Agatha Kratz, Janka Oertel
These firms are able to undercut European companies both in the EU and around the world, including in sectors key to Europe’s future economy and security, from energy to telecommunications.
The EU urgently needs to incorporate the concept and reality of this ‘protected home market advantage’ into its thinking on China.
Europe can defend its own industries by adopting an integrated policy approach, working with like-minded partners around the world, and even prising open closed parts of China’s domestic market.
The EU should also look to enhance its single market – both as a defensive measure and a way to improve its strategic sovereignty.
Introduction
At the tail end of 2020, the European Commission and the Chinese government announced the conclusion in principle of a Comprehensive Agreement on Investment (CAI). When sharing news of the deal, Brussels took pains to underline the commitments it had obtained from Beijing to open up more of China’s market and industries to European firms. Sectors due to open up included healthcare, ‘new energy vehicles’, and financial and cloud computing services. For years, European businesses had been complaining about China’s protection of a range of sectors that are partially or fully closed to foreign competition. Their complaint was that a lack of reciprocal openness in trade and investment relations has meant that European companies have missed out on opportunities in the huge and fast-growing Chinese market. Firms had pinned their hopes on an ambitious investment agreement to open the Chinese market further.
These concerns are valid – but they miss part of the picture. A protected Chinese home market has important consequences beyond revenues foregone. It is also an opportunity for Chinese firms to leverage the vast size of China’s market to build scale, amass profit, and improve productivity, technical capabilities, and product design and quality – all with limited or no pressure from foreign competition. This then enables some of these firms to enter foreign markets on a strong financial footing and to sell tried-and-tested, more tailored products at highly competitive or below-market prices. And it facilitates further international expansion and pursuit of global market share, at the expense of European firms.
Cultivating a large, protected home market as a beachhead for international expansion is hardly a new idea – it was the development model of many industrialised economies in the nineteenth and twentieth centuries, from Germany to Japan. Many of these practices were eventually rolled back due to external pressure, and because of their mixed track-record of producing truly competitive national champions in the long term.
But, for Western countries and businesses, waiting for China to ‘normalise’ its behaviour and open up its economy is a risky choice. Firstly, the size of China’s market – the largest globally for a wide range of goods and services – means that such practices have the potential to do significant permanent damage to European firms. Just over a decade ago, Chinese solar panel manufacturers decimated the German photovoltaic industry by offering their products at extremely low prices. Most of that price advantage derived not from state support but from significant economies of scale that these manufacturers secured as part of a large, protected home market. China’s scale is not a problem in itself. But, combined with restrictions on foreign participation, it can do lasting damage to foreign firms and markets.
Secondly, while many of China’s local industries are open to foreign competition, and not all sectors display higher efficiency as they grow in size or scale, market protections in China tend to be stronger and more prevalent in strategic high-tech industries – many of whose efficiency does increase with scale. The large and protected Chinese home market could, therefore, have particularly severe consequences for a string of sectors that are key to Europe’s future, from green technologies to connectivity equipment, to digital industries. In any case, China’s latest policy announcements, including its recently published 14th Five Year Plan, make clear that Beijing intends to continue protecting and promoting local firms in strategic sectors, curbing hopes for short- or even medium-term normalisation.
Thus, it is time for the European Union to integrate an understanding of China’s ‘protected home market advantage’ – the advantages that derive from the combination of a large and restricted home market – into how it defends and promotes European industrial competitiveness and economic prosperity. Despite the implications of this advantage, it is not yet fully embedded into the European Commission’s work on how Chinese market distortions affect the European market. It does not formally fall within the scope of last year’s Commission white paper on foreign subsidies, for example, despite the fact that the distortions arising from this advantage have much the same effects. Nor is it resolved by the CAI, which secures formal openings in some sectors but leaves many either closed or partially closed and includes myriad exceptions. In any case, the agreement’s effectiveness depends on whether China is ultimately willing to implement its commitments to a level playing field. And, of course, given recent EU-China tensions, the agreement may not even be ratified.
This paper introduces and describes the advantages Chinese firms derive from the combination of a large and protected home market in strategic sectors. It seeks to contribute to European policymakers’ thinking about how China’s market distortions affect EU firms and consumers. It does so, firstly, by providing a short overview of the key features of China’s protected home market advantage. It then points to how this advantage plays out in three industries in China. Finally, it lays out the ways that the EU might respond to this challenge. The paper aims to raise awareness of the issue as European decision-makers consider one of the major challenges of our time – how to manage Europe’s economic engagement with China in the twenty-first century.
China’s protected home market advantage
Increased competition is an important characteristic of China’s reform era, which began in the 1980s. China’s economy has not only marketised prices, economic resource allocation, and business practices, but has also significantly opened up to foreign trade and investment. In the past decade, however, such efforts have slowed. Beijing has facilitated inward investment procedures, allowed foreign firms and brands to gain a major foothold in areas ranging from luxury goods to pharmaceutical products, and continued to open up new sectors such as financial services to foreign capital. But, in a variety of industries, the Chinese market remains partially or fully closed to foreign players.
Beijing still formally prohibits foreign activities in sectors that range from film production and social media to printing and publishing. It also uses trade barriers or joint venture requirements to condition market access in sectors such as general aviation and telecommunications services. Importantly, it continues to block foreign competition in specific industries through informal barriers such as deliberately favouring domestic players in public procurement, ensuring slow or selective delivery of licences and permits, or by imposing domestic standards that make it costly for foreign players to enter a market. Altogether, formal and informal restrictions on foreign activities make China a significantly more restricted market than the EU or the United States. This is particularly true for high-tech sectors that China’s industrial policy designates as priority areas, in which Chinese firms have established monopolies – at the expense of their foreign competitors.
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