Brad Setser on China Shock 2.0

Brad Setser is one of the go-to experts if you want to understand global imbalances, the political economy of China, and the complexities of currency movements. Regardless of whether you agree with him or not, he always backs up his assertions with data—which sets him apart from a lot of other commentators in macroeconomics.

I was recently watching his latest presentation with Markus Brunnermeier on the “second China shock,” which has become a major talking point among policymakers, especially in Europe. It was brilliant, offering fresh insights on why this current wave is fundamentally different from the first.

The original “China shock” concept comes from the seminal paper “The China Syndrome” (and the follow-up “The China Shock”) by David Autor, David Dorn, and Gordon Hanson—one of the most influential economics contributions of recent decades. It animated the discourse on China for over a decade and, more than almost anything else, fueled the underlying anxiety around China in US policymaking.

In a nutshell, Autor, Dorn, and Hanson argued that after China joined the World Trade Organization in 2000, American manufacturing clusters suffered wholesale devastation, effectively wiping out numerous factory towns. While the total number of job losses (estimated at a few million) might look modest as a percentage of the entire US labor market, the shock was heavily concentrated and localized. The lingering damage to these communities has since been linked to growing political polarization, the rightward shift in US politics, the opioid crisis, the broader backlash against globalization, and various other social issues.

I’ve followed this discourse closely for a long time, and if you are interested in this space, Brad Setser’s presentation, along with his Twitter threads and articles on his Council on Foreign Relations writing archive, are absolute must-reads.

By the way, my colleague Kumar (That’s his real name. Pranav Manie is a fake name) coincidentally recorded a podcast with Brad, which I also highly recommend watching.

I asked NotebookLM to write an essay summarizing Brad’s presentation as a way for me to easily reference the main points he made. Here is the essay that NotebookLM generated:

The Second China Shock: Navigating Geopolitics, Missing Money, and Global Imbalances

The global economy is currently undergoing a profound transformation driven by what economist Brad Setser calls the “Second China Shock.” The first China shock—which occurred after China joined the World Trade Organization and lasted until the 2008 Global Financial Crisis—was characterized by a booming Chinese economy where both exports and domestic consumption grew rapidly. It existed in a world that largely believed in a rule-based, multilateral trading system.

Today, the landscape is fundamentally different. We have entered a transactional, bilateral world order where trade is weaponized, and nations are acutely focused on geopolitical “choke points.” This second shock is not a historical event we are looking back on; it is an ongoing reality that is actively reshaping global trade, currency valuations, and the stability of government bond markets.

To fully understand this complex phenomenon, we must explore Setser’s expanded arguments across four critical dimensions: the hyper-concentration of Asian wealth (and its devastating impact on Europe), China’s geopolitical “Dual Circulation” strategy, the mystery of China’s hidden money, and the new, highly leveraged risks in the US Treasury market.

1. The Shifting Geography of Trade and the Plight of Europe

Before 2008, global trade surpluses (when a country exports more than it imports) were spread across the world, shared by oil-rich nations, commodity exporters like Brazil, and China. Today, the global surplus is almost exclusively concentrated in East Asia.

The AI and Semiconductor Boom: Alongside China, Taiwan and South Korea are running massive surpluses. Taiwan consistently runs a surplus over 10% of its GDP, heavily driven by its monopoly-like grip on high-end semiconductor manufacturing (via companies like TSMC) fueled by the AI boom. South Korea’s surplus has also skyrocketed from 5% to 20% of its GDP due to acute global shortages in memory chips.
China’s Unprecedented Scale: China’s manufacturing surplus alone has reached an astonishing 2% of total global GDP. This is twice the size of the largest surpluses Japan ever ran in the 1980s, and bigger than the peak surpluses of Japan and Germany combined.
“Mercantilist on Mercantilist Violence”: This shock is hitting Europe much harder than the first one did. During the first shock, Europe sold heavily into a booming Chinese domestic market. Today, Chinese domestic demand has stalled, and Chinese manufacturers are aggressively expanding their global market share in high-value sectors like automobiles (especially EVs) and clean energy. If you remove Ireland (whose data is skewed by US pharmaceutical tax strategies) from European trade data, the traditional European goods surplus has effectively been wiped out by Chinese competition.

