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Disengagement from China could be expensive for Europe

By Gabriel Felbermayr

Supply bottlenecks in the wake of the Corona crisis have fuelled discussions in the EU about greater economic self-reliance and the relocation of production of certain goods back from China, for example. Sometimes this is only about individual critical products, such as medical goods. But the range of production processes to be “brought home” is readily expanded by those who see China as a particularly powerful strategic rival. There may be good strategic reasons to stop sourcing critical goods or industrially important ones from China alone. What is often underestimated by the advocates of such a policy, however, are the costs involved.

Simulation of EU decoupling

At the Institute for the World Economy, we have simulated what the consequences would be if the EU were to double trade barriers – away from new tariffs – in order to promote domestic production. This could be done, for example, through preferential public procurement, tax benefits or other subsidies for EU suppliers – or through import quotas or bans on selected goods. The result: if the EU were to unilaterally double corresponding trade barriers against China, this would cost 130 billion euros (0.8 percent of gross domestic product, GDP) – with comparable countermeasures by China, the costs would grow to 170 billion euros (1 percent of GDP).

Even partial decoupling from international supply networks would thus significantly worsen the living standards of people in the EU – as well as in its trading partners. By contrast, the alleged benefits of greater autonomy or sovereignty are often diffuse and difficult to quantify. They may even be illusory if risks thereby cluster in a smaller number of markets. The recent flood disaster in Germany has shown that crises can also occur right on our doorstep, so production in Europe is not always a “safe haven”.

Intuitively, one would think that decoupling supply networks would pay off when a supplier country suffers an economic shock – such as China when the Corona epidemic was still a local event there. But even in this case, simulations show that a general decoupling of supply chains causes greater economic damage than if the economic shock from the affected country spreads to others.

A decoupling of the EU from international suppliers would also increase prices for intermediate goods. This translates along supply chains into higher prices both for goods consumed within the EU and for EU exports, which in turn make goods in other countries more expensive. Such unintended side-effects that an EU autonomy policy could have are often ignored.

Alternative instruments for diversification

As a country with particularly strong international economic ties, Germany would be hit harder than many other EU countries: In the event of a unilateral decoupling from China, Germany would bear around a quarter of the burden (32 billion euros, 0.9 percent of GDP). An escalating trade war with the People’s Republic could increase these costs by another 50 percent.

Some sectors in the EU would certainly benefit from a unilateral decoupling from China – such as wholesale and retail trade, the construction sector or mechanical and plant engineering. Other sectors – especially vehicle manufacturing – would lose value added. In the event of a two-sided trade war with China, the result would be negative across all sectors.

Those who want to reduce dependence should choose other instruments. Instead of forcing out Chinese suppliers, it would certainly make more sense to diversify supply networks in order to have access to several suppliers in cases of crisis or conflict. In the case of critical goods, for example from the medical sector, greater weight could be given to supply security in the procurement contracts between the health insurance funds and the pharmaceutical companies – for example by means of appropriate contractual penalties.

Warehousing is expensive, but can become a worthwhile insurance policy against production downtime if the willingness to pay for supply security is higher in the future than in the past. The development towards a circular economy that relies heavily on recycling not only has ecological advantages, but can also reduce dependence on third-party supplies of raw materials, for example. And a deeply integrated European internal market is perhaps the best insurance against dependencies in international economic relations.

Those who discuss the negative aspects of dependence on China must not ignore the costs of putting the advantages of the international division of labour at risk. This does not mean that “business as usual” is the best solution. But the cost-benefit analysis of a new policy approach with regard to China must be complete.

This article belongs in the context of the “Global China Conversations” event series of the Kiel Institute for the World Economy (IfW). On Thursday , Institute President Gabriel Felbermayr and Jörg Wuttke, President of the EU Chamber of Commerce in China, will discuss the topic “China and Europe: Risky Economic Dependencies?” aspart of this format.” China.Table is media partner of the event series.

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