What China is Really Doing With Its “Giant Surpluses” | Brad Setser on China’s Export Dominance, Trade Strategy, and Capital Flows

Episode Summary

Executive Summary: Brad Setser argues that Trump-era trade policy has become incoherent: tariffs are high on allies and selective sectors but weaker on China than advertised, while Chinese surpluses, currency management, and state-bank recycling continue to shape global trade and capital flows. The result is more price pressure, altered trade routes, and a shift from bond flows toward equities—not a crisis, but a persistent imbalance.

Main Topics: China’s export surplus and global imbalance (Priority: 5/5): Setser says China has reoriented toward exports, with imports barely growing and exports surging, creating a massive surplus that deindustrializes parts of Europe and the emerging world while keeping Chinese goods cheap even under tariffs. Tariffs, trade diversion, and embedded Chinese content (Priority: 5/5): He argues tariffs have mostly changed the location of final assembly rather than reducing Chinese content, so goods routed through Vietnam or Mexico often still contain Chinese inputs and do not materially rebalance trade. Tariff incidence and U.S. inflation/business impact (Priority: 5/5): The discussion focuses on who pays tariffs. Setser says importers and U.S. firms are absorbing much of the cost for now, but a larger share will likely pass through to consumers over time, hurting corporate profits and raising prices. Currency undervaluation and exchange-rate policy (Priority: 4/5): Setser criticizes the administration for not prioritizing currency adjustment, arguing the yuan remains meaningfully undervalued in real terms and that weaker Asian currencies sustain external surpluses and U.S. trade deficits. Capital flows, reserves, and gold (Priority: 4/5): The conversation shifts from trade to capital. Setser says foreign demand for Treasuries has softened but not collapsed, while central banks and state institutions have diversified modestly into gold and other assets, with Chinese state banks playing a larger hidden role. Deal-making with allies, China, and investment funds (Priority: 4/5): He is skeptical of U.S. tariff deals that hinge on foreign investment commitments, arguing they are opaque, politically fraught, and inferior to U.S.-funded industrial policy in critical sectors like chips and rare earths. Argentina swap line and balance-of-payments risk (Priority: 3/5): Setser critiques the U.S. Treasury’s Argentina support, saying the peso is overvalued, reserves are still falling, and the swap line may delay rather than solve a balance-of-payments problem ahead of elections.

Key Arguments: China’s trade surplus is the central balance-of-payments force of the last 25 years, and its recent surge is driven by a renewed export push plus weak domestic consumption. Tariffs have mostly shifted assembly to third countries without materially reducing Chinese embedded content, so the policy is more optical than structural. Importers are paying tariffs first; foreign exporters are not visibly cutting prices, and consumers have only partly absorbed the costs so far. Over time, roughly 60%-70% of tariff costs would likely pass through to final consumers if rates remain in place. The U.S. tariff regime is incoherent: allies face high tariffs, some sectors are exempt, and China is not being targeted as consistently as campaign rhetoric suggested. Currency matters more than current policy acknowledges: the yuan is still materially undervalued in real terms, which supports Chinese surpluses. Capital flows have shifted from Treasuries toward equities and private credit, while state-bank and sovereign-wealth-fund activity remains a major, opaque source of global dollar recycling. Gold buying by central banks is real but still secondary to broader state-managed financial flows; much of the apparent rise in gold reserves reflects valuation effects. Foreign direct investment and reserve management are increasingly routed through state banks and sovereign vehicles rather than traditional central bank reserve accounts. The Argentina swap line is risky because it supports an overvalued currency and may not resolve the underlying external deficit without a real exchange-rate adjustment.

Data Points: China customs goods surplus: $1.2 trillion - Setser says China’s goods surplus has surged from roughly $400-$500 billion to about $1.2 trillion. China export increase over 4-5 years: + $1 trillion - He says China’s exports are up by about a trillion dollars over the past four to five years. China import increase over 5-6 years: ~ $100 billion - He emphasizes that Chinese imports have barely moved despite the export boom. China real effective currency change: down 15%-20% since roughly 2021 - Setser argues the yuan is significantly undervalued in real terms, helping exports. U.S. import share of GDP: about 10% of GDP - Used to estimate the scale of tariff incidence and revenue. Tariff revenue: about 1% of GDP - Current tariff revenue is described as roughly one percentage point of GDP. Foreigners’ annual Treasury demand: fell from about 1.5%-2% of U.S. GDP to about 1% - Setser says demand for U.S. bonds softened but did not collapse. China effective tariff rate before Trump 2: about 10% - He says legacy tariffs entering the new administration averaged around 10% on China. China current tariff rate: roughly 30%-40% effective, with some products higher/lower - He repeatedly describes the current China tariff structure as a blended effective rate around 40%. South Korea/Japan tariff level: 15% - He says Korea and Japan landed at 15% in their deals. Southeast Asia tariff level: about 20% - He describes the Southeast Asia deal as roughly 20%. India tariff level: 50% - He says India faces a 50% rate, including an extra 25% tied to Russian oil imports. Brazil tariff level: about 50% with large exclusions - He notes Brazil has a very high tariff rate, though exclusions make it highly variable. U.S.-Argentina swap line: $20 billion - Treasury Secretary Bessent said the exchange stabilization support was finalized at this amount. PBOC/Chinese state banks foreign-currency balance sheet: about $1 trillion - Setser says Chinese banks are major global financial players with roughly a trillion dollars in foreign currency assets. Gold price: briefly above $4,000 - He cites the sharp rise in gold as a signal of diversification and momentum. China-U.S. trade under high tariffs: not zero; could fall by ~80% in some products - He estimates a 40% tariff could cut trade in some tariffed products dramatically but not eliminate it.

Pivotal Quotes: "The Trump campaign tariff plan was more coherent than the actual Trump tariff plan." — Brad Setser: His core critique of the administration’s tariff strategy and its uneven implementation. "It is not transshipping." — Brad Setser: He objects to the common description of rerouted Chinese content through third countries, arguing the issue is rules of origin and embedded content, not simple fraud. "I do not actually think trade with China is going to zero." — Brad Setser: He explains that even with high tariffs, Chinese inputs remain deeply embedded in global supply chains.

Implications: Listeners should expect continued trade diversion, higher input costs, and persistent U.S.-China imbalance. The bigger risks are inflation, corporate margin pressure, and deeper dependence on opaque state-directed capital flows rather than a clean reshoring story.