By Katharine Neiss, deputy head of global economics at PGIM Fixed Income
In an increasingly fragmented world where greater competition is contributing to economic realignment and the US election is fast approaching, the European Union (EU) remains vulnerable to renewed global trade tensions.
Since 2018, when the region was subjected to US steel and aluminium tariffs and threatened with potentially crippling auto tariffs, the EU’s trade surplus with the US has grown significantly. Ex-energy, the US trade deficit with the EU now surpasses that of China, and this growing imbalance could well trigger a resurgence in US-EU trade tensions.
Despite being better prepared than it was in 2018, and against the backdrop of recent proposals to stem Europe’s competitive decline, we see five reasons why renewed trade tensions could be particularly economically damaging for the EU at this fragile time.
Size and importance of US export market
Despite rapid growth in the Chinese economy, the US remains the world’s largest global economy and the EU’s most important export market.
Given the size of the US economy, any increase in imposed tariffs would likely result in a reduction in the price received by an EU exporter and, hence, an improvement in US terms of trade at the expense of the EU.
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The EU is also a much more open economic region than either the US or China, with a total (extra-EU) trade share of close to 45% of GDP, compared to around 35% and 25% for China and the US respectively.
Given the importance of trade to the EU economy, the impact of higher tariffs imposed by its largest trading partner would be severe.
Rising cost of exports
Since 2017, EU productivity has continued to decline relative to the US In large part, the more recent deterioration reflects the substantial increase in energy costs borne by European producers following Russia’s invasion of Ukraine.
Higher tariffs effectively act as an increase in transport costs and would exacerbate the erosion in European competitiveness vis-à-vis the US and China.
Accelerated FDI outflows
The combination of higher tariffs and production subsidies, such as the US Inflation Reduction Act (IRA), could accelerate the outflow of European investment and production to the US. Since the US has adopted an industrial strategy, we have already seen a further decline in net foreign direct investment (FDI) flows from the US to the EU.
The combination of tariffs and subsidies would provide strong incentives for European firms to relocate to the US, as these firms would stand to benefit from the subsidy while also avoid increased tariffs.
Such a dynamic would likely further reduce private investment in the EU from an already low base. This would have negative consequences for EU productivity and potential growth.
Asymmetric tariffs could exacerbate China excess capacity
The potential for asymmetric tariffs levied on Chinese exports could exacerbate excess capacity issues there, putting downward pressure on Chinese manufacturing prices and incentivise dumping of Chinese products on European markets.
This would further erode European competitiveness in its domestic market, as well as having deflationary implications.
These could prove difficult for monetary policy to address in the absence of extraordinary measures. A lack of policy support would likely result in a return to sluggish growth in the region.
Tariff uncertainty
Even in the absence of higher tariffs, uncertainty alone could weigh on sentiment and, in turn, domestic demand as households and firms take a wait and see approach. This dynamic played out during previous bouts of uncertainty.
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Moreover, sentiment in Europe could be further rattled by more confrontational US-EU relations given that the region has become much more reliant on the US for energy imports. In particular, EU LNG and crude oil imports from the US have risen from essentially zero in 2016 to 30% and 15% respectively.
Further erosion of European competitiveness
With the EU already facing economic headwinds and calls for more investment in order to boost growth growing louder, the prospect of renewed trade tensions with the US comes at a particularly difficult time.
For an economy still disadvantaged by high energy costs, even the prosect of higher tariffs has the potential to weigh on an already fragile economy. Whether higher tariffs do, in fact, come to bear remains to be seen, and the outcome of the US election and its resultant trade policy is still highly uncertain.
However, given the region’s growing trade surplus with the US and its resultant susceptibility to tariffs, the likely impact would be a further erosion of European competitiveness and be a headwind to growth.
