The Bear's Lair

The Scramble For Europe

A recent paper by François Godement and Jona Parello-Plesner describes in rather startling terms how China is “buying” up Europe. According to the authors, the main components of this new wave of Chinese activity are:

1) China’s purchases of European countries’ sovereign debt

2) The acquisition of European companies by their technology-hungry Chinese counterparts

3) The exploitation of Europe’s open procurement policies, by low-cost and/or subsidised Chinese competitors

The authors argue that these factors are leading to new fault lines in Europe and making it much harder to implement a coordinated EU approach to China.

China‘s bond diplomacy

Bond markets have dominated the news in Europe for the past two years. With its vast trove of foreign reserves, China has often being mentioned as a possible white knight for stricken European countries. Never one to miss a trick, Wen Jiabao and Chinese diplomats have incorporated this development into their diplomacy and have dangled future bond purchases as a carrot in front of European countries, often encouraging them to shun human rights concerns in the process.

Of the three strands mentioned above however, this appears to be the weakest. As the authors acknowledge, the actual substance of these bond purchases was probably overestimated. They point to a chronic lack of information in both Europe and China as the major cause. Although there are estimates, China’s keeps the exact composition of its own foreign reserves a secret. Europe, unlike the US, publishes no coordinated data on foreign purchasers of public debt in the 27 member states. Very few member states reveal this information either. However this opacity has not stopped many Europeans observers and politicians from hoping out loud that China will move its attention away from US bonds to those of Europe.

However, as economists like Patric Chovanec and Michael Pettis have described, Chinese bond buying, and its viability as a political tool, is a perennially misunderstood topic, particularly by attention-grabbing media outlets. The Chinese purchase of US treasuries is not dictated by a political whim, but rather by the economic realities of China’s trade and exchange rate system. In a nutshell, if China continues to run a large current account deficit with the US, and if it wants to avoid a sharp appreciation of its currency, then it has no option but to continue buying US bonds, no matter what Chinese diplomats may say about switching their attention to Europe.

China’s direct investment in Europe

As the authors point out, China’s direct investment in European companies is growing at a brisk rate. Back in 2006, China’s total direct investment in Europe was $1.3 billion. So far in 2011, there have been three acquisitions of European companies by Chinese firms that have exceeded that amount by themselves. The authors suggest that Europe, and the US are becoming the major new targets of China’s “Going Out” policy, taking over from countries in Africa and Asia.

China’s recent five year plan has the explicit goal of moving China’s manufacturing up the value chain, away from low-end manufacturing. As a result China’s acquisitions focus on sectors that are rich in patents and where China’s own technological prowess is lacking. These ventures are often supported by the China Development Bank, a remarkable organisation whose original remit to invest in China’s interior has changed beyond all recognition.

Such moves are not without their problems. Again transparency is an issue. It is often incredibly hard to distinguish a private Chinese company from a public one. The corporate structure of Chinese companies is often opaque. Huawei is a common example. Officially the Chinese telecommunications giant is owned by 150 employees. However the alleged links of its founder Ren Zhengfei to the People’s Liberation Army has seen a deal to acquire a US company, 3Leafs, stopped dead in it tracks. The deal was stopped by the US Committee on Foreign Investments in the United States (CIFUS) and many in Europe are questioning whether Europe needs a similar body, perhaps involving the European parliament. Huawei seems unperturbed and is currently building a nationwide network with Telecom Italia.

On the whole it appears that China’s overseas direct investment to Europe is increasing as part of a broader diversification of China’s ODI. Officially, the data is hard to follow as China’s overseas direct investment largely flows to three areas: Hong Kong, the Cayman Islands and the Virgin Islands. In reality these funds are channelled to locations around the world. Derek Scissors of the Heritage Foundation publishes regular maps of Chinese ODI that show truly global activity, with China active in every corner of the world.

As the authors note, the problem presented by China’s direct investment in Europe becomes clearer when one considers the limited access of European companies to similar markets in China. Any sector which China deems “strategic” remains locked out to foreign competition, as agreed during China’s entry into the WTO in 2001. As a result European firms struggle to gain any traction in sectors such as air transport, finance and alternative energy. Such difficulties have heightened in recent times, despite the watering down of China’s “indigenous innovation” policies. According to the EU Chamber of Commerce’s 2011 survey, the sentiment among European firms is that China’s government policies have become increasingly less fair for foreign companies over the past two years.

