Understanding commercial relations between China and the EU, August 2008

The expansion of commercial relations between China and the European Union constitutes a signal development in the global economy. Sino-European trade has increased 60-fold since the PRC’s opening in 1978. The EU is now China’s leading foreign trade partner, surpassing the United States and Japan.

 

China is the EU’s foremost supplier of office machinery, textiles/apparel, and telecommunication products. Cross-regional financial links are also deepening, as European companies exploit WTO-mandated liberalization of China’s banking sector and Chinese investors enlarge their stakes in EU financial institutions. Chinese and European small and medium enterprises are also increasingly looking to each other’s markets for profitable growth.

 

ThisSino-European relationship is highly asymmetrical. Chinese exports to the EU dominate cross-regional trade, creating large imbalances that have become a source of friction between Beijing and Brussels. At the same time, once-robust flows of FDI (foreign direct investment) from the EU to China have plummeted as European investors reallocate funds to other emerging markets.

 

These developments illustrate the growing complexity of Sino-European relations and demonstrate the challenges facing EU and Chinese companies pursuing cross-regional commercial opportunities.

 

China overtook the United States as an importer to the European Union in 2005. EU exports to China have also grown rapidly during the 2000s (13.1 percent CAGR between 2002 and 2007). However, EU exports to China lag far behind export sales in the United States (still the primary destination of EU exports despite the current downturn) and the Russian Federation (now the EU’s most rapidly growing export market). 

 

The result is a burgeoning trade deficit which, at 160 billion Euros in 2007, is the EU’s largest trade imbalance. Mounting concern over the deficit has precipitated skirmishes over a range of trade issues including product safety, dumping and GMOs (Genetically Modified Organisms).

 

Further aggravating these trade disputes are the EU’s concerns over Beijing’s policies in Tibet and their broader human rights record. These concerns have impaired political relations and prompted the European Parliament to urge EU leaders to boycott the opening ceremony of the 2008 Olympic Games.

 

China’s 2002 accession to the World Trade Organization (WTO) yielded a significant liberalization of the country’s vast market. The PRC reduced import duties on a wide range of manufactured goods and agricultural products. Furthermore, recent WTO-mandated changes in China’s trade and investment laws have opened finance, professional services and other sectors to foreign commerce. However, European companies still face high barriers to entry in China.

 

A 2006 report by the European Commission estimated that EU businesses lose 20 billion Euros annually as a consequence of market access problems in China. These barriers include enforced joint venture partnerships, local content requirements (preventing European multinationals from fully utilizing homebased vendors to supply their Chinese subsidiaries), preferential licensing of local companies in key industries and intellectual property rights.

 

Chinese and European officials are negotiating a new EU-China Framework Agreement, which replaces the original 1999 pact and which aims to accelerate China’s convergence toward WTO norms on intellectual property rights, customs regulations, technical barriers to trade, sanitary measures, and related issues. The aim is to significantly reduce market barriers to China, which should offer European exporters grounds for optimism.

 

EU-China trade is not only highly imbalanced on the aggregate level. Cross-regional trade is strongly skewed towards a single EU country; Germany is both China’s largest European exporter and importer of Chinese goods.

 

While overall trade turnover between China and other EU countries (France, Italy, Netherlands, United Kingdom) is growing, export companies headquartered in those states have achieved much less success in China than their German counterparts. The gaps between the export and import growth rates of U.K, Italy, and Netherlands are striking, highlighting the sources of the huge Sino-European trade imbalance.

 

Also noteworthy is the deepening of commercial ties between China and Central and Eastern Europe. Starting from a low base, Chinese exports to the CEE-10 are rapidly growing, with three countries (Czech Republic, Hungary, Poland) accounting for nearly three-quarters of PRC exports to that region.

 

Export-oriented companies headquartered in Central and Eastern Europe enjoy important growth opportunities in China, especially high-technology companies occupying specialized market niches (e.g., advanced manufacturing and professional services) in which Chinese demand is strong.

 

Machinery represents the largest sphere of Sino-European trade. The EU’s trade deficit in that category stems from wide gaps in machinery export growth rates, especially specialized industrial machinery (27.7 versus 3.5 percent CAGR), metalworking machinery (18.4 vs. 10.8 percent), office machinery (15.8 vs. 4.6 percent), and electrical machinery (14.1 vs. 9.9 percent).

 

China received USD 128 billion FDI in 2007, fourth behind the United States, United Kingdom, and France and the largest FDI inflow of any emerging/developing economy. The Economist Intelligence Unit projects average annual FDI inflows of USD 135 billion through 2011, a trajectory that would vault China ahead of France and the U.K. in the global bidding for foreign investment. For this reason, the dramatic falloff in EU investment in China is surprising.

 

The magnitude of the recent decline in EU-Chinese investment is cause for concern. However, China’s huge size, high GDP growth rate, and large installed European investor base make it very likely that EU companies will eventually reprioritize the country in their foreign investment strategies. Such a resumption of EU investment in China hinges on the results of the ongoing discussions between Beijing and Brussels on the new EU-China Framework Agreement.

 

In addition to its centrality as a foreign investment locale, China has become a major source of outbound FDI. EIU forecasts annual FDI outflows from China of USD 94 billion through 2011, third behind U.S. and France and ahead of U.K., Germany, Netherlands, and Japan.

 

Notwithstanding these trends, Eurostat reports very modest inflows (USD $1 billion) of Chinese FDI in the European Union, 10 percent the amount originating in India. This figure excludes outbound investment from Hong Kong (which functions as an entrepôt linking mainland China and external markets) and Chinese-based sovereign wealth funds, (often amounting to USD billions in assets and whose portfolios are increasingly investing in Europe.

 

A recent survey by the European Commission (“Observatory of European SMEs”) reported that 90 percent of small and medium enterprises in the European Union do no exporting at all. Another study published by Bruegel (“The Happy Few: The Internationalization of European Firms”) found that outbound foreign trade and investment is concentrated in a handful of high-performance companies. The Bruegel study also found that the members of this exclusive club of European superstars reap substantial gains from internationalization: Greater profitability, higher productivity, greater value added and higher wages.

 

These findings underscore the opportunity costs facing European middle enterprises that fail to exploit growth opportunities in China and other foreign markets. To rectify that problem, the European Commission is launching a European Centre in China for Small and Medium Enterprises. The proposed center would facilitate trade, disseminate business intelligence, and provide other services to EU-based SMEs seeking to export and/or invest in China.

 

European middle enterprises contemplating entry to the PRC are also well advised to engage local advisors to manage the cultural dimensions of international business in China, which have proven vexing even for large EU multinationals with extensive global experience.

 

To read the full report you can download it here