The economic relationship between China and the EU has deteriorated over the past five years due to geopolitical tensions and regulatory instability. European firms are now diversifying away from China, focusing on risk mitigation and supply chain resilience.

The bilateral investment climate between China and the European Union (EU) has radically changed over the past five years. In 2020, the EU sought to take advantage of the US-China trade friction by concluding the Comprehensive Agreement on Investment (CAI). Concluded in December 2020, the CAI is a services and investment agreement that is somewhat limited but potentially would have been useful for European investors. Almost immediately following the conclusion of the negotiations, however, EU-China relations deteriorated over human rights and others issues. The CAI was placed on hold and never signed or implemented. China’s response to Russia’s invasion of Ukraine led to a further deterioration, and EU-China relations remain fractured and in a downward spiral.

Gone are the days when European companies viewed China as a promising investment opportunity offering cheap labour, world-class logistics, a relatively stable business environment, and a burgeoning domestic market. Instead, the focus is now on making supply chains more resilient, risk mitigation, and diversification of production networks—factors which all help firms “de-risk” from China.

This shift is the result of increasingly polarised geopolitics, brought about in part by China’s shift away from market-oriented and business friendly reforms towards a renewed concentration on political motivations, national security, and a drive towards self-sufficiency and technological prowess. Such considerations now impact business in erratic ways—even with crackdowns on domestic sectors as diverse as technology and education. These factors, coupled with a trade war with the United States (including increased tariffs and measures that require monitoring of supply chains such as America’s Uyghur Forced Labor Prevention Act) and the economic uncertainties brought about by non-transparent policies throughout the pandemic, make China a less attractive trading partner and investment destination.

Since the pandemic, few (if any) European firms have entered the Chinese market. Those firms with a presence in the country remain but do not appear to be expanding investments in China. Rather, investments are now going to other destinations to avoid the regulatory barriers, geopolitical friction, and extra tariffs and duties in what has become known as a “China plus-one”; that is, a manufacturing base in China and an independent supply chain and factory elsewhere for diversification. Another version of this, the “in China, for China” strategy, seeks to separate manufacturing for the Chinese market ”in China” and production elsewhere for the rest of the world.

The EU’s cumulative investment into China has stalled at around €160 billion. This can be contrasted with EU investment into the US of more than €3.2 trillion. Chinese investment into the EU fell to €7.9 billion in 2022 from €47.4 billion in 2016, the lowest level since 2013. Worse still, the European Chamber of Commerce in China report that only 13 percent of European companies in China see it as being a top investment destination, down from 21 percent in 2021. The same study found that 68 percent report a declining business environment while over half of the firms surveyed will look to downsize or cut costs (with over one-quarter seeking to reduce staff size) and a decade-low rate of 42 percent saying they plan on increasing operations in the country.

In terms of trade, we see the expected imbalance. According to Eurostat, the EU exported €223 billion worth of goods to China in 2023 (down from €231 in 2022) whereas China exports €514 billion to the EU in this same period (down from €627 billion in 2022). Over a longer-term period, Chinese exports to the EU have been growing by approximately 30 percent year-on-year, while EU exports to China grow by a mere three percent. China is the largest import source for the EU, accounting for 20.5 percent of total imports, whereas China is the third largest partner for EU goods, accounting for nearly nine percent of its exports.

With China becoming a “less predictable, reliable and efficient” investment destination, coupled with Europe turning more insular and protectionist, the future of economic relations in the short term is not bright. One notable exception could be electric vehicles (EVs). China is now seeking to become a world player in EVs, and has already established nine EV manufacturing plants in Europe. The EU is likely to follow the US’s lead in placing additional tariffs in the form of trade remedies on Chinese EVs to counter distortions on the EU market. This means Chinese EV production will increasingly take place within the EU, while European EV manufacturers will continue to compete in China’s high-end EV market. To counter this move, China followed its well-worn playbook by threatening to initiate trade remedies against a range of European products, including cultural exports such as brandy.

The EU-China economic relationship is fragile and declining. European investors perceptions of China have changed as they perceive the regulatory environment becoming more unstable and increasingly tilted towards “self-reliance” and domestic firms. Chinese measures are becoming more permanent. Owing to this and other geopolitical and economic reasons, investors are diversifying away from China to make global supply chains more resilient. Meanwhile, European firms continue to criticise China’s economic model for creating overcapacity and then dumping excess production onto the global market, thereby depressing prices and raising pressures on domestic firms.

The fact remains that China will continue playing a critical role in global supply chains for the foreseeable future. Firms are a step ahead of governments by developing “China-plus one” and “in China, for China” strategies, but recognise that factories outside China may still have to obtain materials or components from China in the short and medium term.

The need for diversification, which became so evident during the pandemic, is a threat that China will have to counter if it is to remain the world’s centre of manufacturing. But this will require a thoughtful and careful balancing between national security considerations and economic growth and development; between self-reliance and the transfer of technology and between domestic champions and full employment.

The EU and China have much to gain from improved investment relations. Both parties can take the opportunity to demonstrate commitment to freer economic relations while not abandoning security or broader strategic interests. The EU could establish clear perimeters for trade and keep its markets open to non-sensitive goods. China could take concrete action to provide better market access opportunities in sectors of interest. Given the change in the geopolitical landscape, words from Beijing may not be enough to placate potential investors. Instead, only concrete action can readjust the landscape and improve economic relations.

Bryan Mercurio is Simon FS Li Professor of Law at the Chinese University of Hong Kong. His latest books include Capital Controls and International Economic Law (CUP, 2023) and Regulating Cross-Border Data Flows (Anthem, 2022). Acknowledgement: The author acknowledges funding support by the Hong Kong General Research Fund (project no. 14609722) for a project entitled, “Engaging with China to Reform the World Trading System.”

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