The Strategist

On the state of European trade

International trade is an economic pillar for European countries that has become increasingly important in recent decades. According to the World Bank, the share of trade (exports plus imports) in GDP of EU members has risen from 40% to 106% over the past 50 years, reflecting the benefits of free trade within the Union and beneficial trade agreements with the rest of the world. Within the EU, the trade share in 2022 ranged from 73% in France to 389% in Luxembourg - the highest dependence on trade in the world. In contrast, the trade share is only 27% in the US and 38% in China, making European countries appear extremely dependent on trade. Is this a problem?

Date
Author
Dr. Felix Kapfhammer, Economist
Reading time
10 minutes

The Strategist EU trade
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Careful - fragile!

Economists regularly preach the benefits of trade through comparative advantage: Nations benefit from exporting goods and services they can produce at relatively low cost and importing what they can only produce at relatively high cost. While this is true in practice, it depends on the stability of trade. Since the beginning of this decade, two events have already caused deep disruptions to European trade: the pandemic and the Russian invasion of Ukraine. Both severely affected European exports and imports, leading to the recent wave of inflation and economic stagnation. European economies will eventually recover from these shocks, but energy costs are likely to remain high for years to come as Europe reduces its dependence on cheap Russian energy imports. The dramatic events illustrate the fragility of trade and the dangers of import dependence. At the same time, the absence of trade has highlighted its substantial benefits in terms of low producer and consumer prices and higher economic growth. 

Reducing import dependence

The above examples suggest that Europe is vulnerable to trade disruptions. However, the vast majority of its exports and imports take place within the EU. Given the impressive stability of the EU's internal market, the economic vulnerability of intra-EU trade is negligible (excluding general business cycle fluctuations). If only extra-EU trade is taken into account, the EU's trade share falls to 25%, slightly less than that of the US. However, Europe's vulnerability lies in its lack of natural resources, especially fossil fuels, which it has to import. To address this weakness, policymakers have recognised the need to diversify energy imports and reduce dependence on any one country. Initiatives such as the construction of LNG terminals to import natural gas are already underway. In the long term, the transition to renewable energy could drastically reduce the problem of energy imports, paving the way for the alternative to import diversification: onshoring. 

Both the US and the EU are currently trying to lure back vital industries such as semiconductor and renewable energy manufacturing by offering substantial subsidies. While onshoring ensures more stable supply chains and provides security against geopolitical tensions, it typically comes at the expense of trade benefits, implying price inflation and lower economic growth. Therefore, onshoring should be seen as a last resort.

Navigating trade relations

The US and China are the EU's largest trading partners, followed by the UK and Switzerland. Trade relations with Western countries remain stable, but the situation with China is different. While trade with China offers great potential due to its size and rapid growth, Europe increasingly perceives the emerging power as a serious competitor rather than a market. In many sectors, from information technology to renewable energy and automobiles, China has moved from replicating to innovating products and is slowly taking market share from Europe around the world. Beyond the economic threat, political tensions between the West and China have risen as China's power has grown, dampening trade prospects. Yet Europe and China have strong incentives to keep their trade relationship working. At the same time, Europe has already looked southwards in Asia and is currently negotiating free trade agreements with India and a number of Southeast Asian countries. Fruitful negotiations would give the EU better access to alternative markets and reduce its dependence on China.

Mail from the US

The upcoming US presidential elections in November could potentially affect trade with Europe. While a Biden administration would likely maintain the favourable trade relationship with Europe, Trump has already threatened to impose a 10% tariff on all US imports (the average tariff on EU imports is currently around 2%). Such a move would be a significant barrier to trade and a drag on both economies, as the EU would likely retaliate.

The cyclical nature of trade

According to the World Integrated Trade Solution, the most important EU exports and imports in 2021 were machinery and electronic equipment (24%), chemicals (18%) and transport (14%). Demand for such goods tends to fluctuate strongly with the business cycle, which partly explains why exports and imports are much more volatile than the other components of GDP. Consequently, a high degree of trade dependence implies more cyclical economic growth, which could be reflected in the volatility of stock prices. 

Summary

Trade is indispensable as it lowers producer and consumer prices and enables economic growth through efficiency gains. To preserve these benefits, Europe needs to maintain good trade relations, reduce its dependence on individual countries for the import of essential goods and, if all else fails, bring the production of such goods onshore. Europe is currently facing heightened geopolitical tensions, as well as the aftermath of the pandemic and the Russian invasion of Ukraine. It has overcome such challenges before and can do so again, ensuring stable and beneficial trade for years to come.

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