Octavian Canuto | The global subsidy war

Janet Yellen, Secretary of the Treasury of the United States, sent a message to China on Wednesday (27 March 2024) demanding that it not flood the world with cheap exports of clean energy, because this would distort global markets and harm workers abroad. In a previous article, published in this Poder360I discussed how the existence of ample idle capacity and consumer restraint in China are part of the challenges faced for higher economic growth in the country.

Exports, as in the past, may well be the means sought to resolve insufficient domestic demand. It is no coincidence that everyone closely follows the evolution of the Chinese exchange rate to see if there is devaluation. In addition to Yellen, officials from other major advanced economies have occasionally referred to a potential flood of Chinese goods.

Xi Jinping, for his part, has referred to clean energy and other high-tech sectors as the main path to the country’s prosperity. As I have also discussed here, in fact, China is now ahead of the United States and Europe in technological rivalry in clean energy. It is no wonder, therefore, the frequent reference to Chinese exports and subsidies in the area by US and European authorities.

The fact is that large-scale subsidies have proliferated, in a race to subsidize so-called “strategic” sectors. In response to China’s subsidies, the Inflation Reduction Act (IRA) and the Chips and Science Act, passed in the United States Congress, implemented attractive subsidies for the local production of clean energy and semiconductor products and equipment. Volkswagen called it “a rush for gold” when it announced its decision to build an electric vehicle (EV) factory in South Carolina.

With the argument of supporting investments to combat climate change and reduce the country’s healthcare costs, the IRA includes huge subsidies in the form of tax incentives, grants and loan guarantees to bolster the US manufacturing industry. Although some of the subsidies, particularly those related to batteries for EVs, are available for investments in countries with which the US has a free trade agreement, their scope and value are lower than those available to companies that commit to manufacturing within the country.

Likewise, the Chip Act aims to subsidize a revival of the US semiconductor industry. As I have already discussed here, the US lead in the sector concerns core technology and equipment, with massive production of advanced semiconductors taking place in Taiwan, South Korea and the Netherlands. The law aims to reduce dependence on Taiwan in the event of a crisis in that country. The IRA alone, in turn, originally estimated at US$385 billion, is expected to reach US$1.2 trillion according to analysts.

The EU (European Union) responded – or has been trying to do so. The EU expressed almost immediate concern about the IRA, with protests focusing on provisions that bolster domestic production. The president of the European Commission, Ursula von der Leyen, called for the creation of an ESF (EU Sovereignty Fund) to directly combat the effects of the IRA.

Ursula von der Leyen stated that the EU needs to take into account “How are our so-called ‘like-minded partners’ proceeding in the ongoing industrial and technological race”. The EU had to change regulations easing restrictions set out in rules limiting national government subsidies to industry. For the first time, national governments of EU member states can match subsidies offered outside the EU if there is a risk that a project of “strategic importance” is likely to be carried out elsewhere.

In addition to defending itself against the IRA, the EU is obviously concerned about China. Its automobile industry has its eyes on the penetration of Chinese EVs, whose production has already been announced in Hungary. Declarations of intent to establish trade restrictions in response to Chinese subsidies have been made.

South Korea and Japan have also implemented their own responses to foreign subsidies. Korea, after initially describing incentives for US-made EVs and batteries as a “betrayal”, received updated IRA guidance from the US Treasury which extended some tax incentives to them. Japan also obtained a similar agreement, qualifying its batteries and EV components for IRA incentives.

Leading battery and semiconductor companies from both countries are planning new factories in the US to ensure they continue to receive US subsidies as local content requirements under the IRA become more stringent over time. However, both the South Koreans and the Japanese recognized that US subsidies also pose a threat to their own domestic industries. Both pursue a dual strategy that encompasses the incentives available in the context of the IRA while implementing their own national subsidy policies to protect key sectors.

Even Australia, which has a free trade agreement with the US and little industry to protect, has decided to enact a subsidy program that seeks to bolster areas such as batteries and the processing of critical minerals considered strategically significant.

Judging by announcements and initial investments, the effect of incentives on U.S. supply chains has been intense. Mexico – a US free trade agreement partner and therefore an IRA beneficiary – replaced China as the biggest exporter to the US last year, the first time since 2006 that it was not the biggest. There is a realignment of global trade underway.

Any economic assessment of the costs and benefits of these subsidy programs faces an inherent difficulty when taking into account that the results sought are not strictly economic. There is a risk that countries, especially the US and China, will adopt ever broader definitions of what constitutes a strategic sector, triggering new “global subsidy wars”. So much worse for countries without fiscal space to, if they want, compete in sectors “cutting edge strategies”.