Europe’s Coming Trade War with China

Isn’t it ironic? For many years, European leaders reckoned that they could use their continent’s economic weight to nudge China into making deeper economic reforms. Now, it seems that the People’s Republic is using its financial clout to lever a debt-plagued Europe into austerity and unlock its vast technology market. Once a model of economic integration, Europe has turned into an outlet store where Chinese companies can pick up brands like Volvo, Saab, and MG at knockoff prices. On top of that, some analysts speculate that Beijing is poised to get the ban on European weapons exports lifted and gain official recognition as a market economy, which would make it harder to slap China with sanctions for unfair trade.

So, are the Mongol hordes about to ride roughshod over the Old Continent? Not really. The truth is that there is no evidence of a Chinese scramble for Europe. If anything, Chinese investors are tremendously reluctant to sink their hard-earned yuan into European markets. That also goes for Chinese companies, which have barely increased their direct investments, apart from a few highly visible takeovers, and have even rid themselves of several billion eruos of European stocks and bonds since 2007. Takeovers of strong brands like Volvo remain the exception, not the rule. Only in Eastern Europe have Chinese firms ventured into greenfield investment projects in the car, machinery, and transportation industries.

As for the Chinese government, it too is holding back from becoming heavily involved in the European Financial Stability Facility (EFSF) set up to bail out struggling countries like Greece, Portugal, and Spain. Europe expects China to buy tens of billions of euros’ worth EFSF bonds. But though the People’s Republic needs to invest its foreign exchange reserves abroad to prevent the yuan from climbing too rapidly, it is rather picky. Because it has little confidence in the politicians managing the EFSF, it prefers to invest via the International Monetary Fund, which exercises tighter control over how the money is spent. But Beijing is not going all-out in extracting concessions from Europe. True, on Sept. 14, Premier Wen Jiabao reiterated his wish to get market-economy status for China, but Chinese officials recognize that any attempt to capitalize from Europe’s weakness will seriously backfire.

"We are at a very precarious juncture," a senior Chinese diplomat in Brussels told me recently. "On the one hand, companies and the public opinion in China have become less positive about Europe and do not want us to make compromises. On the other hand, we know that European leaders are also under a lot of pressure to play hardball with us. Negative perceptions will only get worse if we respond too assertively to Europe’s crisis." Prudence is thus the guideline. If China hopes to achieve anything at this moment, it is a cast-iron guarantee that it will see its money back in case of additional government bond purchases.

Nor is Europe going to give China an easy ride. Advanced member states are not leaving their strategic assets and know-how up for grabs. Even those countries that seem the most desperate to attract Chinese investments or financial support generally stick to the principle that market- economy status can only be granted if China also lives up to the standards of a market economy. They might be all charm when discussing business deals in Beijing, but back in the discreet meeting rooms in Brussels, European diplomats are urging the European Commission to take a stronger position against unfair competition. Over the last two years, the commission, which now has full sway over trade and investment negotiations, initiated various new anti-dumping and anti-subsidy procedures aimed at China. Several more are in the pipeline. Chinese companies might be barred from government contracts if European companies cannot tender in China. There will probably also be more screening of investment from countries like China in strategic sectors. Like the U.S. Congress, the European Parliament is pushing for even bolder moves, like green tariffs and a true industrial policy.

Perhaps Europe will become more forthcoming if it sinks deeper into economic trouble? If anything, the opposite is true. As the economic morass deepens, European leaders are starting to think hard about future sources of growth. Gradually, a consensus is maturing that Europe cannot thrive on the service sector alone and that a total collapse of the welfare state can only be avoided if the continent maintains and strengthens its industrial base — just as Germany, the European Union’s strongest economy, has done. The European Commission recently devoted an entire policy paper to making the case for an EU-wide industrial policy.

European leaders thus see China as a daunting challenge, not a potential savior. Not only is China a cheaper market, but it is also catching up in technological performance, infrastructure, and the productivity of its labor force. Given Europe’s dwindling competitiveness, it will be hugely difficult to boost industrial production — at least without restoring to some form of protectionism.

China will likely retaliate in kind. It will not accelerate the appreciation of the yuan, as beleaguered European exporters want, nor scale back its financial support to exporting industries or open up its service sector to foreign competition. The result will be a cold trade war between Brussels and Beijing, similar to the long standoff between Beijing and Washington over everything from distorted currency rates to intellectual-property rights violations.

Were the coming crisis to last only a few years, Europe’s free trade-minded bureaucracies could withstand the protectionist mood, but as we are heading for a lengthy siege, the liberal firewall might not withstand the populist tide. In good times, Europe tolerated growing trade imbalances and was fairly patient with China’s mercantilist policies. But now that Europe is in trouble, trade revenues, technological assets, and jobs in industry are once again becoming a matter of national stability and political survival.

So is a Sino-European trade war inevitable? The way to prevent one seems obvious: Europe needs to rein in its overconsumption and China its overproduction. Such a coordinated adjustment, however, is highly unlikely. The more Europe pushes for opening up, the more hard-liners in Beijing will pressure their government to stand strong. Ultimately, Europe will start beefing up its defenses. A lot of this will happen unilaterally, mostly because the World Trade Organization does not properly cover issues like investment, services, and government procurement. Chinese leaders will have little choice but to respond by punishing European investors — one way or another.