2. A Bifurcated Economy and Xi Jinping’s “Dual Circulation”

China’s current economy is heavily divided: its export sector is booming, but its domestic economy has stalled, growing at perhaps only 1% to 2% realistically. This is driven by a massive collapse in China’s real estate sector, which previously drove domestic wealth. Rather than bailing out consumers, the Chinese government has funneled investments into high-tech manufacturing.

This is not just an economic policy; it is a geopolitical survival strategy deeply tied to President Xi Jinping’s vision of “Dual Circulation.”

Maximizing Leverage, Minimizing Dependence: Having watched the US sanction companies like Huawei and freeze Russian foreign reserves, Beijing is terrified of Western choke points. The goal of Dual Circulation is to make the rest of the world entirely dependent on China for critical goods (like rare earth metals, battery chemicals, and permanent magnets) while simultaneously executing massive “import substitution” so China no longer relies on the West for high-tech components.
The Domestic Cost—Jobless Growth: Because China is pouring its money into highly automated, high-tech factories rather than the service sector or household consumer subsidies, this export boom is not creating jobs for the average citizen. The result is severe youth unemployment and “jobless growth,” as factory automation outpaces the need for human labor.

3. The Mystery of China’s Missing Money and the Currency Fix

One of Setser’s most vital technical arguments is that the official data drastically underestimates the size of China’s economic imbalance due to bizarre accounting anomalies and strict currency controls.

The Investment Income Puzzle: When a country holds trillions in foreign assets, it should earn massive amounts of interest and dividends (known as the investment income account). Yet, China officially reports a $125 billion deficit here. Setser points out this is practically impossible. The most likely explanation is that Chinese state-owned banks and foreign direct investment vehicles (often parked in offshore havens) are earning huge returns but failing to report them properly in the official data.
A 30% Undervaluation: When you correct for this missing money and recent methodology changes, China’s true surplus is likely around 5.5% of its GDP, not the officially reported 4%. Because the surplus is so large, Setser estimates the Chinese currency is undervalued by closer to 30% against the currencies of its trading partners (much higher than the IMF’s 19% estimate).
The Mechanics of the Fix: Correcting this requires a stronger Chinese currency, which would give Chinese citizens more purchasing power and slow down the aggressive export dumping. However, the Chinese central bank tightly controls its exchange rate by setting a daily “center point” (the fix). Because the currency is so strictly managed, the rest of the world cannot force the market to correct it; Beijing must deliberately choose to strengthen its currency, which it is currently reluctant to do given its reliance on exports for growth.

4. The Risky New Plumbing of US Debt

Every global trade surplus requires a deficit on the other side, historically absorbed by the United States. However, how this is financed has changed in ways that introduce new, invisible risks into the global financial system.

The Old Era (Safe Assets and Toxic Mortgages): In the 2000s, Asian central banks took their export dollars and bought US Treasury bonds as official reserves. They demanded so many safe bonds that the US couldn’t issue enough of them. Wall Street stepped in to create “synthetic” safe assets—mortgage-backed securities—which ultimately triggered the 2008 housing crash.
The New Era (The 6% Deficit and Private Leverage): Today, the situation has flipped. The US government is running a massive fiscal deficit (around 6% of GDP) and issuing a flood of Treasury bonds. However, Asian central banks have stopped buying them. Instead, Chinese state planners are hoarding their export dollars in state banks, sovereign wealth funds, and private lending to avoid the risk of US sanctions.
Wobbles in the Yield Curve: Because foreign central banks are no longer reliably absorbing US debt, the US Treasury must find private buyers. These private investors demand higher returns and often use complex, highly leveraged trading strategies (borrowing money to buy bonds, known as the “basis trade”). This reliance on leveraged private buyers makes the long-term US bond market much more volatile. To adapt, the US Treasury has had to rely much more heavily on issuing short-term “T-bills” rather than long-term bonds, fundamentally altering the stability of what is supposed to be the world’s premier “safe asset.”

Conclusion The Second China Shock is a story of a global system transitioning from mutual economic interdependency to strategic, one-sided reliance. By refusing to stimulate its own domestic consumers and instead flooding the globe with highly subsidized, high-tech manufactured goods, China is exporting its domestic slowdown to the rest of the world. Because the financial pipelines that absorb these imbalances rely on increasingly leveraged private debt rather than stable central bank reserves, the world economy is navigating entirely uncharted—and potentially highly volatile—waters.