Europe Macro & Geopolitical Commentary – June 8, 2022

Leo Nelissen | June 8th, 2022

Estimates are all over the place. Yet one thing is sure, the ECB needs to step it up tomorrow and clearly lay out a plan for the end of QE as well as how aggressively the bank aims to hike rates. Inflation is getting out of hand and supply chain issues won’t fade anytime soon. Related, we discuss stagflation risks tied to deglobalization, political pressure on the euro as well as trade and automotive challenges impacting both Germany and the UK. 

1.  CENTRAL BANKS

1.1 The ECB’s negative interest rates are simply no longer justifiable – Frankfurter Allgemeine

[…] On Thursday, the European Central Bank’s Governing Council will hold a regular meeting at which it will most likely decide to exit its bond-buying programme, which has been in place since 2015, at the end of the month and send clear signals about increases in the key interest rate in the coming months. Presumably in autumn, the chapter of a currently still negative key interest rate of minus 0.50 per cent will come to an end after eight far too long years.

Some members of the central bank’s leadership had opposed the demand for early interest rate hikes for quite some time. But even in the context of a strategy that gives greater weight to future inflation rates than to the current inflation rate, a combination of a current rate of 8.1 per cent and a negative key interest rate is simply no longer tenable. In this respect, too, the world is upside down.

President Christine Lagarde had tried to channel the debate in the run-up to the 9 June meeting in a blog post on 23 May. This could be understood as an unusual step because Lagarde, unlike her predecessor Mario Draghi, has so far shown no inclination to limit the Council’s room for manoeuvre in advance by taking lonely positions. From her preference for a “gradual” but necessary “normalisation of monetary policy” in a difficult environment, many observers have inferred a preference on the part of the president for two rate hikes of 0.25 percentage points each at the Council meetings in July and September, which would raise the key interest rate to zero in the autumn. In fact, however, Lagarde is not being so precise in a situation where several Council members consider an immediate rate hike of 0.50 percentage points worth considering.

These detailed debates for monetary policy gourmets underestimate a bitter truth: in view of the inflation dynamics, all the interest rate hike paths currently being considered in the Central Bank Council will probably not be sufficient to restore the stability of the price level in the medium term.

The central banks – and here the ECB is not alone – are ill-prepared for the current challenges. Since the 1990s, inflation rates had fallen almost everywhere; until the outbreak of the pandemic, monetary policy had settled into a world with very low inflation rates and was more concerned with economic growth and financial market stability. Central banks transformed themselves from monetary guardians to major insurers against macroeconomic risks; they also opened up to other issues such as climate protection, gender equality and the distribution of income and wealth.

[…] In Europe, the ECB saw and still sees inflation as being driven much more by supply effects and less by a very strong increase in demand. Therefore, it has long regarded inflation as only a temporary disturbance against which a central bank should do rather little in the interest of economic growth and with a view to its medium-term orientation of monetary policy.

This analysis by the ECB was as correct as it was wrong: the greater importance of supply effects for the inflation rate in the Eurozone is not disputed by experts, nor is the stronger influence of aggregate demand in the USA. This is shown by a look at the core rate of inflation, which is adjusted for energy and food prices and is suitable as an indicator of home-grown inflation. The core rate was most recently 6.5 percent in the United States compared to 3.6 percent in the Eurozone: the economy in the United States is more dynamic than the Eurozone economy. The ECB is right about that.

But the ECB has nevertheless underestimated the dynamics of inflation, because even a core rate of 3.6 per cent is well above the inflation target of 2 per cent, which is to be reached again in two years at the latest. Significant price increases for energy and food, as well as for industrial inputs whose supply chains are disrupted, spread through the entire economy over time. When the CEO of the Vonovia housing group, Rolf Buch, recently said that in the long run a higher inflation rate would also be reflected in higher rents, some commentators were irritated.

Comment: As Bloomberg reports, “The European Central Bank will begin a new era of monetary policy this week as officials complete their pivot to confront the threat of inflation running out of control.

Armed with new forecasts and with prices rising at a record pace, President Christine Lagarde and her colleagues will end trillions of euros of asset purchases and cement a path to exiting eight years of negative interest rates. Investors now speculate that an end to sub-zero policy could materialize as soon as July.

