EU Economic Security Strategy Should Prioritize Mitigation of Import-Related Vulnerabilities – Here is Why and How (2023)

The cross-border flow of goods, services, capital and data gives rise to a variety of economic vulnerabilities and risks. Vulnerabilities afford other countries to exert geo-economic leverage by threatening to impose significant costs. Risks hold the prospect of systemic disruption and significant economic costs in the event of a broad-based disruption of international economic relations. 

Economic security is also closely tied to national security in terms of a government’s ability to maintain control over its critical infrastructure (in case it is foreign-owned), prevent the leakage of key technologies and retain the ability to maintain access to, or produce goods and services critical to the overall economy, national defense and other critical sectors, such as health.

Mitigating economic risk is costly and not all risks need to be maximally minimized. It is therefore important to identify the most critical systemic risks and prioritize their mitigation in the context of a broader economic security strategy. Broadly speaking, critical vulnerabilities should be reduced to the maximally acceptable level, while non-critical vulnerabilities can be managed through less costly deterrence policies. 

The government has an important role to play in ensuring national economic security. To paraphrase Georges Clemenceau: economic security is too important to be left to the market (alone). In cooperation with the private sector, the government should establish a risk review process to identify and assess systemically relevant risks and coordinate, guide or lead respective risk mitigation policies, particularly in areas where the private sector does not have the ability or willingness to mitigate national level risk sufficiently. Managing firm-level risks does not always translate into low risk at the systemic level. The government is tasked to ensure national-level systemic economic and financial stability.

Aside from national security and technology leakage risks related to the foreign ownership, forced technology transfer related to overseas direct investment and risks related to cyberespionage as well as cyberattacks against critical infrastructure, import-related vulnerabilities bear the greatest potential for systemic economic disruption at the national level. 

Risks related to cross-border financial claims translating into losses can be managed through the implementation of a rigorous country risk management process at the firm level. If need be, it can be backstopped by the government to avoid broader disruption in cases where a firm is deemed systemically relevant. The risk arising from foreign import restrictions is also manageable, as few countries will want to risk a full-blown trade war with the EU. The risks related to German companies owning foreign subsidiaries only represent a systemic problem if they are a critical part of the German economy’s international supply chain (and there are no or few substitutes available). This risk be addressed with the help of supply chain reengineering and diversification.

The greatest systemic source of economic risk is related to critical imports that are essential to the proper functioning of the German economy or critical economic sectors, like defense or health. Import-related risk would cause maximum damage in case of major systemic economic disruption to international, such as an international war (e.g. Taiwan). Import-related risks can be mitigated in a variety of ways.

Cross-Border Trade and Finance Related Economic Risks

 

	Vulnerability	Geo-Economic Deterrence	Short-Term Defense	Medium-Term Defense
Import-related vulnerabilities	Export controls => loss of access to critical imports cascades through national economy or negatively affects the production of essential goods (e.g. defense, health)	Leverage coercer’s own critical vulnerabilities (esp. “cost-effective” import-related vulnerabilities)	Stockpiling of critical goods	Diversification   Innovative substitution   Reshoring
Export-related vulnerabilities	Import restrictions => reduced exports and economic efficiency and growth losses	Germany/ EU have significant deterrent/ retaliatory powers vis-à-vis third parties, given their importance as an export market to third parties	Create fiscal space to buffer short-term demand impact	Negotiate and deepen free-trade agreements
Vulnerabilities related to cross-border financial claims and flows	Seizure, expropriation etc. => financial losses due to impairment of the value of foreign claims   Reduced ability to engage in international trade and finance in case of currency sanctions	Germany/ EU hold financial “collateral’ in the form of foreign investment in EU (esp. government debt)	Rebalancing foreign financial claims	Strengthen country risk management at individual firm level   Strengthen Economic and Monetary  to provide safe assets   Advance capital markets union to make euro more attractive
Foreign direct investment related vulnerabilities	Financial losses    Supply chain- and import-related risks    Technology leakage   National security risks related to foreign ownership of critical infrastructure	Germany/ EU hold financial “collateral’ in the form of foreign investment in EU	Tighten regulation and supervision of critical companies and sectors   Tighten restrictions on foreign investment in critical sectors   Force foreign owners to divest critical companies	Diversification   Tighten restrictions in technology/ national security relevant sectors, broadly   Tighten regulation and  supervision of critical sectors   Strengthen counter-espionage and cyber-defense capabilities of critical companies and sectors

 

Mitigating import-related vulnerabilities

Government policy should prioritize the mitigation of import-related dependencies. Among all the various economic vulnerabilities, import-related dependencies are not only economically the most disruptive, but they are also more likely to be exploited by geo-economic adversaries. Mitigation policies include:

Stockpiling. Stockpiling critical inputs helps buffer the impact of supply shocks and it reduces the ability of geo-economic adversaries to exploit import-related dependencies by buying time to take other mitigating actions. The government can provide financial incentives to the private sector to stockpile critical goods, or the government can set mandatory targets. In the case of extremely important commodities, such as energy, the government might want to get more directly involved in the purchase and storage of critical goods. It could also consider entering into swap and insurance agreements with other government engaged in stockpiling critical commodities. Lastly, the government could consider setting up an international buyers’ cartel. This should help reduce the risk of “panic buying” and of bidding up prices unnecessarily in the event of international supply bottlenecks.

Diversification. Import diversification reduces the risk of economic disruption and curtails the ability of a geo-economic adversary to exploit import-related dependencies. Diversification should be primarily led by private sector. But the government can actively support diversification by providing financial incentives (e.g. subsidies, tax credits) and by negotiating enhanced market and investment agreements with other countries. More intrusively, it can pursue government-to-government supply deals and even, if necessary, impose minimum mandatory diversification thresholds in critical economic sectors.

