On July 19, 2026, Brad Setser joined Markus’ Academy for a two-part conversation on the Second China Shock and the Second Coming of Global Imbalances. Setser is a Senior Fellow at the Council on Foreign Relations and a former official at the US Treasury and the Office of the US Trade Representative.
Watch Part 1 of the talk and read its summary below. We will share the second part with implications for Europe tomorrow. Setser’s slides are available here.
The world order has shifted from a rules-based multilateral system, with a balance of choke points and mutual interdependence, to a transactional and bilateral system where size and spheres of influence dominate and resilience outranks efficiency
Each good/service should be seen as a bundle of (i) the good itself and (ii) build-up of geopolitical dependency. Alongside the current account, we should begin measuring the “resilience account” which would net out geopolitical dependency: how easily the goods in the current account can be sourced from other countries
Comparative advantage is dynamic, built by industrial policy in sectors with increasing returns and learning-by-doing, as in the infant-industry / strategic-trade tradition of Krugman (1987) and Grossman & Helpman (1990). This should impact tariff and exchange rate policy
China’s manufacturing surplus is ~2% of world GDP. This is roughly twice the largest surplus Japan ever ran (the target of the 1985 Plaza Accord) and twice Asia’s pre-GFC peak.
Tooze (2026) has dubbed this “mercantilist-on-mercantilist violence”, as China’s gains come partly at other surplus economies’ expense (e.g. Europe)
[21:00] An export boom bolted to a stalled economy
The real-estate bust cut property investment from ~12% to ~6% of GDP; capital has shifted into manufacturing and “new productive forces” aimed at cutting reliance on US and European choke points
China’s share of global investment has started to decline while its share of trade has continued growing. The slow-down in investment has weighed on consumption, with the actual domestic demand growth likely half as large as the officially-reported (3%)
Since 2021, China’s import growth has decoupled from demand growth
Pre-GFC, the surge in reserve accumulation and a safe-asset shortage fed the housing-securitization machine. Today reserves are flat, while with its deficits the US has been oversupplying treasuries
With the end of low-for-long rates in the US and the appreciation of the dollar, countries have seen less of a need to prevent their currencies from going up (and in the process accumulating reserves)
Instead of accumulating reserves, the big reserve holders have been funding quasi-private channels, such as China’s state banks or Korea’s national pension service, that chase return, not just safety
This shift has led to a more opaque recycling of surpluses and more treasuries being held by private investors (the basis trade). Even if the incoming treasury investors are more levered, this may prove more stable than the old reliance on housing securitizations: housing bubbles burst, whereas Treasuries always converge to par
[50:11] China’s statistical puzzles and the undervalued yuan
China reports an unexplained investment-income deficit (~$125bn). However, under standard assumptions of the return of its net foreign-asset position it should show a ~$100bn surplus. The likeliest culprits are under-counted income from state banks and offshore FDI vehicles
This understates China’s true surplus. Setser puts the real surplus near 5.5% of GDP versus a reported ~4%
This mismeasurement drives the currency debate. Measured against the IMF (2025)‘s ~1%-of-GDP norm, the official surplus implies a ~19% undervaluation; while with Setser’s corrected figure it rises to ~30%