Europe should worry but not panic over China

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The shift in EU thinking about trade policy has been positively whiplash-inducing. Brussels has gone from being an (almost) committed free trader — which was itself a welcome change from a dominance of corporatism and agricultural protectionism in the EU’s early decades — to being dominated by a geostrategic view of international trade. The approval in member state capitals has ranged from grudging to enthusiastic.

That’s not a bad thing — it is clear that some trade links were weaponised by geopolitical adversaries to make the EU and its member states dependent on them. That was true for gas pipelines with Russia, and it could become true wherever China is a monopoly supplier of critical goods. But it is one thing to appreciate the dangers one faces and take the best steps to eliminate them. It is quite another to overreact and rush for a response that ends up being both costlier and less efficient than it needs to be. The EU and its member states could do well with a bit more of the former and a bit less of the latter.

A case in point is the current concern about the bilateral trade balance. The EU’s trade deficit with China has roughly tripled in five years, causing much harrumphing among EU trade officials and no doubt strengthening protectionist feelings.

It’s a basic lesson of international economics that bilateral balances vis-à-vis particular countries matter less (if at all) than an economy’s overall external balance. But economic irrelevance has never been a hindrance to political salience. In any case, such a big change in so little time is quite breathtaking, so it’s worth checking what’s behind it. Here are the key facts.

First, the ballooning bilateral deficit is entirely driven by a rise in imports rather than a fall in exports. As the chart below shows, the two grew more or less in parallel at the end of the last decade. Then, after the first lockdown-related swings, EU exports to China remained more or less stable, while imports soared.

Second, the change in imports is visible across broad categories of manufacturing, although machinery and transport equipment (think of China’s electric car boom) may be contributing more than its proportionate share.

Third, the EU’s bulging Chinese imports bill has as much to do with the imports’ price than their volume. From June 2021 to September 2022, the unit value of the stuff the EU bought from China rose 30 per cent, while that of the goods sent the other way only rose 18 per cent. Even if trade volumes had stayed constant, this terms-of-trade shock would have made the deficit deteriorate significantly. Not that this is nothing to worry about; it obviously made the EU poorer. But it is increasing volumes of goods bought that would indicate a deepening dependence.

Import volumes grew too, of course, if not as much as prices. But fourth, and most importantly, all these changes have recently been going into reverse. Import volumes have fallen by about 10 per cent since the peak in August last year; import prices by about 15 per cent. The total import bill, consequently, is down by a about quarter since a year ago. Exports, meanwhile, have been stable in both nominal and real terms over the same period. That still leaves the deficit a lot higher than before the pandemic. But it doesn’t do to use 2022 numbers as justification for policy.

This is just one example of where nuance is crucial so as to avoid knee-jerk policy responses to temporary or oversimplified challenges. And fortunately, such nuance is forthcoming in the debate. Here are two examples that have come across my desk in the past week.

One of the fears in Europe is that China could use its dominance in the critical raw materials that green tech manufacturing depends on, for geopolitical purposes — and that fear is justified, as an interactive visual report from my colleagues brings home. And yet: in a letter to the FT, the economist Daniel Gros has pointed out the curious fact that the value of EU imports of rare earths is not that high ($121mn in 2021, he says). He argues that this means it’s more affordable to stockpile critical raw materials than to plough billions into subsidies for their domestic extraction. Of course, China may limit sales to prevent precisely that, or the demand might rocket so high that there is nothing left to stockpile. But it nonetheless puts the geopolitical dependence into a different perspective and encourages us to think of more policy solutions.

Another example is the European fear that the US will steal its green transition bacon. So I welcome a new note from the Franco-German Council of Economic Experts — which is made up of the two countries’ government-appointed but independent economic advisory councils — on how the EU should react to Washington’s Inflation Reduction Act. That piece of legislation, you will recall, has helped fuel a boom in factory construction in the US, and was received with horror by European politicians who were told by their industrialists that with the new American subsidies they would up sticks and shift their investments across the Atlantic.

The joint team of economic sages are telling their governments to calm down: the IRA will not have a large effect on the EU economy. Even in the specific sectors where new US subsidies are making businesses ponder if the grass is greener on the other side of the Atlantic, there is no evidence of “significant risks for the EU”. The reasons include that the IRA largely just makes the US catch up with the subsidies the EU already offers, which the report documents, and that the EU’s reliance on carbon pricing makes any given amount of subsidy much more effective. Overall, the conclusion is that the bulk of green tech will be consumed within the same economic bloc where it is produced, so there is not that much scope for subsidies in one bloc to upset activity in the other.

None of this means Europe shouldn’t worry about its dependence on other economies. But its leaders should think more broadly about policy solutions, making an effort to learn when the situation is not quite as dire — or simple — as it may have served their interest to tell voters. Above all, don’t panic. It doesn’t make for good policy.

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Numbers news

• Global trade is shrinking at the fastest pace since the early pandemic on a year-on-year basis.

• The Kyiv School of Economics has published its latest chartbook on the effect of sanctions on the Russian economy.