While consumer prices surging at more than four times the 2% goal are alarming enough, it’s the economic outlook beyond the immediate term that will underpin the ECB’s shift. Its projections are likely to show inflation won’t drop below the target again through 2024.

Those new quarterly numbers will be the first to fully account for Russia’s war in Ukraine, which no matter when it ends will have lasting effects on energy and food costs. The new reality will show that the ECB’s criteria for rate liftoff are finally met — allowing it to join the Federal Reserve and its peers in hiking borrowing costs.

“With the forecast, they can show that their three conditions are fulfilled” to start removing stimulus, said Karsten Junius, an economist at Bank J Safra Sarasin in Zurich. “They can really close the old chapter and face the new threats.”

Those challenges stand in stark contrast to the picture pre-pandemic, when officials fought sluggish consumer-price growth that fell well short of their target — a situation ECB researchers blame on past crises, demographics, globalization and digitization.

The turnaround has been dramatic. Inflation now tops 8%, driven by energy costs and logistics snarls. Even when those issues are overcome, the “disinflationary dynamics of the past decade are unlikely to return,” according to Lagarde.

Economists surveyed by Bloomberg see the 2024 inflation projection coming in at 2% — up from just shy of that level in March. That would satisfy the ECB’s requirement that price growth not only quickens for a brief period, but remains elevated over the medium term.

The upshot will be a first rate increase in more than a decade in July, after net bond-buying is wound down. By how much is the subject of vigorous debate within the Governing Council, where some want a 50 basis-point hike.

Money-market wagers on Tuesday crossed half the way toward calling that officials will begin with a move of that size on July 21.

While that would chime with the forecast of Bank of America, which predicts two half-point steps in the third quarter, most economists see only quarter-point moves at the July and September decisions. 

Lagarde has portrayed Russia’s invasion as a pivotal moment that may prove to be a “tipping point for hyper-globalization,” while speeding up the green transition — both implying more durable inflation pressure. She’s charted a course out of subzero rates by October in a return to more “normal” settings.

But despite the ECB acting much more slowly than its peers, some still fret that it’s moving too rapidly as the continent’s pandemic rebound runs up against the price shock and dwindling confidence over the war.

As the cost of staples soars, almost half of German citizens say they’ve had to cut back strongly or very strongly on consumption, according to a survey published last week.

“There seems to be a priority in this Governing Council to signal they’re doing something on inflation even though there are growth risks,” said Evelyn Herrmann, an economist at Bank of America in Paris. “It’s a very single-sided discussion that largely ignores risks that inflation could move the exact opposite way.”

Calls to move slowly to account for an uncertain economic environment have become rarer. But even when they’ve come — like from dovish Executive Board member Fabio Panetta — there’s been an acknowledgment too that rates must rise from record lows to keep price expectations in check.

Spain’s Pablo Hernandez de Cos, another dove, last week summed up the change of tone that’s left only the size of the initial rate hike in question.

While stressing that policy-normalization must be “gradual,” he said, “it’s crucial that inflation expectations remain anchored and significant indirect or second-round effects that could put that anchoring at risk are avoided.”“

2.  INFLATION/GLOBALISATION

2.1 Stagflation risk to world economy – The Times

The global economy is at risk of falling into a 1970s-style “stagflation” trap, the World Bank has warned, as it slashed its growth forecasts and raised the alarm over growing sovereign debt defaults.

In its first economic outlook since the war in Ukraine, the World Bank said Russia’s invasion, surging energy prices and a slowdown in China would “hammer” economic growth in the years to come.

The Washington-based bank slashed its global growth forecast from a 4.1 per cent GDP projection made in January to 2.9 per cent this year, down from 5.7 per cent GDP growth in 2021, when the world economy rebounded from Covid-19 lockdowns.

“For many countries, recession will be hard to avoid,” David Malpass, World Bank president, said, adding that on a per capita basis many countries could fall into zero growth territory if downside risks emerged.

“The danger of stagflation is considerable today,” the bank said. “Between 2021 and 2024, global growth is projected to have slowed by 2.7 percentage points — more than twice the deceleration between 1976 and 1979.

“Subdued growth will likely persist throughout the decade because of weak investment in most of the world. With inflation now running at multi-decade highs in many countries and supply expected to grow slowly, there is a risk that inflation will remain higher for longer than currently anticipated.”

