Very dangerous European cars part II

“Many countries charge us extraordinarily high tariffs or create impossible trade barriers. Impossible. And I’ll be honest: European Union — very, very difficult. The barriers they have up are terrible. Terrible. In many ways, worse than China.” (Donald Trump, 12 November 2019 at the Economic Club of New York)

As early as this week, President Donald Trump may announce whether the United States will raise import tariffs on European cars. In February of this year the US Department of Commerce concluded that imports of passenger cars and parts pose a threat to national security. A 180-day negotiating period between the EU and the US to address this threat ended on 13 November. President Trump will now have to decide whether he deems higher import taxes necessary to protect national security.

The overarching deal between the EU and the US, that was supposed to withhold the US administration from upping the ante, has failed to arise. While an immediate tariff hike at this stage as a result of this failure is quite unlikely, we believe there is still a reasonable chance that the dispute will continue to linger and at some point still escalates.

In this report we examine the likelihood of US tariffs being implemented. This is done by first looking at the causes behind the rising trade tensions between the US and the EU since the start of the Trump administration, and also by putting this dispute within a broader global context. We also assess and quantify the possible economic impact of higher US tariffs on European cars.

Already during his campaign, President Trump made no secret of his dislike of the US trade deficit with China and the EU. In particular with Germany due to the car balance. Irritations and tensions between the US and the EU over trade have been building since the Trump Administration imposed tariffs on steel and aluminum in May 2018 and the EU retaliated in July 2018, instead of conceding to US demands to lift the tariffs. Around the same time, Trump stepped up his threat to increase tariffs on European cars, as he ordered the US Department of Commerce to start a national security investigation into car imports. A further escalation at the time was averted, as then EC President Juncker and President Trump reached an agreement to work towards zero tariffs and barriers, reform the WTO and towards zero subsidies on non-car related industrial goods. Since that agreement, little progress seems to have been booked, however.

Since the start of this year the risk of car tariffs by the US has increased. As in February 2019[1], the US Department of Commerce concluded that cars and car parts are imported by such large amounts that they ‘threaten to impair national security’[2]. On 17 May, President Trump proclaimed that the renegotiated agreement with South Korea, and the USMCA deal with Canada and Mexico could help to mitigate the risks for national security. US Trade Representative Robert Lighthizer was given 180 day to also negotiate agreements with Europe and Japan to address the security threat. Hence, 13 November that negotiation period ended and a decision is imminent. While the US has reached a preliminary deal with Japan, there has been limited progress on trade talks with the EU. The EU refuses to include agriculture policy in the trade negotiations, while the US refuses to negotiate if agriculture policy is not included.

No tariffs, but threat to be kept alive

While failure to negotiate an overarching trade deal could have sufficed to raise import tariffs on European cars, we still think such a move is unlikely at this stage. Commerce Secretary Wilbur Ross already indicated earlier this month that discussions with individual companies about their investment plans in the US will bear enough fruit so that “it may not be necessary to put the 232 into effect, may not even be necessary to put it partly in effect”. Furthermore, we think the US is still too engaged in the US-China trade dispute to also take on the EU.

Still, a dismissal of the possibility of future tariffs altogether is not warranted in our view. President Trump will likely choose to extend the negotiation period to keep the threat of (car) tariffs alive. This could act as leverage in the trade negotiations with the EU. Moreover, the US might want to use the threat to get the EU to prop up defense spending and align with US’ foreign policy on China.

[1] For a more elaborate view on the report we refer to our Special Very dangerous cars (February 2019).

[2] Through Section 232 of the 1962 trade law, the Commerce Department argues fierce foreign export competition has eroded profit margins of domestic car producers to such extent that it hampers R&D investment by US car producers. These R&D investment are regarded as being crucial for maintaining a state-of-the-art defense system, via intersectoral knowledge spillovers.

In order to predict how the transatlantic trade dispute will develop we could pose the question whether the current US-China trade war serves as a blueprint for a potential trade war between the US and the EU. As we argue below there are indeed several commonalities but also significant differences, making the answer to that question a speculative one. But several factors could still tip the balance towards an escalation at some point. We briefly discuss some of these factors below, but this is obviously not an exhaustive list.

Main differences

There are multiple factors underlying the US-China dispute that are not applicable to the US-EU relationship. One of the most pressing issues, according to the US administration, is that foreign companies investing in China are often required to hand over proprietary technologies. Furthermore, there is an economic and geopolitical power struggle going on between the East (China) and the West (led by the US) (also see here and here). In recent speeches, US Vice President Mike Pence and US Secretary of State Mike Pompeo have also stepped up their rhetoric vis-à-vis China. Meanwhile, the US and Europe share a long history of cooperation and as such are much more interconnected. Partly for these reasons, US Congress is backing the trade war with China but is not keen on picking a fight with Europe as well. That said, Trump is unlikely to care too much about Congress’ opposition. At least, that has not stopped him from raising protectionist barriers against foreign countries not complying to US demands before. Breaking up NAFTA and multilateral trade negotiations and imposing steel- and aluminum tariffs are key examples.

Main commonalities

Moreover, neglecting the possibility of tariffs based on historical ties would smack of complacency. President Trump has made no secret of his dislike for some of the existing multilateral organizations, such as the WTO. Moreover, we can also draw several parallels with the US-China dispute. For one, President Trump has made it clear that he is not a big fan of the US trade deficit, which in his opinion is the result of unfair foreign trade practices, i.e. high barriers to trade in China and the EU, amongst others. In 2018, the US ran a trade deficit with the rest of the world of 875bn USD. Although China is responsible for the larger part of the US’ trade deficit (420bn), the annual trade deficit with Germany is also roughly 70bn. Another (potential) similarity is the state aid that both Chinese and European companies receive.[3] We do have to note that, here too, the European state aid is of a completely different magnitude compared to the support China provides to its state-owned corporates.

However, dissatisfaction with the protective nature of EU agriculture policy to some extent resembles dissatisfaction with closed Chinese markets and as such it is no surprise that the US have said they want to include the agricultural sector into any discussions about a future trade agreement between the US and EU. Last, but not least, recent EU fines for and investigations into US tech companies and comments by Chancellor Merkel about Europe’s heavy reliance on US tech companies for their data storage, could also be seen as a threat to the US’s digital dominance.

Whether or not one agrees with these claims is actually less relevant, as President Trump may still use them for targeting Europe, if only for political purposes.

Other lingering triggers

Next to these commonalities, there are some potential triggers lingering in the background that could move Trump into action despite opposition in Congress. In a way these potential triggers are an extension of the current tensions between China and the US. For example, the recent deal between the EU and China over geographical indications of food may be viewed by the Trump administration as ‘evidence’ that the EU choosing the side of China. The same can be said of (some) European Member States’ openness to China’s One Belt One Road initiative and Chinese 5G network providers. Several EU member states have engaged with China to attract investments. The expected tariff hike by the EU next year as punishment for US government subsidies to Boeing could also sour relations even if it is perfectly aligned with the WTO rules. Insufficient progress by European countries on NATO’s defense spending target of 2% GDP will be viewed by the US as ‘weak’ and showing little commitment. Finally, with the elections on the radar, President Trump’s inability to act on domestic policy (given the Democrat-dominated House) might actually induce him to force wins on trade policy for which he does not need Congress’ backing.

In other words, whilst it can be argued that the US-China dispute is not a great blueprint for future tensions between the US and the EU given their significant differences, there are also certain commonalities whilst other factors can still spark an escalation of tensions between the US and the EU.

[3] For example, the WTO recently ruled that Airbus received illegal state support. A similar case for Boeing is still ongoing. For more information see this report.

Another important factor in determining whether the US will actually impose tariffs is the evolution of the US-China trade war[4] itself. We believe that the Trump administration does not want to get involved in a trade war on two fronts. This could weaken the US’ negotiation position and have significant ramifications for the economy and financial markets due to increased uncertainty.

If a phase one deal between China and the US were come to pass however, this could provide room to raise pressure on Europe (see Figure 2). We argue that this would have to be a solid and sustainable deal, lasting until the next US elections.

We think that in this scenario the US would first choose to intensify its tariff threats. At that moment the EU would have to decide whether or not to accommodate any of the US requirements or hope the President will not follow-up on his threats. If the Trump administration believes the EU is not doing enough to accommodate its wishes, car tariffs would become a real possibility.

If the US actually hikes tariffs, the EU would have two options: make concessions on US demands and/or retaliate. The EU has already made clear that it would hike tariffs on a broad-based package of 35 billion euro worth of US imports if the US raised import tariffs on European cars. Thereafter, the EU might continue to try and broker a deal with the US. But clearly, the risk of a full-fledged transatlantic trade war would increase in that scenario.

[4] We focus on developments in the coming year, since it is most likely that president Trump would like to impose tariffs before the presidential election of 2020. Taking a tough stance against Europe could prove to do well with his electorate.

If the EU at any point in time decides that it wants to accommodate US demands, concessions in the area of the EU’s attitude towards China (becoming more critical), defense spending (raise), import tariffs on American cars (reduce) and protectionism of the agriculture sector (less) could prove to be avenues to alleviate the tariff threat. Below we look more closely at some of those potential concessions the EU could offer.

China policy

Firstly, Europe can offer to align with the US on its foreign policy against China. The US has put pressure on its allies to exclude certain Chinese network providers. They emphasize that certain technologies, such as for example (5G) technology, delivered by Chinese providers would enable China to gather confidential information since under Chinese law corporations are obliged to cooperate with information requests by the government. Making an explicit choice in considering or exempting Chinese providers by EU countries would effectively amount to choosing sides in this ‘conflict of ideologies’. However, fears of deteriorating relations (and hence) trade with China could make member states with a large export exposure to China, such as Germany and some Eastern member states, reluctant to bar Chinese businesses. For example, Germany recently announced that they will not exclude Huawei from the list of potential 5G technology suppliers. More broadly could one think of policies that restrict access to Chinese companies in certain markets and sensitive sectors of the economy. A move on this front by the EU could be regarded by the US administration as a step in the right direction, but for now it seems EU member states are still divided on these issues.

Defense spending

Secondly, Europe could consider to (further) raise defense spending. President Trump has made it clear that the US expects its NATO allies to commit to spending 2% of GDP on defense, as agreed. However, most European countries are nowhere near that target. If President Trump were able to negotiate a deal including increased defense spending, he could present this as a major win to his electorate. Several European leaders and ministers have recently indicated to be in favor of an increase in defense spending, but it could take a while before these policies are approved and implemented. Moreover, since it is impossible for the EU to force member states to spend more money on defense and considering the fact that higher defense spending would probably be at the expense of more green/infrastructure spending, we do not deem this a very likely option in the short term.

Agriculture sector

Thirdly, concessions on agriculture protectionism could move President Trump to reconsider imposing tariffs on European cars. Currently, the EU levies tariffs of between 20% and 30% on American agricultural products. Common Agricultural Policy has been one of the mainstays of the EU and several Member States have a strong agricultural lobby to protect their domestic agricultural sector. Lowering tariffs will likely prove to be a bridge to far, as it would be hard to get all countries on the same page. In any case, in our view the EU is not likely to make big concessions in this area, although we acknowledge that this is more of an assumption than a conclusion.

Car tariffs

A final area we can think of is the car sector itself. The EU could choose to lower its import tariffs on American cars to the same rates as the US taxes European cars. Currently, the US imposes a tariff of 2.5% on European passenger cars and car parts, while the EU taxes American cars with 10%. We disagree with Trump’s argument that this is unfair, as these tariffs cannot be viewed in isolation of the entire trade agreement between the EU and the US. But lowering the tariffs on imported cars from the US would partly comply with US demands and might be sufficient to avoid further protectionist measures by the US. While the EU would not give in easily, lowering tariffs on cars shipped from the US to European shores might actually be seen as the path of least resistance and sufficient to prevent a further souring of the relationship between the US and the EU.

In order to quantitatively assess the economic impact of higher US tariffs on European cars and car parts, we have used the GTAP sectoral trade model.[5] In this scenario, we hike the tariff on cars and car parts to 25%, a tariff rate frequently mentioned by US officials and President Trump himself. Currently, import tariffs on these products range from 1% to 2.5%, so adopting 25% tariff rate in our scenario more or less is equal to raising tariffs on cars and car parts by 25 ppts[6]. Using the impact on production from GTAP we can estimate the impact on Gross Value Added (GVA). We are aware of the fact that this does not show the full implication of higher US tariffs for these economies, as it excludes other sectors in the value chain of the car sector, such as metals and services and it excludes other second-round effects, such as on economic sentiment. But nevertheless we think this is a useful exercise.

Not surprisingly, production in the motor vehicle sector suffers the most in countries which themselves export a large share of motor vehicle production to the US or which provide parts to producers in other countries with high US exposure.

[5] GTAP has the advantage of incorporating the interlinkages between different sectors, both nationally and internationally. Higher tariffs on imported cars in the US lowers demand for these cars based on car sector price elasticities. This leads to a decline in production not only in the vehicle sector, but also in other sectors that contribute to production in the automotive sector.

[6] In GTAP passenger cars and car parts are part of an overarching motor vehicle sector. We have calculated and imposed a weighted tariff target based on the share passenger cars and car parts have in the total motor vehicle sector exports to the US, for each EU Member State separately.

Countries with large car export shares to the US and a large share of car sector production in total production are effected the most by the higher tariffs (Figures 3, 4 and 5). Production in the German car sector would suffer a 5% drop, but also in Hungary and Slovakia the impact would be significant (Table 2). Given the relatively large automotive sector in these countries, the impact on the gross value added is also significant.

An important shortcoming in our calculations is that the model does not capture any adverse sentiment effects. The European manufacturing sector is currently already under stress from the trade dispute between the US and China and a global drop in car sales (partially due to new emissions test in Europe and withdrawal of policies encouraging car ownership in China). As the risk of further escalation in the transatlantic trade dispute would grow, it could accelerate the already worsening sentiment. In countries with a large manufacturing sector, like Germany and Italy, these effects could dent labor markets and spending decisions. As such, rising trade tensions between the US and Europe could still tip the balance towards a full-fledged Eurozone recession in 2020 or 2021.

Impact on the United States

By imposing tariffs on foreign cars and car parts, the Trump administration aims to protect the domestic automotive sector, which could boost of the sector’s domestic market shares and should result in job creation for US citizens since car tariffs directly affect the competitiveness of European car producers. The results from GTAP for production in the American automotive sector (+2%) underline this, but there are other factors at play as well. Firstly, foreign manufacturers can choose to translate (part of) the tariffs into higher retail prices. This holds for complete cars but also for car parts and since American car producers import European car parts as well, these tariffs are affecting consumer prices in two ways. Hence, US consumers partly pay the price of higher tariffs. This import inflation results in a lower growth of private consumption and thus other sectors will be indirectly affected by car tariffs as well.

Overall, we expect the American economy to lose out slightly, as the negative economic impact on the European economy due to higher prices (due to the higher tariffs) also spills over to lower demand for other US goods.

In this report we have argued that there are considerable differences between the trade war between the US and China and the potential trade war between the US and the EU. However, there are commonalities as well and in the light of the experience of the past three years, the risk of rising trade tensions between the US and the EU cannot be dismissed.

If the US-China trade dispute cools down, it might just be that Europe is the US’ next trade target, as the Trump administration is looking for ways to influence the EU’s political- and geopolitical choices. There are a lot of ifs and buts before this scenario will actually come to pass, which makes gauging it’s probability a rather speculative exercise. But we feel it is sufficiently high to ponder the case and think about the consequences.

We calculate that the impact for the European car sector could be significant. GDP-wise the impact is likely to be relatively modest, but countries with a big car sector, Germany, Hungary and Slovakia in particular, could still see a material impact on their economies.

If it were to come to a trade dispute between the US and the EU, we deem it more likely that it will be solved through diplomacy than in the case of the US-China trade dispute. That said, the risk of a full-fledged transatlantic trade war would increase if the US raised car tariffs since it would likely lead to retaliation by the EU, before the EU would be willing to talk concessions, if at all. That in turn could raise pressure on the Trump administration to prepare the next set of protectionist measures, and so on.