Agatha Kratz, Patrick Body Authors

Loosening Ties

March 06, 2023

Rhodium Group director Agatha Kratz discusses the shaky nature of the current EU-China relationship

Loosening Ties

The relationship between Europe and China has been deteriorating and has particularly suffered since the start of the Russian war in Ukraine. While the tensions are not at the same levels as those in the US-China relationship, there is much to discuss for business leaders, politicians and academics, from both China and Europe, if relations are to get back on track.

Agatha Kratz, director at independent research firm Rhodium Group, believes that at this point, the best that both sides can probably hope for is keeping the relationship from souring further, given profound fault lines between the two partners. She also discusses some of the issues that sparked a degradation in the relationship, current challenges with China research and data, and shifting research priorities.

Q. How would you describe the current state of the China-EU relationship and how has it changed over time?

A. The current relationship is not good, and has been deteriorating quickly in recent years. The inflection point came in 2014-2015, when European businesses started expressing promise fatigue, and pointing to deteriorating business conditions for foreign firms in China—including persistent market access and reciprocity issues. The bigger change, however, occurred in 2019, with the formulation of EU’s “three-pronged” position on China (partner, competitor, rival) and the development of a more strategic approach to Beijing. China’s sanctions on members of the EU parliament and academics then upended the EU-China “positive agenda,” which had relied heavily on the negotiation of the Comprehensive Agreement on Investment (CAI). Recently, actions taken against Lithuania, among other countries, have further ramped up tensions. So, at the moment, I would say the relationship is frosty at best and there isn’t too much hope for returning to normal.

Q. To what degree is Europe’s stance on China aligned with that of the US?

A. Europe has not fully aligned itself with US policy on China, but it has certainly come to many of the same conclusions as the US in terms of China’s policy direction. The EU’s reaction is still more centered on the economic realm, less nominally targeted at China, and somewhat more bureaucratic (rather than political), and therefore a bit more limited for the moment, but it comes from the same assessment of a divergent economic model, and deep concerns around China’s industrial, tech, self-sufficiency and foreign policies, as well as an increasing protectionism and assertiveness in many fields.

Q. How has the war in Ukraine affected European opinions on China?

A. The war in Ukraine has certainly affected opinions on China in Europe. It is not the main turning point, because so much was already happening, but it is changing perceptions in three main ways. First, by putting Sino-Russian ties under the spotlight. The consolidation of a Russia-China axis is something that is making Europeans, who are now experiencing war on their doorstep, very uneasy.

Second, indirectly and perhaps in a more long-lasting way, the war has reminded everyone in Europe of the cost of excessive dependencies on any one country. Today we’re talking about Russia and gas, but countless other European value chains, especially critical ones around green energy, are tied to China. And there is a growing understanding that the de-risking that hadn’t happened with Russia, will probably need to happen with China because Europe is currently highly dependent on China for lots of highly critical goods.

Third and finally, is the rising specter of something similar happening in Taiwan, with yet starker consequences.

Q. What are the priorities for each side in terms of their relationship?

A. The priority now is almost just to prevent too much of a downward spiral by keeping the dialogue going and making sure that both sides are speaking to each other on a regular basis. The key here is to ensure that for the big items on the international agenda, from climate to global security, to preventing global food crises, that the EU and China can have a constructive discussion.

Q. What would you say are the biggest barriers for Chinese and European businesses operating in each market at the moment?

A. The European market remains extremely open to Chinese players, much more so than the Chinese market to European ones, in terms of trade, investment and especially procurement. Given the trends I mentioned earlier, the EU has decided to develop instruments to re-level the playing field between European and Chinese firms, and to screen for national security concerns. But the way these instruments are designed is keeping the European market very much open. The aim is to put up barriers where there are concerns about Chinese companies’ ability to distort the playing field, but if competition is fair, and the level of reciprocity high, then Chinese players are very much welcome.

Chinese players do however have to manage a crisis of reputation and self-confidence in Europe. It is very possible that some Chinese players might self-censor and not dare to invest in Europe for fear of public scrutiny and the political pushback that might trigger. So there are some political barriers affecting Chinese players’ appetite, but the market remains very open to them.

Q. Why has FDI into China been going up when, geopolitically, most countries have been moving away from China? To what extent does Hong Kong play a role in these rising numbers?

A. Hong Kong is a big factor, because of the significant level of round-tripping (namely Chinese companies investing into the Chinese market through Hong Kong subsidiaries). This of course isn’t foreign investment as we usually understand it. Another key factor was the high interest rates in China in 2020 and early 2021, which triggered a wave of more speculative (or at least, financially driven) investment into China—channeled through FDI channels or within single companies. Finally, foreign investment into China has become much more concentrated around a few large foreign firms, rather than the diversity of transactions as in the past. So in short, foreign direct investment is still flowing into China, but less so than official numbers would show.