The eurozone’s 19 countries suffered the biggest growth downgrade since January’s forecast, with projections dropping 1.9 percentage points to a 2.5 per cent GDP expansion this year. US economic growth would fall to 2.5 per cent this year after 5.7 per cent growth in 2021, according to the bank’s forecasts.

Malpass said the inflationary crisis should be tackled by “massively” increasing the production of goods that have been hit by new Chinese lockdowns and trade disruptions from the war in Ukraine. He also called on central banks to remove the accommodation that has defined more than a decade of monetary policy since the financial crisis.

“There should be a reduction in the bond holdings of major central banks, which would then free up capital for small businesses and developing countries through the banking system,” Malpass, who was nominated by President Trump, said.

[…] The World Bank, which has a focus on developing nations, said the poorest countries are already facing the brunt of a global downturn, which risked causing chronic food shortages and famine in regions such as sub-Saharan Africa that rely on grain imports from Ukraine. The bank called on richer countries to provide sweeping debt relief to low-income nations, a process that has stalled in the last year following disputes among rich creditors including China and India.

Comment: Commodities are outperforming every other asset by a wide margin. The performance is even better after an already outperforming double-digit performance in the first six months of 2021.

This isn’t a new issue. What’s interesting – or worrisome – is the changing trend in geopolitical relationships.

The days of happy globalisation during the last three decades are clearly over, according to Philippe Chalmin, a professor at Dauphine university, who coordinated this report. Over the past decades, global raw materials markets functioned smoothly, and a market equilibrium was the way to set prices. Today, the world is fractured, violence re-appears, borders close, and government turn their back on liberalism to intervene.

What will this world of tomorrow look like? It is clearly too early to tell. But we see tendencies already. Europe is moving out of Russian gas, diversifying towards other suppliers and renewable energies. Russia turns towards China and India to export its gas and towards Africa to export grains. The recent visit to Moscow of Macky Sall, the Senegalese president who is also the chair of the African Union, who was reassured by Vladimir Putin that grain will be allowed passage to Africa, is highly symbolic of the change we are about to see.

According to Chalmin, we are moving into a bi-polar world, with liberal democracies and their free markets on the one hand, and autocracies that buy support from other countries through favours to the other. The world of yesterday is no more.

3.  EURO RISKS

3.1 The French far-Left is the biggest threat to the euro – The Telegraph

Leather jacketed Greek finance ministers with plans to restore national currencies. Hawkish German professors armed with legal actions on monetary sovereignty. Italian economists plotting parallel currencies. The euro has faced plenty of threats during its often rocky first two decades. And yet the real one is now emerging in France – Jean-Luc Mélenchon, the firebrand leader uniting France’s Left.

With parliamentary elections scheduled for Sunday, with a second round a week later, Mélenchon’s alliance is gaining momentum in the polls. Whether he can do enough to deprive the centrist Emmanuel Macron of a majority remains to be seen. But keep in mind that the four times the French Left was united during the 20th century it won power each time.

With a radical programme of massively increasing state spending for one of the most indebted countries in the world, for scrapping the deficit rules that hold the currency together, and for breaking free of Brussels’ restraints, the anti-EU, anti-euro Mélenchon would tear the currency apart – if he becomes PM.

When Macron was comfortably re-elected as President for a second five-year term last month, defeating the far-Right Marine Le Pen, many investors thought French politics could be safely forgotten about. And yet the presidential election is swiftly followed by elections for parliament.

And while last time around Macron’s centrist alliance won a comfortable majority, this time that is far from certain. Jean-Luc Mélenchon, the leader of the France Unbowed party, made a decent showing in the race for president, only narrowly failing to make the run-off and is doing even better in the parliamentary contest.

Most notably, he has managed to unite the Left, bringing together his own party with the socialists, communists, greens and a handful of smaller anti-capitalist parties to form “Nupes”. The alliance is rising in the polls, and looks set to make the second-round run off a very close contest.

One poll by Ifop-Fiducial last week forecast that Macron would fall short of an overall majority. And if that happens, Mélenchon could well end up as Prime Minister.

History suggests that is more than likely. The French Left united on four occasions in the last hundred years, in the 1920s, in the 1930s, in the 1970s, and the 1990s. Each time, it ended up winning at least a slice of power, most recently with Francois Mitterand’s election in 1981, and Lionel Jospin’s term as Prime Minister from 1997 to 2002, when he introduced the 35-hour week.

