economy. The occasion is the presentation of a new analysis by an international research team led by the Kiel Institute ("What if? The Effects of a hard decoupling from China on the German Economy"). We will be discussing the results of the study live in an online event this morning, details at the bottom of this email.

In terms of methodology, the calculations are based on the much-discussed study on decoupling Germany from Russian gas, in which some of the authors predicted early on that this would be manageable.

Hostile trading blocs: Loss of economic prosperity of up to 5 percent

In the current analysis, the research group models a disintegration of the global economy into hostile trading blocs. The European Union, the USA, and the G7 states, on the one side, and China with its allies, in particular Russia, on the other side are opposed to each other. All direct trade relations between these two blocs are being cut. There is also a group of neutral states, such as Brazil, Indonesia, and Turkey, with which both blocs continue to trade.

Such a collapse would result in a considerable loss of prosperity for Germany if it were to occur abruptly and hit the country unprepared (cold turkey scenario). According to the calculations, Germany's economy would then contract by up to 5 percent in the first year.

In the medium to long term, after 4 to 5 years, when the German economy has adjusted to the new reality and organized alternative trade relations within its allies and with neutral countries, the permanent loss of prosperity will be around 1.5 percent per year.

Existing trade links with China cannot be compensated for ad hoc

The high costs for Germany are therefore primarily caused by the short-term effects of a sudden trade disruption, as existing trade links with China cannot be compensated for ad hoc.

The authors compare the trade shock with a scenario in which German-Chinese trade relations remain intact.

"German politicians have allowed themselves to be unsettled by exaggerated warnings from interest groups on the question of whether Germany can afford to stop supplying Russian energy. Our current calculations are intended to provide politicians with scientific facts as a basis for decision-making in their dealings with China, for example when it comes to the question of what economic measures Germany or the EU should or can take in response to a Chinese invasion of Taiwan," says Schularick.

A gradual, cautious reduction in trade relations between the Western and the Chinese bloc, culminating in a trade freeze after three years, would result in the same loss of prosperity in the long term as the abrupt termination of trade—around 1.5percent of economic output per year (gradual decoupling scenario). However, the sharp economic slump in the first months and years would be avoided, instead, the loss of prosperity would be gradual.

A so-called de-risking scenario, in which the German economy only partially detaches itself from China but generally maintains trade relations, would result in an annual loss of prosperity of around half a percent in the medium to long term.

In intermediate scenarios, in which trade relations end abruptly but Germany has previously decoupled from China to some extent, the economy falls back onto the path of the cold turkey scenario and then follows its adjustment path to a long-term loss of prosperity of around 1.5percent. Therefore, the slump after the trade shock is far less severe than in the original scenario.

In all simulated scenarios, the costs for China in relation to its size of the economy are significantly higher than for Germany, namely by around 60 percent.

Decoupling from China is a political decision

"Every decoupling of German-Chinese trade relations is associated with costs for Germany. The comparatively low costs of partial decoupling or de-risking only in certain sectors can be seen as an insurance premium against a painful economic slump that occurs if the interdependence remains close and then ends abruptly," says Julian Hinz, trade researcher and research director at the Kiel Institute and lead author of the study.

"Whether and to what extent Germany wants to move away from trade with China is a political decision. It is primarily linked to the question of whether the geo-economic negotiating position of the West or Germany is strengthened or weakened by close trade links with China."

In their paper, the authors emphasize several limitations inherent in the nature of model calculations. The most important is that the result is influenced by the assumption of how quickly Germany can organize new trade links when the old ones severed, i.e. how large, economically speaking, the so-called trade elasticity is. The authors are guided here by the latest literature and use the elasticities rather conservatively, so as to calculate an upper bound of the effect.

Furthermore, the model calculations do not capture all (short-run) business cycle amplification effects. However, the authors emphasize that this does not change the fundamental conclusions of the study.