External imbalances are back in the news, with both the G7 and the G20 saying that they will be a key topic for 2026. This attention reflects the ongoing surge in Chinese exports and the US tariff hikes aimed at reducing the US trade deficit. Recent data indicate that the US deficit is likely to be modestly lower in 2026 than it was in the two previous years. The International Monetary Fund and most other forecasters project that external imbalances, and associated international tensions, will remain quiescent over the next two years. We disagree. We believe China’s booming trade surplus has much further to rise and will increasingly take sales away from producers in the rest of the world, especially in the advanced economies of Europe and Asia. Already heightened trade tensions are likely to intensify even if global growth remains strong. A global slowdown, perhaps led by a collapse of the US artificial intelligence (AI) boom or prolonged instability in the Middle East, likely would plunge the world into a major trade war as countries pursue beggar-thy-neighbor policies, destroying what remains of the current international economic order.
China’s growing surplus is driven by ultra-competitive exporters not only in traditional industries like electronics, toys, and home appliances but increasingly in new products like automobiles, robots, and solar panels. With domestic demand blunted by the collapse in the property market, China’s producers have been forced to focus on exports. Moreover, the export surge is facilitated by a large incipient financial imbalance, as Chinese savers looking for foreign investment opportunities are not matched by a similar foreign desire to invest in China. While China’s leaders have paid lip service to the goal of consumption-led growth, their policies have mainly enabled a massive investment surge into new export industries while keeping costs in China far below global levels. The outcome of these choices is now being unleashed on a world that is not prepared for a second China shock.
If global growth—currently supported by a US-led boom in AI investment—persists, most of the widening in China’s surplus is likely to come from reduced surpluses in regions other than the United States. Europe and advanced Asia are especially vulnerable to China’s move out of low-tech manufactures into medium- and high-tech goods such as automobiles. Their economies are more orientated toward the manufactures that Chinese firms are now producing and, because their economies are much more export-intensive than the United States, raising tariffs offers their producers less protection, as Chinese goods would still eat away at sales in third markets. Surging Chinese exports will exacerbate existing trade tensions between China and Europe/advanced Asia as domestic firms are undermined. These concerns about Chinese competition were on display in the recent visit of German chancellor Friedrich Merz to Beijing.
Tensions will be far more extreme in the event of a global recession caused by a collapse of the US AI investment boom or the fallout from prolonged instability in the Middle East. Such a slowdown would force many economies to return to the zero lower bound on interest rates and, with deficits and debt already elevated, fiscal policy is unlikely to be able to provide sufficient support to plug the gap in activity. Conditions would be ripe for an all-out trade war, plunging the world into trade conflict on a scale not seen since the 1930s as countries pursue beggar-thy-neighbor policies to defend their own producers at the expense of others.
Data Disclosure
This publication does not include a replication package.