On top of that, the last two presidents to win second terms both faced periods of cohabitation with Prime Ministers from other parties: Mitterand with Chirac, and Chirac with Jospin. In French politics, it would hardly be unusual for Macron to be forced to share power with a Prime Minister from a different part of the political spectrum. It has happened plenty of times in the past.

To his credit, while Macron has not exactly revolutionised the French economy, and he has run up vast deficits, he has also reduced unemployment, boosted inward investment, and most of all remained committed to making the single currency work.

But the timing of the parliamentary election could hardly be worse. Inflation is rising relentlessly in France as it is in most countries, living standards are getting crushed, and to make it worse the European Central Bank will start raising interest rates this week, making mortgages and bank borrowing more expensive. French voters will be feeling the squeeze. It is not a great moment for incumbents to run for re-election.

Here’s the problem, however. Mélenchon is a real threat to the stability of the euro. Much like the Polish government, he is not threatening to leave, at least not right away, but is planning to undermine the project from within.

His economic policies make Jeremy Corbyn look like a moderate. He wants to increase state spending by a massive €275bn, even though France already has one of the biggest governments in the developed world. He wants to reduce the retirement age to 60, at a time when every other government in the world recognises that people need to work for longer.

He wants to increase tax rates, taking rates up to a punishing 90pc for the highest earners, with higher property taxes, and higher VAT on luxury goods, on top of that. Perhaps most significantly, he wants to get rid of international trade agreements so that he can protect French industry and jobs, and renegotiate the deficit rules that control spending for eurozone countries, and if the rest of the 27 members don’t agree to that, threaten to hold a referendum on whether France should leave.

It would be the most radical challenge to the stability of the euro from any major member since the currency was launched.

The elections could hardly have come at a worse time for Macron. With living standards starting to fall, French voters may like the idea of a Left-leaning PM alongside the centrist Macron. Unlike a Le Pen presidency, it may well seem like a relatively safe option, and one that would keep Macron in power while rejecting unpopular policies such as raising the retirement age.

As it grapples with its first serious bout of inflation, and the winding up of quantitative easing that held it together, the euro has been looking very wobbly. Bond yields are already starting to soar across the periphery, tripling in both Italy and Greece since the start of the year, and with the currency hurtling down towards parity against the dollar, and with inflation in countries such as Estonia hitting an alarming 20pc.

Against that backdrop, the election of the radical Mélenchon as PM would be the trigger for a re-run of the eurozone crisis of 2011-12. The currency has survived plenty of challenges from the French far Right – but it may well be the far Left that proves its undoing.

Comment: The euro came close to parity versus the dollar in May as a result of an ECB that is behind the curve, structural economic issues, geopolitical tensions, and an energy crisis threatening the core of the euro area economy.

Add French election issues to that list as Melenchon is a political tinderbox. Higher taxes for the rich and corporations, higher government spending on top of Macron’s lavish spending habit, new stability pact rules, and new trade deals are reasons why we have a new factor of uncertainty threatening euro stability.

L’Opinion reports that “Would the victory of the left on 19 June guarantee Jean-Luc Mélenchon to take Elisabeth Borne’s office on rue de Varenne in the following days? Emmanuel Macron hinted, in an interview with the regional daily press published on Saturday, that his choice could go to another personality: “The President chooses the person he appoints as Prime Minister by looking at the Parliament. No political party can impose a name on the President.

On a purely legal level, Emmanuel Macron is right. Article 8 – paragraph 1 – of the Constitution gives the President alone the choice of the Prime Minister. “It is one of the very few prerogatives of the President that is not framed, for which he does not need to ask for any opinion or countersignature,” said constitutional scholar Didier Maus.

But politically, the argument of the head of state is a bit short. In the – to date highly unlikely – hypothesis that the Nupes would win the legislative elections, Emmanuel Macron would have no choice but to appoint its leader, namely Jean-Luc Mélenchon. This is what happened in 1986 when François Mitterrand appointed Jacques Chirac, then leader of the RPR, to Matignon. Or again in 1997, when the same Jacques Chirac chose Lionel Jospin, then first secretary of the PS, as head of government. And when Edouard Balladur was appointed Prime Minister in 1993, it was because Jacques Chirac himself had made it known that he did not want to be Prime Minister.

