Wed
Jun
10

Relocating production from China to Central Europe? Not so fast!

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Western European imports from central Europe have fallen dramatically, while imports from China fell much less, and had already recovered to pre-COVID level by April 2020. Central European governments should instigate new measures to foster the transition towards knowledge-intensive economic activities.

The COVID crisis caused a major setback to global trade and disrupted the functioning of global production networks. From the perspective of Central, Eastern and South Eastern European (CESEE) countries, this has raised the hope that Western European manufacturers will bring their suppliers from East Asia closer, potentially boosting investment in CESEE.

The volume of merchandise trade is expected to drop by almost 20% in the second quarter of 2020 compared to the same quarter of the previous year, the steepest decline on record according to the World Trade Organisation. Almost half of global trade is composed of intermediate goods for production, and there were companies in Europe and elsewhere which did not receive essential intermediate inputs for production during the height of the COVID crisis. Such disruptions to global trade and global production networks, or global value chains (GVCs), can call the benefits of globalisation into question, and might prompt companies to bring their suppliers closer. For Western European producers, the CESEE region would be a natural place to relocate their suppliers due to its geographical closeness. Relocation would boost investment in CESEE, which in turn could speed up the recovery from the corona-recession and support medium-term growth and jobs.

Foreign trade facts disappoint relocation hopes

However, recent trade data paint a sobering picture of such hopes: the imports of the first fifteen European Union member countries (EU15) declined the most from the CESEE region, while imports from China had reverted back to their 2019 level by April 2020, the latest available data at the time of writing (Figure 1). Imports from CESEE declined by a shocking 35%, while within the EU15 imports (such as German import from France and French import from Germany) declined by 30% on average by April. EU15 imports from the United States and Japan declined by about a quarter. The decline of EU15 imports from China had already started in February 2020, earlier than from the rest of the world, given that COVID-19 hit China first. Yet even at the lowest point in March 2020, the EU15’s imports from China was ‘just’ 16% lower than on average in 2019, while in April 2020 it had returned to the same level as in 2019. 

Figure 1: EU15 imports from different regions, euro billions at current prices, seasonally adjusted, 2019 average = 100

Source: author’s calculation, using bilateral trade data from the IMF’s Direction of Trade Statistics dataset (accessed on 6 August 2020), which includes US dollar values. Average euro/US dollar exchange rates from Eurostat were used to convert USD figures to euros. The euro values were seasonally adjusted using the X12 method. 

Note: EU15: first 15 members of the European Union. CESEE13: the 13 countries that joined the EU in 2004-2013.

Among the 13 CESEE countries, Slovakia was hit the hardest by its exports to the EU15 almost halving. Romania was the second hardest hit, followed by Hungary and the Czech Republic with about 40% export losses. At the other end, Estonia, Latvia and Lithuania suffered from ‘just’ about 15% trade losses. 

Relocation would boost investment in CESEE, which in turn could speed up the recovery from the corona-recession and support medium-term growth and jobs.

The composition of EU imports from China shows that some product categories saw major increases, while others declined; however, several intermediate goods categories gained or did not suffer much from April 2019 to April 2020. The highest increases in April 2020 compared with the same month last year were recorded for automatic data processing machines (+€884 million, +33%), articles of apparel of textile fabrics (+€129 million, +36%) and electronic tubes, valves and related articles (+€92 million, +12%). (Textile articles include COVID-19 related products, such as textile face masks, surgical masks, disposable face masks and single use drapes). The largest decreases in absolute terms were observed for imports of footwear (-€254 million, -52%), telecommunications equipment (-€232 million, -6%) and baby carriages, toys, games and sporting goods (-€225 million, -28%). Other intermediate production inputs such as pumps, compressors, fans, electric power machinery and parts, motor vehicle parts fell less.

What can we make of these developments?

First, the limited fall and the quick rebound of EU15 imports from China is really remarkable, given that the economic activity and total imports of the EU15 was much lower in April 2020 than on average in 2019. Perhaps imports from China in April 2020 partially replaced imports from other countries suffering from COVID-related lockdowns. The rebound of imports from China suggests that East Asian supplier problems were short-lived; and from the perspective of disrupted supply chains, there is not much justification to relocate suppliers from East Asia to Europe. The adverse public health situation due to COVID-19 was addressed quickly in China, allowing suspended production and shipments to restart – and faster than in Europe. Such rapid control of the epidemic in China might even reinforce the reliability of Chinese suppliers.