Q. How about FDI going the other way, from China into Europe?

A. That’s come down quite drastically, as is the case for all of China’s outbound investment, mostly for reasons that have to do with Chinese policy. China’s outbound direct investment shot up in the early to mid-2010s, reaching a record high in 2016. But since then it has receded, mostly because of much stronger capital controls in China. Of course, some of it has to do with policy in recipient countries too. For example, we’ve seen a very sharp decline in Chinese investment in the US, especially following the start of the trade war. And once again, there might be a level of self-censorship from Chinese players, not daring to go into the European market at the moment for fear of seeing their investment screened or even blocked. But most of the drop started and came from China’s policy change around capital flows.

Q. What have been the major results of the current global geopolitical issues on investment and decision-making with regard to China?

A. There are two main reactions that we can observe. First, a “wait and see” attitude among a multitude of smaller foreign investors, who are deciding to put China investments on pause before potentially moving to a “China plus one,” “two” or “three” strategy in future (rather than leaving altogether, which is still quite rare). The alternative approach comes from a few very large companies, such as the big German automakers, that still have an appetite for the Chinese market, because they know it so well and see huge growth opportunities on the ground. They have good local partners and know local consumers. But because of local policy and geopolitical risks, these companies are doubling down on their investment to localize it more and make it more resilient. This means investing more in local IT infrastructure, local supply chains, local innovation—to respond to Chinese localization and self-sufficiency policies, but also to shelter from geopolitical pressures.

Q. What are the main issues Rhodium is addressing in its research on China now and how does this compare to a few years ago?

A. We’re an economics shop, but one of the big changes has been the integration of much more geopolitics into our analysis. We’re following US and EU policy ever so closely, because it is a key factor in China-world trade and investment patterns. Second and crucially, we are focusing on analyzing China’s macro economic slowdown, something that we could already see happening five years ago. We’re trying to understand the structure and timeline of that slowdown, as well as specific effects on individual sectors, industries and businesses, because a wider slowdown does not mean that every sector will contract at the same rate, or even at all.

Q. To what degree does ease of access to data and information on China differ from other countries and has this changed in recent years?

A. Accessing China economic data has gotten harder recently. A key difficulty naturally was not being able to be in China (this is changing finally), which had to be replaced with constant conversations with people on the ground. It’s not perfect, but it helps you piece together what is happening. And of course it’s also quite hard even for those in China to travel sufficiently, or get relevant access to policymakers.

In terms of data series, we’ve always known that different Chinese data series had biases and issues. The bigger problem is that some of them are being discontinued, often for political reasons. This is really hard for us because we need that to be able to interpret what’s happening, and that’s even harder with fewer data series.

Fortunately, a lot of people have invested tremendous amounts of time and energy in developing alternative data series that we are trying to use effectively. These range from alternative, high-frequency indicators of railroad traffic (which we used throughout the pandemic to try and understand if and when consumption was going to pick up), to proxies for trade or construction through single industries. You just need to get more creative, while maintaining as much objectivity as possible.

Q. How do you see the relationship between China and Europe developing over the next five to 10 years?

A. In the past, our job at Rhodium was mostly to tell people what we thought the next five years of China’s economic development was going to look like. We had just one main scenario for it, based on our assessment of how much or how little reform we expect to happen. But today, this is not enough any more. Things are moving so fast and so abruptly that it is easier and more helpful to think about China’s future in terms of plausible scenarios, and signposts for whether we are moving towards one of them or the others.

The main divide in our scenario is between a reformist China and a (continuously) statist one, to oversimplify. As economists, we don’t think statism can work in the long run, without there needing to be a sharp drop in productivity and growth. In a statist scenario, besides, your key economic partners (advanced economies) will continue to push back. This is still our highest probability scenario, and clearly the most pessimistic one.

On the other hand, we also know that at key junctures throughout China’s history, Chinese leaders have taken very bold reformational steps. The launch of similar drastic reforms is therefore not out of the question—and with the current growth slowdown, the likelihood of a reformist turn increases slightly. If it were to happen, growth would probably drop in the short term, but longer term you could return to potential growth and a much healthier trendline, both economically and geopolitically.

Interview by Patrick Body

Agatha Kratz is a director at independent research firm Rhodium Group. She heads Rhodium’s China corporate advisory team, as well as Rhodium’s research on European Union-China relations and China’s economic statecraft.

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