“The Constitution requires the President to take into account the electoral results. It would be impossible for Emmanuel Macron to choose another personality than the one Jean-Luc Mélenchon would like to impose on him”, certifies Jean-Philippe Derosier, associate professor of public law, member of the University Institute of France.

If Emmanuel Macron ventured to appoint another personality from the Nupes, the bet would be risky. Who would accept? All the candidates who have subscribed to the alliance sealed on the left have committed themselves to supporting Jean-Luc Mélenchon as Prime Minister. It is written in black and white in the agreement between La France insoumise and its partners (EELV, PS and PC): “In this perspective, in accordance with the republican tradition, the Prime Minister would come from the largest group in the Assembly, that is to say Jean-Luc Mélenchon.

It is therefore hard to imagine a personality accepting Emmanuel Macron’s offer of services even if it means alienating the rebel leader and all his allies. Then, the Nupes could block the new Prime Minister, in case the choice of the President does not suit him, by voting a motion of censure in the National Assembly that would follow the general policy speech of the new Prime Minister, which should be held a priori on 5 July.”

4.  AUTOMOTIVE

4.1 Britain’s car industry is in an existential crisis – but don’t blame Brexit – The Telegraph

In 1986 Margaret Thatcher painted an eye on a Japanese daruma doll, a traditional symbol not just of luck but also perseverance, in the new factory Nissan was building just outside Sunderland. It marked the renaissance of an industry that had been beset by incompetence and industrial strife. Just over 35 years on, the charm appears to be wearing off as the UK’s car industry faces yet another existential crisis.  

Car manufacturing is a totemic industry in the UK and one of the last big links to the country’s manufacturing heritage. The regular curmudgeonly complaint that Britain doesn’t make anything anymore can swiftly be countered with a quick nod to the nearly 350,000 Qashquais, Jukes and Leafs (Leaves?) that roll off Nissan’s hyper-efficient, state-of-the-art production line in the North East each year. Cars remain the UK’s number one export.

But for how much longer? The UK’s car manufacturers have faced four huge roadblocks in quick succession. First they only just managed to swerve the worst form of Brexit which would have resulted in tariffs being placed on exports. Then they got into a fender bender with Covid that resulted in factories being shut down and supply chains becoming gummed up. Now they are having to make evasive manoeuvres to avoid head on collision with an imminent recession and the drive towards net zero.

Much has been made of Thatcher’s pitch to Japanese car makers, which sold the UK as a beachhead into the common market. But that was only ever part of the deal. She also offered tax breaks to encourage investment and presided over a booming economy that boosted demand. The UK became an enormous market in its own right. The Bavarian nickname for Großbritannien is Treasury Island because one in five cars built in Germany ends up here.

One of the most important concepts that Japanese carmakers brought with them to the UK was “kaizen”, which roughly translates as “continuous improvement”. It is thought that this is one of the reasons why productivity in the industry between the financial crisis and 2015 increased by 30pc even as it flatlined in most other sectors.

But following the Brexit referendum, the UK government and car industry essentially became locked in a long-running debate about maintaining the status quo. Having at the last possible minute achieved that aim and avoided the imposition of margin-destroying tariffs on exports to the EU, there is now a dawning realisation that the standing still is patently not good enough.

In July last year, Honda closed the doors on its Swindon factory after 36 years with the loss of 3,000 jobs. Brexit was the obvious culprit especially given how vocally Honda had opposed it. But industry experts pointed out the plant had been struggling for some time. Analysts believe that car plants need to produce roughly a quarter of a million cars a year in order to achieve the required economies of scale. Swindon was struggling to produce 160,000.

The real issue facing the UK car industry is that it has emerged from the threats posed by Brexit and Covid and a long cessation of “continuous improvement” into a fuzzy period between the twilight of the combustion engine and the full dawning of electric vehicles.

There are two chicken-or-egg situations – one around demand for electric cars and the other around how they are built – that need to be resolved. Normally one would expect the market to just figure these problems out. But the state has at least partly precipitated both – by setting an artificial deadline for net zero and prolonging the uncertainty around Brexit – and will therefore have to help resolve them.

The UK is banning the sale of new petrol and diesel cars by 2030. Figures out on Monday showed that new UK car registrations fell by 20.6pc to 124,394 units in the second weakest May since 1992. (The worst May was when the country was in lockdown in 2020 and therefore doesn’t really count.)