The rebound of imports from China suggests that East Asian supplier problems were short-lived; and from the perspective of disrupted supply chains, there is not much justification to relocate suppliers from East Asia to Europe.

Second, while the CESEE countries are geographically close to consumer markets in the EU, they are still very far away for the value chains of some goods that are produced in China. For instance in ICT goods, the value chain is predominantly East Asian, so moving certain intermediate inputs from China to Europe would mean getting closer to the consumer but farther away from other suppliers. Replicating whole value chains in Europe seems to be a difficult and costly task.

Third, the lower decline of EU15 imports from the United States and Japan than from CESEE suggests that distance to Western Europe is not the primary determinant of trade flows, even in times of lockdowns and trade disruptions. The product composition of trade seems to be a more important factor. This again highlights that the geographic proximity of CESEE to Western Europe should not be overrated.

Fourth, the extent of trade losses depends on the sectoral and product composition of exports to EU15, including the mix of intermediate and final products. It seems that CESEE countries which are more integrated into Western European production networks, such as Slovakia, Romania and Hungary, suffered from larger declines in exports. Since the bulk of exports includes manufacturing products, export decline should coincide with industrial production decline. Indeed, industrial production fell the most (by about one third) from May 2019 to May 2020 in Slovakia, Hungary and Romania among EU member states, according to Eurostat. This suggests that greater participation in European value chains exposes an economy to greater variation in production, with associated consequences for employment and GDP growth.

Fifth, as industrial production recovers, so does trade. Eurostat data shows that industrial production started to recover from April to May 2020 since lockdowns were eased, and is expected to recover further in subsequent months. At the time of writing, the latest bilateral foreign trade data available is for April 2020. Hence the large drop in intra-EU trade by April is expected to correct itself, at least to some extent, over the coming months. It will be interesting to analyse whether intra-EU trade will recover as fast as EU15 imports from China, or whether it does so at a slower pace.

Greater participation in European value chains exposes an economy to greater variation in production, with associated consequences for employment and GDP growth.

And sixth, GVC-related trade also suffered much more in the aftermath of the 2008 global financial crisis than traditional trade, but it also recovered faster after 2009 (see Figure 1 here).

Thus, greater participation in GVCs exposes trade and production to greater variation, which can have adverse consequences for output, employment, government budget balances and many other indicators in times of economic shocks. Such adverse variation should certainly make CESEE policymakers think about their industrial policy strategies, although shorter-run (or cyclical risks) and longer-run structural impacts should also be jointly analysed.

Global value chain participation has longer-term benefits

Participation in GVCs has a number of longer-term benefits. As Richard Baldwin argues, emerging and developing countries with less developed industrial structures and smaller domestic markets can join the supply chains of firms from high-tech nations, instead of building such supply chains as Korea and Taiwan had to do over a long period of time, since these countries developed themselves before the GVC era. Joining GVCs since the mid-1980s has allowed less developed countries to embark on a faster-track development, specialising in certain tasks. 

A recent IMF study concludes that it is GVC-related trade, rather than conventional trade, which has a positive impact on income per capita and productivity, even though such gains appear more significant for upper-middle and high-income countries.

Such longer-term benefits have likely induced CESEE governments to attract as much foreign direct investment (FDI) as they can by offering the maximum amount of state aid which is possible in the EU, such as tax exemption for a decade, or financial support to train employees and reduce labour costs. FDI can foster participation in GVCs by local suppliers. The recent races between CESEE countries to attract prominent foreign manufacturers seem to suggests that this development strategy is set to continue. 

Most CEESEs have not moved up in the value chain

An important aspect of development is whether companies participating in GVCs gradually move up in the value chain: that is, whether the initial contributions to low-wage sectors are gradually replaced by higher value-added and higher technological-level production. The IMF study mentioned above finds unfavourable results for most CESEE countries, by analysing Germany’s auto supply chain: for the Czech Republic, Hungary, Poland, and Slovakia, the contributions of high and low technological-level sectors remained broadly the same between 2000 and 2013, suggesting there had been no moving up on the value chain. For Romania, in contrast, there has been a shift away from low-tech to more high-tech manufacturing. As regards non-EU countries, the study finds that China’s contribution to the German auto supply chain is showing a shift towards more high-tech services, while Russia’s contribution became more intensive in low-tech manufacturing due to the mining and quarrying sector.

