STRATFOR ANALYSIS

Europe considers a new trading status for China

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FORECAST

The European Commission will make its decision on whether or not to grant China market economy status, which can define trade agreements, later in the year, most likely in the summer.

Italy, which will have grave concerns about exposing its steel sector to Chinese competition, will be against the decision and lead other countries opposing it.

The United Kingdom, which will seek future benefits from a strong relationship with China, will support the decision and lead the argument in favor of it.


Europe will most likely recognize China’s market economy status before the end of 2016.

CHINA’s much-publicized slowdown is affecting the world in different ways. The drop in the yuan has already forced the Bank of Japan to adopt interest rates below zero percent. The European Central Bank is expected to increase monetary easing in March. Uncertainty has gripped global financial markets in general, causing equities to experience their worst annual start in decades. Commodity prices, which have relied on Chinese investment, continue to fall, causing problems for producers all over the world. But it is not just producers who are suffering: China’s slowdown is also hitting the global industrial sector, particularly European steel.

In this context, the European Union will have to decide this year whether to grant China market economy status at the World Trade Organization (WTO). A market economy, as the name implies, is one driven by market forces, such as businesses, banks and consumers. Conversely, a non-market economy — China’s status since it joined the WTO in 2001 — is one that is controlled by institutions other than the market, such as a central government. Governments can set prices for goods artificially in non-market economies, often putting them at odds with their more liberalized counterparts. Thus part of the WTO’s purpose is to give market economies the means to rectify potential price disparities set by a government. China is on the cusp of changing its status from non-market to market economy, and the countries of Europe, especially those with struggling steel sectors, will be picking sides over whether to support the change to its trade status.

Economic background
Europe’s steel sector has been in a long decline. Industrializing countries traditionally produce steel because it is used not only in industrial sectors such as construction but also in finished goods, such as automobile manufacturing, that can create immense economic growth, as it did in Germany and Japan. But the resulting economic wealth begets a more educated population that demands higher wages than can be earned by tending a blast furnace, leading a country out of steel production. It moves instead toward the services sector (or sometimes high-end manufacturing), where those with higher levels of education can earn higher wages. Then the next country moves into steel production to fill the demand, as China did most recently.

Of course, it is not always a clear-cut transition. While Western Europe has largely moved from manufacturing to services, value in the steel sector remains. By innovating to make thinner and more durable steel, countries such as Germany can compete with developing economies such as China. Nations have also found it useful to maintain a steel industry to serve their automobile sectors, another area that still yields profits.

Over the last thirty years China has embarked on its own industrialization path on a scale that was previously unprecedented. Total Chinese steel production in 2013 was 22 times the output in 1980. The Chinese share of global output rose from 5 to 50 percent over the same period. However, an equally dramatic rise in Chinese demand largely absorbed its new supply of steel, somewhat tempering the global market’s reaction to China’s growth.

Unfortunately for China and the world’s steel producers, that trend has reversed in recent years. In 2007 Chinese production began to overtake demand, creating surpluses. Then in 2013, Chinese demand actually started to shrink, and production levels were slow to respond. Thus, in 2015, UBS calculated that China had produced 440 million metric tons more steel than it could consume that year, roughly four times Italy’s total production output. The result has been a surge of steel in global markets, driving prices down and leaving China exposed to allegations of dumping, the practice of purposely exporting a product at lower prices than what it sells for domestically, often in an effort to capture more of the global market. In 2014 alone, China was the subject of 55 percent of all global anti-dumping investigations.

Recognizing market economies
Europe must now decide whether or not to grant China market economy status, a decision that could make a difference for China when it comes to anti-dumping cases in the WTO. According to the trade agreement, if dumping takes place, the importing country can apply a tariff close to the difference between the export price and the market price as a means of protecting its local industry and preventing exporters, for example China’s steel sector, from dominating foreign markets. However, that system breaks down when the government sets the domestic price. Instead, for anti-dumping cases involving non-market economies, the WTO compares the export price, not to the offending country’s domestic prices, but rather to the export prices of a market-driven economy that is at a similar level of development. Guided by these standards, the WTO has allowed importing countries considerably more flexibility when imposing tariffs and duties on Chinese goods. (Prices for Chinese goods in these surrogate market economies are often 20 percent higher than they are in China.)

But there is some disagreement over when China’s non-market economy status expires and what happens afterward. China believes that it expires after 15 years, in November 2016, making China a market economy automatically at that point. The United States holds that recognition of China’s market economy status is up to each country and not automatic. Every country must also decide where they stand on the matter. Thus far countries supplying commodities to China’s industrial machine, generally in Latin America, Africa, Australia and Asia, have recognized it as a market economy, often as part of broader trade agreements. Japan has brought few anti-dumping cases against China, meaning the decision will not greatly affect it either way. And the United States has made its views on the matter clear: For Washington, China is not a market economy.

