The electric vehicle revolution comes for German industry

MUNICH — At September’s IAA auto show in Munich, German Chancellor Olaf Scholz appealed to domestic car manufacturers, urging them to welcome competition from Asia rather than trying to curb the influx of Chinese-made electric vehicles (EV). No other country, he insisted, could match Germany’s automotive engineering expertise. But while Scholz’s assertion was certainly true in the golden era of the internal combustion engine, Germany lacks the expertise required to compete directly with Chinese manufacturers on EVs.

European automakers have been slow to embrace the EV revolution. Volkswagen, for example, faced setbacks in China during the COVID-19 pandemic. By the time China started to reopen, homegrown brands like BYD and Nio had doubled the number of electric models they offered. And most of these vehicles were not only cheaper, but also superior to Volkswagen’s offerings.

As German carmakers grapple with high-energy prices in the wake of Russia’s energy embargo, Chinese car makers are setting their sights on Europe. In a historic shift, 2022 marked the first year that Europe imported more cars from China than it exported to the country.

The shift away from the internal combustion engine presents a strategic opportunity for China, whose carmakers already dominate the global markets for batteries and clean-energy technologies. Europe’s manufacturing sector, especially Germany’s, could soon face a “China shock” comparable to the one that followed China’s accession to the World Trade Organisation in 2001.

The stakes are enormous. As Gideon Rachman notes, if “Chinese BYDs replaced German BMWs on the autobahns”, far-right illiberal parties, adept at capitalising on economic grievances, could see their popularity soar. The automotive industry provides nearly 13 million direct and indirect jobs, accounting for nearly 7 per cent of the European Union’s economy and roughly one-third of its total research and development spending.

The prospect of China securing dominance over yet another industry has raised alarm bells in the United States and the EU. The US imposed a 27.5 per cent tariff on Chinese-made cars under former President Donald Trump, and the Inflation Reduction Act, enacted by President Joe Biden’s administration, includes incentives for producing cars and batteries within North America.

For its part, the EU has imposed a 10 per cent tariff on imported cars. While European national subsidies for EVs still apply equally to imports and domestically manufactured models, European Commission President Ursula von der Leyen recently announced an anti-subsidy investigation into Chinese-made EVs, alleging that they might be “distorting” the European market. European companies are often “excluded from foreign markets” and “undercut by competitors benefitting from huge state subsidies”.

The EU investigation is long overdue, but it might still have a meaningful impact. Over the past two decades, the Chinese government has heavily subsidised its EV industry, dominating the supply chain, from raw materials to production. By subsidising electric and autonomous vehicles, China distorts competition and provides its domestic industries with a lasting comparative advantage.

In industries characterised by learning curves and dynamic Economies of scale, past output determines current production. In a paper that introduced the concept of learning curves into trade models, Nobel laureate economist Paul Krugman showed that subsidies could speed up the learning process and boost the productivity of subsidised sectors, thereby putting competitors at a permanent disadvantage.

Krugman’s theoretical argument has recently found empirical support in a research paper by Oxford Economist Nathan Lane. Using South Korea’s sector-specific industrial strategy under President Park Chung-hee as a natural experiment, Lane found that, on average, subsidised industries experienced an average growth rate 80 per cent higher than non-subsidised ones. Crucially, this growth advantage persisted even after subsidies were lifted, underscoring the learning effects.

With more than a decade of experience in EV production and bolstered by government subsidies, Chinese car manufacturers have a significant lead in this market over their European counterparts. But implementing temporary import tariffs could give European car makers the breathing space they need to go down the EV learning curve, while penalising China for violating WTO rules.

As I recently argued, Germany could bridge the knowledge gap in EVs and autonomous cars by reverse-engineering China’s industrial policy. Over the past 20-30 years, China attracted foreign direct investment through joint ventures, particularly with German car manufacturers. This strategy, which enabled China to master the internal combustion engine, also helped it become a global leader in the EV market.

By working with Chinese EV and battery manufacturers, German auto makers could acquire the technical expertise required to remain globally competitive. The European Commission could broker such partnerships, providing China with access to its market in return for a commitment to invest in Europe and establish joint ventures with European firms.

Dalia Marin, professor of International Economics at the School of Management of the Technical University of Munich, is a research fellow at the Centre for Economic Policy Research and a non-resident fellow at Bruegel. Copyright: Project Syndicate, 2023. www.project-syndicate.org