The region’s advantage as a low-wage supplier of western European manufacturing networks is gradually diminishing.

Related indicators suggest similarly unsatisfactory progress for most CESEE countries. The European Union’s innovation scoreboard, which is measured using 27 performance indicators distinguishing between ten innovation dimensions in four main categories, concludes that with the sole exception of Estonia, CESEE countries rank well below the EU average in 2019. Moreover, the improvement in innovation performance from 2012 to 2019 in the Czech Republic, Hungary, Bulgaria and Slovakia was below the average improvement in the EU, and there was even a setback in innovation performance in Romania and Slovenia. CESEE countries do not rank highly in the World Economic Forum’s Innovation capability component of the Global Competitiveness Index either. Slovenia (28th), the Czech Republic (29th) and Estonia (34th) have the highest rankings in the CESEE out of 155 countries, while the lowest rankings in the CESEE region belong to Latvia (54th), Romania (55th) and Croatia (73rd). 

Overall, it seems that while participation in global value chains has brought major benefits to CESEE countries in terms of growth and jobs, it has not been associated with improved technological and innovation capabilities. This is a key problem, because with continuing fast wage growth and a deteriorating demographic outlook, the region’s advantage as a low-wage supplier of western European manufacturing networks is gradually diminishing. Most CESEE countries rank disappointingly in the World Economic Forum’s Skills ranking, which considers various indicators related to the current and future workforce, suggesting that the workforce is not up to the challenge of moving away from low-wage activities.

Sustained convergence requires transition towards knowledge-intensive economic activities

Sustained convergence toward western European productivity and living standards will be possible by moving up the value chain towards more knowledge-intensive activities. This, first and foremost, requires better education and research, which in turn necessitates higher public spending. 

For example, public expenditure on tertiary education is below 1% of gross national income in most CESEE countries, but around 1.5% or more in most northern and western European countries. In a forthcoming study we find a statistically significant correlation between public spending on universities and a number of educational result indicators. Primary and secondary education are equally important. As James Heckman argues, in disadvantaged families the highest rate of return in early childhood development comes from investing as early as possible, because skills beget skills in a complementary and dynamic way. There are many poor and disadvantaged families in CESEE. Secondary education, vocational training and lifelong learning are similarly crucial. 

Given the relatively low public debts of CESEE countries and their prospectively faster economic growth than in Western Europe (which will help their fiscal sustainability), it is surprising that these countries do not devote more resources to education and research. The COVID-19 economic shock and the associated collapse in trade should serve as a wake-up call for policymakers in CESEE countries. The existing economic model, which has fostered as much foreign direct investment as possible as well as greater participation in global value chains, has served its purpose, but it will soon run its course. Even a short-term boost cannot be expected from a hypothesised strategic reorganisation of suppliers from East Asia to CESEE. Instead, policies fostering upward movements on the values chain should be significantly stimulated.

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Sun
Nov
03

The INF is dead. Now what?

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By Michal Onderco | Rotterdam

On 2 August 2019, the Intermediate Nuclear Forces (INF) treaty, signed by the United States and the Soviet Union at the end of the Cold War, ended. The United States formally withdrew from the treaty, although it had already been clinically dead at least since the US suspended its compliance with the treaty in February 2019. The United States had already publicly accused Russia of noncompliance five years ago, during the Obama Administration.

At that time, the State Department noted (in a bureaucratic document outlining compliance with arms control agreements) that “[t]he United States has determined that the Russian Federation is in violation of its obligations under the INF Treaty”.

A year later, the United States added a detail, noting that the violation was related to a groundlaunched cruise missile which Russia had developed. The US strategy at that time seems to have been to bring Russia into compliance, but also to develop its own potential responses to the violation.

 Russia for her part denied engaging in such activity, and instead also charged the United States with having violated the treaty. European countries’ response to the end of the INF should be based around stepping up their defence spending and commitments. Such steps would help Europeans to address the security vacuum emerging after the collapse of the INF, and would also reinvigorate Europe’s defence posture and strengthen its position within NATO.

The birth and the death of the INF found Europe in different states

During the Cold War, the treaty was of crucial importance for Europeans, who would have been the primary targets of Soviet intermediate-range missiles if conflict broke out between the USA and the Soviet Union. During the late 1970s and early 1980s, European leaders voiced concerns about Russian missiles, particularly the SS-20. For European policymakers, and especially West Germany, the development and deployment of the SS-20 tipped the balance of forces vis-à-vis any future conflict between West and East decidedly towards the Soviet Union.

Germany, as well as other Western NATO nations, demanded that the US react with the development and deployment of equivalent missiles. Yet Europe’s publics mainly perceived the crisis in the light of possible nuclear holocaust. Hundreds of thousands of citizens went onto the streets to demonstrate against nuclear weapons and in favour of nuclear disarmament.

The domestic pressure on Western European (democratic) governments was enormous. The mass protests were memorable: in 1983, over half million people came to the Malieveld park in the Hague to protest against nuclear war and oppose the deployment of American nuclear weapons in Europe.

The conclusion of the INF treaty therefore helped European leaders to solve two problems: both the external security problem, and the domestic public pressure. As opposed to the massive protests against intermediate-range missiles in 1980s, the Russian violation in the mid-2010s was not met even with a shudder. By that time, nuclear weapons had fallen out of the public’s attention, and Europe – convulsed by the Greek debt crisis and the migrants streaming across the Mediterranean – simply did not pay attention.

European response to the end of the INF should be based around stepping up the defence spending and commitments. Such steps would strengthen Europe’s position within NATO.

However, to be fair, the United States was also not exactly forthcoming with information, and shared only very few details with its allies. Therefore, while US analysts such as former State Department official Steven Pifer accused European governments of not confronting Russia about the violations in its bilateral interactions, the Americans did not make it any easier for Europeans by withdrawing and classifying much of the evidence of Russian noncompliance.

Conversely, European countries realised the gravity of the situation only when it became obvious that the United States would withdraw from the treaty. Numerous Western European governments, alarmed at the erosion of the treaty they saw as fundamental to their own security, perceived the situation as the epitome of their strategic predicament in 2019.

 European countries rely on the United States in strategic questions, even though the interests of the United States seem to diverge from theirs, and are confronted by challenges which Europe cannot address on its own. The end of the INF was a sign of tensions easing at the end of the Cold War and the beginning of a new era, in which international institutions (whether treaties or organisations) held a promise of a more orderly future for European countries.

The end of the treaty punctures that image for Europeans. The collapse of the INF has special relevance for the Central European region. Intermediaterange missiles are often thought to influence the balance of power on the battlefield, rather than having an innate strategic importance (although it is arguably difficult to consider any use of nuclear weapons as non-strategic).

For numerous observers, any potential conflict between NATO and Russia will start in Eastern Europe, and will therefore involve (or at least take place on the territory of) Eastern Europe. The Eastern European countries should thus be most concerned about the collapse of the INF and its aftermath.

However, the governments of these countries, with the exception of governments in Poland and the Baltics, have remained conspicuously silent. The Polish and Baltic governments have, compared to their Western European counterparts, been more critical of Russia, and have raised louder appeals for the United States to provide a deterrent solution.

The European predicament

Because European countries did not possess the relevant technological capabilities, they usually left strategic discussions to the Americans and Russians, in order not to engage in what German political scientist Ulrich Kühn called “arms control without arms to control”.

This led European policy-makers to resort to “seeking allied unity” and calling on Russia to return to compliance with the treaty. European analysts, the above-mentioned Kühn prominent among them, suggested solutions as varied as strengthening missile defence, rotational deployment of bombers, and the deployment of conventional-tipped sea-launched ballistic missiles on US submarines in European waters.

While such solutions are within the realm of the technologically possible and politically feasible, they might potentially be strategically destabilising and could increase the chances that nuclear weapons might be used. For instance, a recent review by Beatrix Immenkamp of the European Parliament’s Research Service ruled out every solution offered as being impossible, either because it was technically unfeasible or because the necessary political will was lacking.

However pressured and worried about the United States’ future commitment to European security the European countries are, they nonetheless realise that they have no replacement for the key role that the United States has played in European security since the end of World War II. However, the potential for the use of intermediate-range missiles creates a different type of challenge to Europe than to the United States, particularly due to the former’s geographical proximity.

European countries should support the development of a conventional deterrent, including developing A2/AD capabilities. These could give Europeans a bargaining chip.

 While the end of the INF unties the United States’ hands in a certain way (especially in relation to responding to China’s development of intermediate-range missiles and the future of American alliances in Asia), for Europe the end of the treaty opens up the option of nuclear war on the continent. Although this problem is particularly acute in Eastern Europe, the whole region is caught in this predicament.

For the same reason, the European countries need to consider their own unity in the aftermath of the INF’s end. Such unity is important both for the symbolic image of Europe as a global actor, as well as for the adoption of any future Europewide solution to the INF crisis.

Therefore, while Europeans should not stop seeking cooperative solutions together with the United States, they should also think about the potential steps that they themselves could take to mitigate the threat from Russian intermediate-range missiles in the future. The first step in mitigating this threat is to think about what scenarios might lead to the use of intermediate-range nuclear weapons, and then think about how to prevent any such scenarios from emerging through deterrence.

One of the most likely scenarios for a future nuclear conflict between NATO and Russia usually revolves around a miscalculated Russian attack on NATO’s Eastern flank, one in which Russia would start to lose ground. To prevent such a scenario, European countries should support the development of a conventional deterrent, including developing capabilities in the anti-access and area-denial fields.

There is no doubt that such a development would be a sea change from the practices of the past, but the upside of such capabilities is that Europeans might actually build capabilities which Russians might want to limit, which could give Europeans a bargaining chip for future negotiations on intermediate-range missiles.

Cross-domain deterrence offers another avenue for deterring future conflicts. The principle of cross-domain deterrence is to deter attack in one domain (in this instance, nuclear) by developing tools in another domain.

For European countries, there are multiple possible options. European countries could, either within the framework of NATO or outside it, develop deterrent tools in cyberspace which could significantly deter Russia from ever contemplating the use of intermediate-range missiles.

To ensure long-term security in the region, the countries on the continent need to start thinking and acting for themselves .

Of course, it remains questionable whether such tools could persuasively signal Europe’s willingness to use them, and whether they would lead to more stability or not, but offensive cyber weapons provide an option for Europe. The framework of Permanent Structured Cooperation within the EU creates an opportunity for both economies of scale and opening new avenues for European cooperation. The potential is enormous, especially for Central European countries, to both expand their industrial bases and to develop their own defence capabilities.

What not to do and the way out

One pipedream that European countries should not continue chasing is bringing Russia into compliance with the INF, or attempting to revive the INF in its original form. For starters, it seems that neither of the original parties to the INF is unhappy with its collapse. However, Europeans should recognise the fundamental security considerations at play.

If Russia considers intermediate-range missiles as fundamental to its security, it is very unlikely to give them up. The same applies to the dream of universalising the INF through a global regime. Not only are the United States and Russia uninterested in such treaty, but China – about whose intermediate range missiles both the US and Russia are concerned – as well as other countries currently developing such missiles also have no interest in limiting such development.

While the costs of developing technological, military, and political solutions are sizeable, the domestic political costs should not be forgotten. While European societies are no longer aroused by the potential of nuclear war, they are in no way pro-nuclear. However, citizens also tend to be sensitive to military expenditure, and would probably be opposed to steps which could be seen as escalatory towards Russia.

However, the aversion to nuclear weapons among European publics might provide a conduit to supporting the deployment of responses to Russian norm-breaking. The post-INF crisis should make it clear to European countries that, as much as they need to work with the United States to maintain their security, the interests of the United States are different from those of European allies.

Primarily, the United States – like Russia – is concerned about developments in China, and might therefore view the collapse of INF through a different lens. Proposals to develop European capabilities should not mean the end of cooperation in NATO. However, they would mean a development of European military muscle – something that even the United States has called for within the framework of NATO.

Relying on American-supplied solutions will not address the security concerns felt in Europe. To ensure long-term stability and security in the region, the countries on the continent need to start thinking and acting for themselves. In the same way as the European countries learn to represent each other’s interests in trade negotiations, they should get serious about security considerations, especially the Central and Eastern European member states.

Even if Europeans have a natural predilection for negotiations – and some analysts suggested that Europe should negotiate with Russia on a future grand bargain for European security – Europeans know too well that it is much easier to negotiate when one has something to offer. The fate of Europe’s counterparts when it comes to trade negotiations should have taught them that.

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