Few people have heard of IMST — a small German company with just 145 employees, specialising in satellite, 5G, and radar technology. That was until last month, when the government in Berlin stopped it being acquired by a subsidiary of Casic, the Chinese arms conglomerate. The deal, concluded the German economics ministry, represented a “serious threat to public order and national security”.

“What is being sold? It’s a key technology that the Chinese don’t have . . . Why is it being sold? Because there’s a gap the Chinese have to fill,” a German official told the Financial Times. “It’s not just about weapons, it’s also about high tech, different sectors where Germany is a world leader.”

The nixing of the IMST deal is symptomatic of a growing mistrust overshadowing the Sino-German relationship. It also provides important pointers to the future direction of German policy on China after Angela Merkel, chancellor for the past 15 years, finally quits the political stage.

Ms Merkel personifies old ideals of rapprochement — the principle that ever deepening economic ties with the west would encourage political change in Beijing, and a shift to liberalism and western values. “Wandel durch Handel” — change through trade — was for years a key precept of German policy.

Yet her approach is looking to many in Germany to be increasingly out of date. “There is no willingness on Merkel’s side to change, but there will definitely be a more robust approach to China after she goes,” says Nils Schmid, foreign policy spokesman for the Social Democrats, the junior partner in Ms Merkel’s grand coalition.

Europe’s approach to China is in a moment of considerable flux. The EU has just signed a long-awaited investment treaty with Beijing — a big victory for both Chinese diplomacy and European business, which was completed during Germany’s six month presidency of the bloc.

But the EU is also increasingly alarmed at the growing influence of what it calls “authoritarian powers”, such as China, and has called for a stronger alliance with the incoming US Biden administration to assert the interests of democracies in global governance — putting aside the many frictions of the Trump years. Berlin will be central to how this plays out in Europe.

“There’s going to be a discussion between democratic nations about the threat from authoritarian regimes, whether it’s China, Russia or other countries,” says Noah Barkin, a Berlin-based analyst at research firm Rhodium Group. “If Germany is going to be part of that discussion, it’s going to feel huge pressure from its allies to speak out more, to be more forceful in its approach to China.”

While some German politicians want to take a stronger line on human rights, others worry about the consequences that might have for German companies active in the highly lucrative Chinese market.

The concern is understandable. Germany has profited handsomely from China’s integration into the global economic system, as Chinese companies and consumers snapped up German cars and machines. By 2018 Sino-German trade volume had reached €200bn and China was Germany’s largest trading partner.

In such circumstances, Trump-style “decoupling” of economic links was never going to be an option for Germany. Ms Merkel has strongly resisted any tendency to see China as an adversary, in a replay of the old cold war between the west and the USSR. “If we have this continental drifting apart of our nations, populations, and public opinion and so forth, that is a concern,” says Jörg Wuttke, a German businessman and head of the EU Chamber of Commerce in China. “[This] is not the Soviet Union, where you basically had a common border but no other interest. We have no border with China, but we have huge global supply chains and economic interests.”

Yet the hope of some of Merkel’s camp — that economic engagement would open China up politically — has failed to pay off. China has become more repressive at home — in Hong Kong and in its treatment of the Uighurs — and more assertive abroad, for example, in its island-building in the South China Sea. Under President Xi Jinping it has aggressively countered criticism abroad with “wolf warrior diplomacy”, while ramping up its economic and political espionage activities throughout the west — including in Germany.

“We’re all pretty disenchanted, all of us who saw China opening up and reforming in the past couple of decades and thought it would lead to a rapprochement, and that we would end up being more in sync,” says one German official. “It didn’t happen.”

Ms Merkel has defended her commitment to dialogue with China. She argues that without co-operation from Beijing, the world cannot possibly hope to solve some of its biggest challenges, such as climate change.

But her “partnership” approach has come under mounting criticism, with a chorus of politicians accusing her of prioritising the interests of German business above human rights.

Line chart of German goods exports to China as a % of total showing The Chinese market has become increasingly important for Germany

“We need a real foreign policy for China — not just a business-oriented policy,” says Mr Schmid. “We need to decouple our foreign policy from the commercial interests of big business.”