Europe‘s open market for procurement

As the authors note, the past decade has seen the rise of Chinese infrastructure companies abroad – building everything from railways in Saudi Arabia, to ports in Africa. Now they are “taking” on Europe.

Spurred by on by austerity, European governments are casting their attention eastwards. Chinese diplomats, for their part, are asking for shopping lists of infrastructure projects that they can bid on. Worryingly there are political implications to some deals. When Serbia acquired a bridge over the Danube with financing from the China Development Bank, they initially acquiesced to China’s demands not to show up at the Nobel Peace Prize ceremony for Chinese activist Liu Xiaobo (they later relented).

The authors point to a failed contract between a Chinese stated owned enterprise COVEC and the Polish government to build the A2 highway in Poland as an example of what the future may look like: Chinese companies winning European infrastructure deals by offering unbeatable low prices – based on the use of Chinese employees working below European labour and environmental standards.

However although the authors touch on some of the difficulties that Chinese firms have experienced, they appear to underestimate the huge challenges that the Chinese model faces in Europe. In a recent searing editorial, Caixin, the Chinese investigative magazine, looked in depth at the failed project by COVEC to build the new Polish motorway. According to Caixin, the project involved a litany of mistakes from day one.

Initially Covec’s winning bid was “so low it shocked the European construction industry”. According to Caixin’s sources, COVEC allegedly planned to gradually jack up the prices – “a standard China method”. However while this worked in Africa in the past, it didn’t fly in Europe. COVEC was also forced to handle increased raw material costs and legal issues (the contract was only in Polish).

Due to skimping on feasibility studies, Covec under-estimated the technical difficulties of the project. As a final insult, when a special species of frog was discovered on the grounds, outraged COVEC officials were forced by environmental regulations to build a special passageway for the frogs, at a significant cost. The whole project ended in acrimony with COVEC walking away, the Polish government demanding 741 million zlotys in compensation and two Chinese working dying in a fatal crash on the road itself.

The long-term question, particularly in the wake of China’s recent high-peed rail crash, is whether China’s infrastructure companies can build a reputation for competence that will be a pre-requisite for growing their business in Europe.

Europe‘s new fault lines

According to the authors, the three factors above are leading to new fault lines in the relationships between European countries and China. Increasingly countries like France, Germany and the UK are banding together as “frustrated market-openers”. While not advocating protectionism, these countries increasingly resent China’s highly subsidised competition and is closed domestic markets.

On the other side is a growing band of “cash-strapped deal-seekers”, including countries such as Portugal, Greece, Spain and Hungary, who now see China as an increasingly attractive alternative to European or IMF loans.

So what to do?

As ever Europe needs to coordinate. The authors advocate for a new system to monitor and track government debt purchases, a system for vetting direct investment and attempts to promote fair competition in public procurement.

The first would follow the example of the US treasury and develop a unified statistical system to account for foreign holders of public debt. This is a smart move as it would deflate the publicity bubble that follows China’s buying, or alleged buying, of member states’ bonds.

The second proposal would bring a new layer of European supervision to foreign investment, particularly in sectors such as defence, critical technologies, media and education. As the authors point out, this would simply follow the huge degree of regulatory and administrative oversight in China (and even in the US). However protectionism, without good cause, is rarely the answer.

In public procurement the authors acknowledge that the EU cannot block member states from accepting bids from Chinese companies who are backed by soft loans. However it could deny EU subsidies to public projects involving companies from countries that do not grant access to their own public markets. This is a controversial suggestion and would likely raise considerable ire in China, where infrastructure companies are keenly aware of how and where EU funds are distributed. However it deserves to be discussed.

Finally the authors also propose building an index of the foreign share of public markets in both developed and developing markets. This would not just put pressure on China but also countries such as Japan, where procurement is closed to outsiders. The authors also argue that this could be incorporated into the upcoming EU-Japan FTA negotiations.

China has always been more comfortable focusing on bilateral relationships. As the authors note, China needs Europe and the European market for business. However they may also relish a divided Europe, for its own purposes.

The three trends outlined in their paper differ in their weight and it is unclear whether all of them will be sustained. However they all raise very real questions for European leaders. In deciding what to do, they will need to keep a cool head and propose practical, business-friendly solutions. The suggestions in this paper provide a useful starting point.

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