The decline, compared with the first full month of reopened showrooms in May last year, demonstrates the impact of continued global supply chain disruptions but it is also the result of cash-strapped households holding off from making big purchases, especially when the choice is between a petrol or diesel powered car, which will soon be obsolete, and an electric vehicle they may struggle to charge.

As SMMT boss Mike Hawes says: “To… drive a robust mass market for these vehicles, we need to ensure every buyer has the confidence to go electric. This requires an acceleration in the rollout of accessible charging infrastructure.”

At the same time, traditional manufacturers are struggling to reconfigure their product lines and supply chains. Battery vehicles have far fewer moving parts, which has significantly elevated the importance of localised production. New rules of origin requirements meant that car makers have to prove that 40pc of the value of the parts in a finished car were produced in the UK or the EU before they can be exported to the continent.

This threshold rises to 45pc next year and 55pc in 2027. Batteries tend to make up about 50pc of the total value of an eclectic car. What’s more, they’re really heavy. Those for the Nissan Leaf weigh about 300kg, while those for the Jaguar i-Pace come in at roughly one tonne. The upshot is, batteries need to be made very close to where the car is assembled.

Nissan, for example, is increasing production in the UK after signing an exclusive deal with a battery producer called Envision, which has a plant near Sunderland. The trouble is, there aren’t many Envisions around. This is why the UK needs to do everything it can to attract gigafactories to these shores.

The countries that win the race to scale up battery production will be the ones that are able to generate the efficiencies and economies of scale that ensure they can maintain a meaningful mass-market car industry beyond the end of this decade.

Comment: It’s one of the most important articles out there at the moment as it covered an issue we’ve been on top of for a long time. Changing automotive demand is not only challenging the British manufacturing industry but all of Europe – including automotive giant Germany.

Electric vehicles have fewer parts than traditional ICE vehicles.

This means the massive automotive supply chain will have to change. Forget the final assembly, which is important, but not as important as thousands of smaller companies supplying various parts for ICE vehicles. Going from 2,000 moving parts to 18 will have a major impact on employment and total manufacturing well-being.

For example, Handelsblatt reported that Germany’s biggest suppliers like Mahle are now in trouble because of this rapid trend.

“”Mahles’ situation is serious, but not hopeless,” says car professor Stefan Bratzel of the Center of Automotive Management. “However, the Swabians must finally bring their innovations to the market and make money, otherwise it will be bitter.” The pressure is growing, also because no new combustion engines will be allowed in the EU sometime after the 2030s. An electric motor has no pistons. Mahles’ core business would be effectively dead by then at the latest. It is not only the workers’ representatives in Cannstatt who are afraid of this financial piston choke.”

While all of these companies are diversifying, it’s hard to keep up in an industry that is slowly turning into a tech-focused industry with major players that dominate big parts of the supply chain – like Bosch and Continental. 

Today, EU lawmakers discuss when and if ICE cars can be banned. They need to be careful as these developments threaten hundreds of thousands of jobs.

5.  GERMANY/CHINA

5.1 The situation in China is becoming increasingly difficult for German companies – Frankfurter Allgemeine

The interaction between German business and politics in relations with China worked well for a long time. Group representatives travelled with federal ministers or chancellors to the Far East, where politicians were happy to do business. The interests were also promoted by the taxpayer, for example through default guarantees for exports or investment guarantees. The latter have now come under fire since new appalling reports of human and minority rights violations in the Muslim Uyghur province of Xinjiang in northwest China.

After the revelations, the Ministry of Economics under Robert Habeck (Greens) announced that “for the first time, four applications by a company for the extension of investment guarantees would not be granted on human rights grounds”. The reason given was that the applications had been related to an operating site in the Uyghur region: “Accepting guarantees for projects in the province of Xinjiang is not conceivable in view of the human rights situation there.” The ministry did not name the company, but it appears to be Volkswagen , which together with its state-owned partner SAIC from Shanghai has been operating its own plant in the provincial capital Urumqi for nine years, the first car production ever in Xinjiang.

It is remarkable that the cases mentioned are follow-up guarantees; until now, activities in the region were not an exclusion criterion. It is only now that Berlin has decided not to provide investment guarantees for projects that, according to a ministry spokeswoman, either concern the Autonomous Region itself or are linked to business relations there: “This includes extensions of existing guarantees.”