This leaves the European Union, China’s number one trading partner. The European Commission must come to a decision on the subject by November, but it will act before that, proposing a directive that would then have to be ratified by the European Parliament and the European Council. Thanks to pressure from the European steel lobby, the commission has already procrastinated, postponing its decision from January 2016 to an unspecified date this summer. The United States may also have had a hand in the postponement, using negotiations surrounding the Trans-Atlantic Trade and Investment Partnership (TTIP), which the commission sees as a priority, as leverage to delay the decision. However, the key factor will ultimately be not what the European institutions in Brussels think, but what the individual nations would like to happen. While the exact voting mechanism in the European Council (composed of heads of state from EU member nations) will not be known until the commission has proposed the law, it will likely require a majority rather than unanimity.

Europe chooses sides
Thus the commission looks set to begin the process by making its determination in the summer, taking into account the needs of the national governments. To anticipate the decision, it is useful to consider which countries will be hurt by China becoming a market economy and which will benefit. A recently-leaked European Commission study revealed that the number of jobs in the sectors currently helped by anti-dumping duties against China is between 73,300 and 188,300 — considerably fewer than a 2015 study which put the number between 1.7 million and 3.5 million. The newer study also revealed that more than half these jobs are located in Italy and Germany.

But recognizing China’s market economy status would also be lucrative for some countries. The fact is that China is now the world’s second-largest economy as well as a significant creditor nation. European states have some incentive to appease China to attract future investment. Near the end of 2015, the United Kingdom gave President Xi Jinping a royal reception. Visits by French President Francois Hollande and German Chancellor Angela Merkel to China quickly followed. China may be going through a slowdown at the moment, but Europe’s leaders appear to be preparing for better days, taking the flurry of diplomatic activity seriously.

Italy will be leading the camp that opposes the change in China’s status. Italian steel, which has long struggled for competitiveness, has been particularly affected by developments in China, typified by the struggles of the Ilva plant in the southern city of Taranto. The largest steel factory in Europe, the plant has been struck by below-capacity production — Italian steel production was down by 10.6 percent in the first half of 2015 — because of weak demand after the 2008 economic crisis — and by allegations of pollution that saw the plant placed under government administration in 2013. Italy also suffers from an inherent north-south political split, as the majority of Italian wealth and production is in the north, while the south remains blighted by high unemployment. The Taranto plant was built in part to help alleviate this divide by becoming an important job creator in the south. Thus Rome is politically motivated to sustain the plant, and its steel sector in general: It would have the most jobs to lose if China gained market economy status.

The United Kingdom will likely lead the opposing camp supporting China’s change in status. The British steel sector has taken issue with Chinese dumping over the last year, with recent plant closures and job cuts energizing the steel lobby. In a situation similar to that of Italy, the manufacturing areas of the United Kingdom’s north felt disenfranchised by government reforms in the 1980s, which empowered the south, specifically the financial services sector in London. But unlike Italy, the steel sector is small, currently employing 18,000 workers compared to 320,000 back in 1971. Subsequently, the relatively insignificant steel sector should carry little weight against the powerful financial services sector of London, which wants to capitalize on its burgeoning relationship with China. Any political losses caused by diminishing manufacturing jobs can be somewhat assuaged by infrastructure deals signed between the United Kingdom and China during Xi’s visit.

The rest of Europe will choose their sides as well. Scandinavia tends to favor the free market over protectionist duties, and it would not suffer many job losses as a result of China’s changing status, so it will likely side with the United Kingdom. Italy, on the other hand, may find some allies in Southern Europe, specifically Spain, which shares many of Italy’s economic issues.

The key swing nations will likely be France and Germany. In the past, the former has often sided with the south and the latter with the north. But in this case, France will not be severely hurt if China becomes a market economy, and beckoning Chinese investment might convince Paris to vote yes. Still, that is by no means certain, as protectionist instincts run deep in the country. Germany, meanwhile, views China as an important trading partner. Superior German steel and the domestic demand from its automotive industry will probably protect Berlin from any resulting economic pain following the change, leading it toward a yes vote as well.

There is plenty of time before a decision is reached, and there are still many unknowns regarding voting processes. Nevertheless, at this point the most likely result is that the European Union will grant market economy status to China in November.

© 2016 STRATFOR GLOBAL INTELLIGENCE

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