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Diversification is not enough to address Europe’s economic dependence on China – The Diplomat

Diversification is not enough to address Europe’s economic dependence on China – The Diplomat

 


In the European Commission’s latest document on the EU’s strategic dependencies, the term diversification appears no less than 28 times. It represents a key pillar of proposed policy responses to dependence on Chinese supplies. The whole world depends on China for rare earth minerals, metals and the magnets produced with them: China accounts for 63% of global rare earth oxides, 85% of refined minerals and 93% of global magnet production . As for Europe, the recently discovered rare earth deposit in Sweden, the largest known mineral reserve on the continent, could help improve Europe’s resilience in rare earth supply.

Yet the crux of the problem is not dependency, but vulnerability, the pain inflicted by disruptions in trade, measured in economic costs, social suffering and, eventually, political upheaval.

Dependency is a fairly crude criterion of vulnerability. The European Union may depend almost entirely on Madagascar for its supply of vanilla beans, but even a total loss of these supplies would hardly cause serious macroeconomic difficulties. On the other hand, vulnerability can exist even without dependency: Spain has never relied on Russian natural gas supplies, but the shortfall to other European markets has sharply increased the price of electricity throughout Europe, which hit Spain hard and revealed its vulnerability.

Vulnerability exists when three aspects combine. First, a major disruption of economic exchanges must be plausible. Second, the affected economic sectors must be limited in their ability to adapt to disruptions by turning to alternative sources and/or to support reduced demand. Third, the consequences of the disruption must have a significant impact on the overall performance of the affected economy. The European Commission has carried out some of the necessary analysis of European vulnerabilities, but much remains to be done at the national level.

In response to vulnerability, diversification has drawbacks. For businesses, diversification is a natural risk management strategy. This will happen anyway in response to market forces if the additional costs are low. Most companies diversify from the Chinese market not because of any governmental diversification strategy on the part of their home country, but rather in response to the impact of Chinese policies on the market. However, as a geopolitical strategy, diversification will generally be costly, and the costs will have to be borne either by economic actors (businesses, consumers) or by taxpayers, and should therefore be adopted with caution. In a crisis, security considerations may mobilize support for the additional expenses incurred. Yet, over time, concerns about security of supply tend to fade and diversification becomes an expensive alternative.

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The experience of the oil shocks of the 1970s is instructive here. The stranglehold of Middle Eastern exporters on world oil markets has remained to this day, as they possess huge reserves with very low production costs, and therefore the ability to offer oil at low prices prevails. on political risks.

If the cost of diversification is funded by subsidies or imposed on consumers by trade protectionism, it risks creating high-cost production and powerful vested interests that will push for continued protection. The EU’s Common Agricultural Policy was born out of food safety concerns and ended in a heavily distorted sectoral protection policy with a powerful lobby.

Geopolitical diversification efforts can also encourage a race for subsidies between countries pursuing this same strategy. At worst, diversification produces all these problems simultaneously, as with energy: Europe has remained dependent on fossil fuel imports and beholden to domestic high-cost coal and lignite producers and their lobbies.

Finally, diversification defines solutions to geopolitical vulnerabilities in terms of alternative supplies and tends to crowd out alternative approaches focused on conservation, substitution and recycling. Conservation allows importers to settle for less, thereby reducing dependency; the same goes for recycling by offering domestic alternatives to imports. Substitution removes the need for certain inputs by developing alternatives, with a chance of abolishing dependency altogether.

All in all, better demand management can contribute as much to managing geopolitical vulnerabilities as alternative supplies, with the added benefit of being more sustainable.

In short, there are significant complications with diversification strategies. They are intuitively attractive and therefore easily garner political support, but they risk ending up supporting costly and ineffective policies. Given the delays in the development of alternative sources, they also represent a structural and long-term response to geopolitical vulnerabilities that could suddenly erupt.

While it is difficult to accurately predict the reactions of economic actors to disruptions, there are steps businesses and governments can take to build flexibility, and therefore resilience. One is storage, including strategic stocks owned or mandated by governments. Another is to encourage innovation. Flexibility can also be built into manufacturing systems at all levels, improving resilience, often at relatively low cost.

In its efforts to assess problems and develop policy responses to European vulnerabilities to supply shortages, the EU has been well ahead of many of its member states, including Germany, its largest economy. As part of its new industrial strategy update, the EU undertook an assessment of its strategic dependencies in 2021, followed by an in-depth review in 2022. The Commission’s approach tends to equate strategic dependency with vulnerability and look to diversification as the key response. It includes the national security sector, where the stakes are fundamentally different. The notion of strategic dependence conceals this difference and lends itself to abuse.

Thus, while the European space industry may be important from a national security point of view as well as for reasons of prestige and industrial innovation, it hardly deserves to be treated as a priority in terms of economic security. In addition, EU policy responses emphasize industrial policies and international cooperation with partners with similar concerns. Both are important, but policies that target demand receive much less attention. This risks a costly misallocation of funds by investing in uncompetitive industries and overlooking industries where the EU is stronger.

Ultimately, the European Union can do little to identify and address the risks of European vulnerability to economic disruption; the bulk of the work has to be done by the Member States. Storage deserves much more attention than it has received so far, as it saves time for adjustments both at European and Member State level.

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An important precedent for coordinated storage policies exists with the International Energy Agency’s Emergency Oil Sharing System. This agreement sets national oil storage targets, stipulates mandatory conservation efforts in the event of a major disruption and provides for a redistribution of available supplies to benefit the most severely affected countries. It could serve as a model for European efforts to reduce vulnerabilities in its trade relationship with China.

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