Friedrich Merz, a conservative politician who is vying to be the new head of Ms Merkel’s Christian Democratic Union, exemplifies the more hawkish tone on China. “We are dealing with an expansive, imperial foreign policy,” he told a recent campaign event. “China has a Europe strategy — do we have a China strategy?”

But any dramatic shift in policy is unlikely as long as Ms Merkel is still chancellor. “The biggest constraint is Angela Merkel herself,” says one diplomat in Berlin. “The system is already moving — now everyone’s watching to see how far Merkel will be willing to let it go.”

Some of the unresolved questions over German policy on China — and their potential to become an irritant in relations with the US — resurfaced in recent days as the EU clinched the “China-EU Comprehensive Agreement” or CAI.

Brussels says the deal, seven years in the making, will improve European companies’ access to the Chinese market and create a more “level playing field for EU investors”. It will, the bloc said in a statement, “prohibit . . . forced technology transfers and other distortive practices” and remove barriers, such as the requirement that companies form partnerships with local firms in joint ventures.

The deal was one of the crowning achievements of Germany’s six-month presidency of the EU: Ms Merkel has been one of the CAI’s most vocal champions.

But the agreement could cause tensions with the incoming administration of president-elect Joe Biden, who would like the US and EU to show a united front in their dealings with China. Jake Sullivan, who will serve as Mr Biden’s national security adviser, tweeted recently that the new administration would “welcome early consultations with our European partners on our common concerns about China’s economic practices”. A former official with the Obama administration said the message to the EU contained in the tweet was to “slow things down”.

The EU has rebuffed US criticism of the deal, saying it is merely winning similar trade benefits to those established in the so-called “Phase 1” trade deal struck by the Trump administration with China last year.

But there has also been criticism of the CAI from human rights advocates. As part of the agreement, the EU had wanted China to ratify International Labour Organization conventions, including those on forced labour — an issue that has taken on increasing urgency in the light of China’s incarceration of millions of Uighurs in Xinjiang. In the end, though, the Chinese government merely agreed to make “continued and sustained efforts” to ratify the relevant ILO conventions.

Some smaller EU member states felt that Berlin had swept aside their misgivings about the CAI in its rush to conclude the deal. “The internal EU tensions caused by the way Germany whipped through this deal at the end of its EU presidency are leaving their mark,” Mikko Huotari, head of the Mercator Institute for China Studies, wrote this week.

Friction over the CAI came to the surface in the Bundestag last month when a Green MP, Margarete Bause, brought up the ILO issue and asked Ms Merkel whether, in her eagerness to clinch a deal, she was ignoring the plight of the Uighurs and the Chinese crackdown in Hong Kong.

The chancellor said that when it comes to trying to help people affected by Chinese repressive practices, one should always ask oneself whether “dialogue is more useful than not speaking at all”.

“This contradiction between the values we share. and the interests we have . . . that’s the point where we will always have to make political trade-offs,” she said.

The exchange shed light on how German rhetoric on China could change after the Bundestag election in September, when Ms Merkel bows out after 16 years as chancellor and a new governing coalition is formed.

“Regardless of who replaces Merkel, the next German government is likely to include the Greens, who are the most hawkish party in Germany on China and very focused on human rights issues,” says Mr Barkin. “If they’re in government, that is going to change the way the government sounds on China.”

Ask any German official when alarm bells began to ring about the intentions of the Chinese leadership, and the answer is always the same: the €4.5bn acquisition of Kuka, Germany’s largest maker of industrial robots at the time, by the Chinese appliance maker Midea in 2016.

The deal prompted fear that critical German knowhow was ending up in Chinese hands. Politicians complained about a lack of reciprocity — German companies would never be able to acquire any Chinese firm as strategically important as Kuka. Shortly afterwards, Germany tightened its law on overseas investment, enhancing ministers’ powers to block foreign acquisitions of strategic assets. It was this change of law that allowed the cabinet to block the IMST deal last month.

Yet concerns about Beijing’s economic strategy continued to grow, fuelled by Made in China 2025, President Xi’s 10-year plan to transform the country into a technological superpower. Germany fretted that in pursuit of these goals, Beijing would target German companies and siphon off their intellectual property.