The change of mind is justified by the fact that the situation has “come to a head” and is “characterised by forced labour and mass internment of members of the Uyghur minority”. At the same time, the “possibilities of influence and control” of German companies operating there are “extremely limited in view of the repressive political framework conditions”. The hair-raising situation in China’s largest province has been known for many years. In 2009, more than 200 people were killed in riots. Four years later, shortly before VW opened its plant in Urumqi, another 21 were killed. Two Turkic activists were sentenced to death at the time.

There have been many warnings. The F.A.Z., which was the first to report on VW’s plans at the time, wrote about the new factory: “VW doesn’t really want or need it. But Beijing wants to pacify the province of the rebellious Uyghurs, with settlements and also with the targeted immigration of Han Chinese and foreigners. Then, according to the calculation, the foreigners and their governments will also want things to remain calm there.” So it was always clear that the investment was politically motivated, that Wolfsburg allowed itself to be harnessed to the cart so as not to jeopardise its other interests in the most important car market – and that federal and state politics went along with this path. Lower Saxony has a stake in VW, the government sits on the supervisory board.

[…] According to business circles, the companies are also afraid of the German supply chain law and, last but not least, the secondary sanctions imposed by the Americans in 2020, which reprimand China’s actions against the Uyghurs. Another sensitive issue is a Chinese anti-sanctions law passed last summer. It explicitly prohibits foreign investors from withdrawing from Xinjiang under threat of punishment, citing the human rights situation. So far, this regulation has not affected German companies, but that could happen if they give in to growing pressure from home or America and pack their bags in western China.

It is also not easy for the Germans to break with Xinjiang because the region is extremely important for the energy transition and for digitalisation. About half of the polysilicon produced in the whole world comes from there. This is needed for semiconductors and solar panels. But it is also clear that German companies cannot continue as before in China. The deficits in democracy and the rule of law have been known for a long time, says Zenglein. “But given the large and lucrative markets there, many entrepreneurs and politicians didn’t want to see that.” He calls this an “egg dance”, but also sees that politics and business are now rethinking.

After the terrible images from Xinjiang, no one can look away any more, and the harsh Corona policy with the lockdown in Shanghai is also opening the eyes of many foreigners, says the economist: “Many of these expats are only now realising where they personally see their freedoms restricted, that they are living in an autocracy.” The economic successes had long covered up the differences in systems and values, but that is no longer possible. Not only politicians, but also companies cannot avoid rethinking their China strategy. “The German economy must diversify,” says the expert. “The luxury of relying on China alone is over.”

Comment: The situation is getting tenser. The German government is eager to lower its dependence on China, which means major corporations will have to re-think their strategies. This will be tough as we reported earlier as 80% of Germany’s GDP is dependent on imports and exports. Changing this in a time of high inflation is almost certainly going to lead to higher inflation – on a more sustained basis.

Moreover, China’s propaganda newspaper Global Times is also covering the issue as it blames the EU for following a “value-based” approach. 

“Germany’s new government signed a coalition agreement in December 2021. The current administration now stresses on reducing strategic dependence in its China policy.  

With the continuation of the Russia-Ukraine conflict, EU companies will have to reconsider their future investments in China, their market expansion, the prospect of industrial chain dependence, and look for alternative places for their production against the backdrop of intensified ideological confrontation. Chinese companies and exporters will also have to consider the impact of this trend on their development in Europe.

A “decoupling” situation, if it happens, in China-EU economic and trade relations, will be detrimental to both sides. Take employment, the interdependence between the two is obvious to see. 

In April, the European Think-Tank Network on China published its eighth research report on Europe’s economic dependence on China. Two sets of data in the report are telling. A total of 900,000 jobs in Germany are in one way or another related to business with China, accounting for 2 percent of the German workforce, while German companies directly employ more than 1 million staff in China, jobs created by their Chinese suppliers and partners not included. China-Germany interdependence reflects the degree of China-Europe interdependence.

That being said, China and the EU need to view their economic and trade issues with a broader attitude, and to minimize the impact of ideological conflicts on the development of their economic and trade relations.”

China clearly knows that it has leverage over Germany given its dependence on the Chinese middle-class buying Volkswagens and related. It will use its leverage if Germany tries to work on a “soft-exit”. And again, to emphasize this dependence, we refer you to our favourite chart relating thereto: