In wrestling with its economic vulnerability to China, the EU is betting on diversification to solve its problems. It’s not the panacea it is made out to be, say Francesca Ghiretti and Hanns W. Maull.
In the most recent European Commission document on EU strategic dependencies, the term “diversification” appears no less than 28 times. It represents a key pillar of the proposed policy responses to dependence on Chinese supplies. The whole world depends on China for rare earths minerals, metals, and the magnets produced with them: China accounts for 63 percent of global rare earth oxides, 85 percent of the refined minerals, and 93 percent of the world’s magnet production. As for Europe, the newly discovered deposit of rare earths in Sweden, the continent’s largest known mineral reserve, may help to improve Europe’s resilience for the supply of rare earths.
Yet the crux of the issue is not dependence but vulnerability – the pain inflicted by disruptions in commercial exchanges, measured in economic costs, social suffering, and, possibly, political upheaval.
Vulnerability may exist even without dependence
Dependence is a rather crude yardstick for vulnerability. The European Union may depend almost completely on Madagascar for its supply of vanilla pods, yet even a complete loss of those supplies would hardly result in serious macroeconomic pain. On the other hand, vulnerability may exist even without dependence: Spain never relied on Russian natural gas supplies, but the shortfall to other European markets sharply increased the price of electricity throughout Europe, which affected Spain severely and thus revealed its vulnerability.
Vulnerability exists when three aspects combine. First, a major disruption of economic exchanges must be plausible. Second, the economic sectors affected must be constrained in their ability to adjust to disruptions by pivoting to alternative sources and/or endure reduced demand. Third, the consequences of the disruption must have a significant impact on the overall performance of the affected economy. The European Commission has conducted some of the necessary analysis of European vulnerabilities, but much remains to be done at the national level.
As a response to vulnerability, diversification has drawbacks
As a response to vulnerability, diversification has drawbacks. For corporate actors, diversification is a natural strategy for managing risks. It will happen anyway in response to market forces if the additional costs are small. Most companies are diversifying from the Chinese market – not because of a government diversification strategy on the part of their home country, but rather as a response to the market impact of China’s policies. As a geopolitical strategy, however, diversification will usually be expensive, and the costs will have to be shouldered either by economic actors (corporations, consumers) or by taxpayers, and thus should be adopted with care. In a crisis, security considerations may mobilize support for the extra expense incurred. Yet as time goes by, concerns about security of supply tend to fade into the background, and diversification becomes a high-cost alternative.
The experience of the oil crises of the 1970s is instructive here. The stranglehold of Middle Eastern exporters on world oil markets has remained to this day, as they possess huge reserves with very low production costs, and thus the possibility to offer oil at low prices trumps political risks.
If the cost of diversification is funded through subsidies or imposed on consumers through trade protectionism, this risks creating high-cost production and powerful vested interests that will push for continued protection. The EU’s Common Agricultural Policy originated in concerns about food security and ended up as a highly distorted policy of sectoral protection with a powerful lobby.
Geopolitical diversification efforts may foster a subsidy race
Geopolitical diversification efforts may also foster a subsidy race between countries pursuing that same strategy. At worst, diversification produces all those problems simultaneously, as with energy: Europe has remained dependent on fossil fuel imports and beholden to domestic high-cost coal and lignite producers and their lobbies.
Finally, diversification defines the solutions to geopolitical vulnerabilities in terms of alternative supplies and tends to crowd out alternative approaches that focus on conservation, substitution, and recycling. Conservation allows importers to make do with less, thus reducing dependence; so does recycling by offering domestic alternatives to imports. Substitution does away with the need for certain inputs through developing alternatives, with a chance of abolishing dependence completely.
Altogether, better management of demand can contribute as much to managing geopolitical vulnerabilities as alternative supplies, with the additional advantage of being more sustainable.
Diversification strategies risk supporting costly and ineffective policies
In short, there are significant complications with strategies of diversification. They are intuitively appealing and therefore easily garner political support, but they risk ending up supporting costly and ineffective policies. Given the lead times involved in developing alternative sources, they also represent a structural, long-term response to geopolitical vulnerabilities that will likely erupt suddenly.
While it is hard to predict the responses of economic actors to disruptions precisely, there are steps that both corporations and governments can take to enhance flexibility, and thus resilience. One is stockpiling, including strategic stockpiles owned or mandated by governments. Another is to encourage innovation. Flexibility can also be wired into manufacturing systems at all levels, thus enhancing resilience, often at relatively small expense.
The EU Commission approach tends to equate strategic dependence with vulnerability
In its efforts to assess the problems and develop policy responses to European vulnerabilities to supply shortages, the EU has been well ahead of many of its member states, including Germany, its largest economy. As part of the EU’s update to its New Industrial Strategy, the EU undertook an assessment of its strategic dependencies in 2021, followed by an in-depth review in 2022. The Commission approach tends to equate strategic dependence with vulnerability and to look toward diversification as the key response. It includes the national security sector, where the issues are fundamentally different. The notion of “strategic” dependency obscures that difference and lends itself to abuse.
Thus, while the European space industry may be important from a national security perspective as well as for reasons of prestige and industrial innovation, it hardly deserves to be treated as a priority in terms of economic security. Also, the EU policy responses emphasize industrial policies and international cooperation with partners with similar concerns. Both are important, but policies that target the demand side receive much less attention. This risks an expensive misallocation of funds through investing in non-competitive industries and forgetting about industries where the EU is stronger.
In the end, the European Union can do only so much to identify and address the risks of European vulnerability to economic disruptions; the bulk of the work needs to be done by the member states. Stockpiling deserves much more attention than it has received so far, because it buys time for adjustments both at the European and at the member state level.
One important precedent for coordinated stockpiling policies exists with the Emergency Oil Sharing System of the International Energy Agency. This agreement sets targets for national oil stockpiling, stipulates compulsory conservation efforts in the event of a major disruption, and provides for a redistribution of available supplies to the benefit of the most seriously affected countries. It could serve as a model for European efforts to reduce vulnerabilities in its commercial dealings with China.
This article was first published by The Diplomat on January 27, 2023.
In addition, this article was published in Spanish by Política Exterior on February 1, 2023.