In 2019 the BDI, Germany’s main business organisation, released a landmark policy paper saying the country’s liberal, open model was increasingly in competition with China’s “state-dominated economy” and needed to protect itself more effectively from Chinese companies.

Mr Wuttke says Germany and Europe should see China’s comprehensive industrial policy, which contrasts so starkly to the approach of most western countries, as a “Sputnik moment” — a reference to the panic the Soviets unleashed with the launch of the world’s first satellite into space in 1957. “They have a plan,” he says. “How come we don’t have a plan?”

There are also concerns about China’s Belt and Road Initiative, which Germany began to see as a “fundamental challenge to the EU”, according to one senior official in Berlin. He said Europe was investing similar amounts in infrastructure in areas like Central Asia, a key element of the BRI, and yet the “political impact of China’s investments was much greater . . . It’s still very difficult to find an answer to a state controlled system.”

The sense of gloom is, if anything, deepening, with German companies increasingly concerned that they will end up being squeezed out of the Chinese market by domestic upstarts. A recent study by the Bertelsmann Stiftung, a think-tank, warned that if Made in China 2025 is a complete success, Germany’s critical machine-building industry could see its exports to China shrink from €18bn in 2019 to €13bn in 2030.

Ulrich Ackermann, head of foreign trade at the German Machinery Association, says the age of “eternal growth” in exports to China may be coming to an end. “We need to be constantly aware of our dependence on the Chinese market and prepare to develop new, alternative growth markets in Asia in a timely manner,” he says.

Yet despite calls for greater diversification, some German companies continue to retain a laser-like focus on China. The auto industry in particular has become, if anything, more dependent on China — largely because it has recovered so much more quickly from the corona pandemic than other countries.

Daimler recently announced that it sold more Mercedes passenger vehicles in China between January and November last year than in the whole of 2019. It also said that it produced more than 600,000 Mercedes cars last year in China itself, up from the 560,000 it made there in 2019.

German politicians say auto industry executives are lobbying hard against a tougher stance towards Beijing, warning a backlash that closes off the Chinese market could cost jobs at home.

The example of Chinese telecommunications equipment maker Huawei highlights the dangers. In 2019 German politicians first began demanding that the company be excluded from the buildout of Germany’s 5G network, on security grounds. The reaction from Beijing was forthright: its ambassador to Germany, Wu Ken, said Berlin would have to “expect consequences” from such a move. “The Chinese government will not stand idly by,” he said.

Fears of repercussions for German companies was seen as one of the main reasons why Ms Merkel firmly resisted any move to explicitly bar Huawei. But the pressure from China sceptics — even those in her own CDU — has been relentless. Late last year her cabinet finally adopted a new IT law that creates significant hurdles for any participation by Huawei in the 5G network.

The German foreign ministry has also signalled its desire for a shift. Last year it issued new Indo-Pacific Guidelines, which reflect a fundamental rethink of its policy on the Asia-Pacific region. The message is that the country has become too reliant on China, and must now “diversify” its relationships in Asia, “in order to avoid lopsided dependencies and to become more closely interconnected with the power centres of tomorrow”, according to the document.

German officials stress that this bears no resemblance to US-style decoupling: one foreign policy official refers to the new policy as “China + X”. There have already been some successes: officials point to the trade deals the EU has struck in recent years with Japan, Vietnam and Singapore, and the one it is currently negotiating with Indonesia.

The dangers of moving too slowly on trade were made clear in November, when China spearheaded the Regional Comprehensive Economic Partnership, a new free trade deal with 14 other Asia-Pacific nations that account for 30 per cent of the world economy.

Politicians in Europe saw RCEP as a wake-up call — and a sign that the EU must join forces with the US to counter China’s efforts to establish an international economic architecture more suited to its interests.

Speaking to reporters last month, Manfred Weber, head of the centre-right European People’s party group in the European Parliament, said the west was losing economic influence in the world “at breathtaking speed”. When the EU and US negotiated their aborted Transatlantic Trade and Investment Partnership, he noted, they accounted for 50 per cent of the global economy: now it is just 42 per cent

“Either we team up with the Americans to try to shape the global agenda, or the Asian countries will do it instead,” he said.