Reshoring. Reshoring seeks to reduce risks to a disruption of imports by producing critical goods domestically. This will tend to require moving the entire upstream supply chain onshore. This is generally very costly. While it lowers the risk in terms international disruption, concentrating production onshore may increase the risk of other types of domestic disruption. This needs to be taken into consideration when devising reshoring policies. Reshoring is worth considering, however, particularly in critical sectors, such as defense or health.

Innovative substitution. Innovative substitution seeks to find substitutes for critical imports over the medium term through the development of new, alternative goods. Government can provide incentives to subsidize to the private sector to engage in research and development. War economies have often proven adept at finding, even relatively quickly, substitutes to sustain critical production, even if they often proved of lower quality and higher cost. Alternatively, reusing and recycling critical commodities can also help reduce import dependence.

Deterrence. Deterrence seeks to dissuade politically motivated attempts to disrupt imports rather than mitigate the impact of global systemic disruptions. Deterrence policies should be well-calibrated in terms of the potential geo-economic coercer’s politically most salient economic vulnerabilities (including its import-related vulnerabilities). Targeting import-related vulnerabilities is generally most cost-effective than opting for broader retaliatory measures. However, deterrence can and does fail, and this is particularly true with respect import-related dependencies, which often provide for cost-effective coercion (e.g. Arab state oil embargo).

See also: Germany Needs an Economic Strategy that Prioritizes the Mitigation of Import-Related Vulnerabilities

Shifting Global Income Shares and the Balance of Economic Power in Asia (2023)

The rising share of emerging Asia in global output has come almost entirely at the expense of the G7 countries. Asia’s rising share of global income has been primarily driven China, which helps explain the rise of the US-China antagonism. Just read your Paul Kennedy and Robert Gilpin. 

In the 1980s, the world’s leading industrial nations (or G7) accounted for 50% of global GDP on a purchasing power parity basis. In 2022, their share had fallen to 30%. By contrast, the GDP of emerging and developing economies is almost 60% today. Emerging Asia, including China, accounts for the bulk of emerging and developing economy. Emerging Asia’s share of global income makes up 33% versus the G7’s 30%. China alone accounts for nearly 19% of global GDP. The share of all other emerging regions has been virtually unchanged over the past forty years. The share of income of Emerging Europe, Latin America and the Middle and Central Asia not only remain well below 10%, but their shares have barely moved at all in the past couple of decades. 

Large growth differentials account for the change in global income shares. China averaged real GDP growth of 8.4% year in the past two decades. India averaged 6.8%. The G7 countries eked out a modest 1.5%. Large growth differentials reflect different levels of economic development with poorer countries benefitting from a greater growth potential due to their greater distance from the technological frontier. Despite their growing shares of global income, per capita incomes remain far below those of the advanced economies. Chinese per capita income (adjusted for purchasing power) is $23,000, compared to India’s $9,000 and America’s $80,000. 

During the remainder of the decade, emerging economies in Asia will continue to outperform all other regions, though the extent of this outperformance will heavily depend on China’s performance, which will continue dominats Asian GDP aggregates. All emerging regions will outpace the G7 in terms of economic growth. Emerging Asia will continue to register the strongest growth among all emerging regions and will continue to increase its share of global GDP more than any other region, once again largely at the expense of more slowly growing G7 countries. Although the Middle East and Sub-Saharan Africa are projected to put in a decent growth performance, in aggregate it will fall far short of Asia’s. Growing from a much lower base than Emerging Asia, the non-Asian emerging regions will fail to make any meaningful gains in terms of global income distribution. 

According to the IMF, EM Europe and Latin America are set to grow 2.5% over the next five years. The Middle East and Sub-Saharan Africa will generate around 4% growth, and Emerging Asia slightly less than 5%. Emerging Asian growth will heavily depend on China’s near-tern growth trajectory, as China account for more than half Emerging Asia’s GDP. Finally, the G7 countries will grow a little less than 2%. The income share of the G7 countries will continue to slide and reach 27% by 2030, while EM Asia will reach 37%. The income share of Latin America and the Middle East will remain below 8%. Sub-Saharan Africa’s share will remain below 4%. Low, lower-middle and upper middle-income have registered an average real GDP growth rate of 1.6%, 4.2% and 4.6% over the past ten years, while high income countries grew 1.6%. This patterns is not going to change significantly over next decade.

The North Atlantic and the North Pacific will continue dominate global economic production, but the center of gravity will shift, if very slowly to somewhere between China and South Asia during the latter half the century. In the short term, the continued shift from the “West” to the “East” will largely, but not exclusively depend on China’s economic performance. Despite significant challenges in terms of rebalancing its economic growth model, China is highly unlikely to grow less than the United States or the G7 countries. A relatively low per capita income should enable China to generate annual growth rates exceeding those of America and Europe and hence increase its share of global GDP. Its relative income share will therefore continue to increase. Meanwhile, India’s economic growth now exceeds China’s, which will also contribute to Emerging Asia’s growing share of the global pie, particularly as India weight increases over time. 

In the short- to medium-term, this continued economic shift will – all other things equal – lead to more intense US-Chinese geopolitical competition. While China will continue to outgrow the US, the rate at which it will so will decline. To the extent that India is moderately aligned with the United States and has antagonistic relationship with China, it will make an ever greater contribution to maintaining the economic balance of power in Asia. India’s share of global income will continue to rise, first slow, then more rapidly. As Chinese growth will also continue to slow over the medium, all of this will likely translate into stable economic balance of power. Or put differently, the growth dynamics are not such that they will prove massively destabilizing, as they might do if US growth were to slow materially and China continued to grow 6% a year over the next fifty year.