The European economy is renowned for the intensity of its trade compared to others major economies. Over the past three decades, it has consistently increased its reliance on imports and exports, setting it apart from countries like China, which shifted away from an export-led growth model in the mid-2000s, and the USA, which is primarily focused on its domestic market (see chart 1).

Chart 1

Europe's increased openness to trade, which coincided with the creation of the EU single market and the signing of the UN General Agreement on Tariffs and Trade (GATT), has been a success story. S&P Global Ratings estimates that this openness has made the average EU citizen €19,000 richer and contributed about 5% of the cumulative increase in per capita GDP since the mid-1990s, mostly by fostering labor productivity.

However, there are signs of fatigue in this strategy. The EU's trade surplus, which remains significant, at 3.7% of GDP in 2023, has declined almost a full percentage point since peaking in 2015. Growth in global trade has slowed to 2% a year on average since the pandemic, down from 5.7% over the previous 25 years. This deceleration is largely attributable to the pandemic and geopolitical developments that have constrained the expansion of value chains and trade in intermediate goods. Yet, Europe is also losing market share, primarily to China, in international merchandise trade, which accounts for the lion's share of global trade (see chart 2).

Chart 2

The recent dip in Europe's share of global trade is attributable, in part, to the spike in the cost of energy imports that followed Russia's 2022 invasion of Ukraine. Europe, at that time, was heavily reliant on energy imports from Russia, and the resulting disruption resulted in the value of energy imports to Europe increasing by 4 percentage points (pp) of GDP in 2022.

That lead to an unprecedented deterioration in terms-of-trade and a decline in export competitiveness. The shock prompted energy-intensive industries such as the metal, chemicals, and paper industries, particularly in Germany, the Netherlands, and some eastern European countries, to move their production (primarily to China in the case of the German chemical industry). This relocation resulted in a 5pp decline in European manufacturing production, which ended only in late 2023 when energy costs normalized following significant European efforts to substitute cheap Russian energy.

The recovery in terms-of-trade is almost complete (see chart 3), but energy-intensive sectors, and in particular the metal industry, have proven slow to restart production in Europe. Consequently, Europe's share of global trade has not completely recovered. We believe that reforming the energy market is a strategic objective for the incoming European Commission (see "Credit FAQ: The Next European Commission’s Policy Choices: A Credit Perspective," July 17, 2024).

Chart 3

U.S. And Chinese Policies Could Threaten European Trade

Energy cost is not the whole story. Europe's position in global trade is being challenged by its top two trading partners, the U.S. and China. In 2023, the EU had a trade surplus of €113 billion with the U.S. and a trade deficit of €187 billion with China. There is a risk that the U.S. will raise tariffs on imported goods, depending on the outcome of its elections. Meanwhile China, continues to pursue a policy of enhancing its value-added in sectors where Europe has traditionally excelled. What is more, China has recently initiated an investigation into some European exports in response to tariffs imposed by the EU on electric vehicle (EV) imports from China.

Exports of goods to the U.S. account for about 2.6% of EU GDP, while exports to China are about 1.5%. About half of that trade is European value-added. Among the largest regional economies, Germany is unsurprisingly the most exposed to these flows.

U.S. tariffs on European goods vary from 1.2% on capital goods to 5% on consumer goods (see chart 4), which is in line with equivalent tariffs on imports from other countries.

Chart 4

The previous increase in US tariffs, in 2019, had a minimal effect on the European economy as it affected very few sectors and was temporary. This time, the risk is more significant. If the next US administration imposes a 10% across-the-board tariff increase on imports from Europe, we estimate that this could shave about 0.2% off European GDP and 0.4% off gross exports, based on an average of benchmark elasticities (see table 1 and references listed at the end of this article).

Our estimates align closely to the average of the benchmark trade elasticities. It is notable that the benchmark elasticities are of a similar magnitude whether we look at EU exports to the U.S. or to China.

Table 1

Such estimates are useful, but they remain an econometric exercise. It is conceivable that the impact on EU exports could be greater if the rise in U.S. tariffs affects confidence and shakes financial markets. Alternatively, the effects on Europe could be mitigated if the U.S. were to impose heavier tariffs on imports from other regions, or if European exporters reorganized trade routes to bypass the new tariffs. Furthermore, fluctuations in the exchange rate could amplify or damp the impact of higher U.S. tariffs on trade.

China's Importance For European Trade Has Grown

In terms of gross exports, the U.S. remains a more significant trading partner for the EU compared to China. In 2019, prior to the pandemic, China accounted for 10% of total EU exports, while the U.S. accounted for 17%. That gap is almost equally important in both goods exports (11% to China versus 19% to the U.S.) and tradable services exports (9% to China versus 16% to the U.S.) (see chart 5). However, China's emergence as an export destination has been remarkable since 1995 (see chart 6), and the gap between China and the U.S. is narrowing across all sectors.

It is also important to recognize that Europe's trade with the U.S. and China differs in nature. The U.S. is a key destination for the European pharmaceuticals, accounting for about 50% of the sector's exports. Meanwhile, China has become the primary export destination for the Europe's computer, electronics, and optical industries, surpassing the US. For Europe's base metals industry, China and the U.S. are now on parity as trading partners, although their trends are divergent, with an upward trajectory for China and a downward trajectory for the U.S.

Chart 5

Chart 6

The Differences Between Trade With The U.S. And China

Looking solely at gross exports reveals only a partial understanding of EU trade with China and the U.S. The importance of the two blocs takes on another dimension when foreign trade is considered in terms of the origin of value-added in final demand. As mentioned earlier, the EU has a trade surplus with the U.S. but a trade deficit with China. This indicates that the EU's trade with China is import-oriented, which becomes evident when we look at the composition of Europe's final demand by sector. In certain sectors, content originating in China exceeds that from the U.S. This is the case for European sectors including computers and electronics, electrical equipment, and machinery and equipment. On the other hand, sectors including pharmaceuticals, chemicals, transport equipment excluding motor vehicles, and base metals have a higher U.S. content (see chart 7). In some cases, China's share of Europe's final demand even reaches double digits, with value-added at 19% for computers and electronics and 12% for electrical equipment, creating genuine dependence on China.

The growth in China's share of EU final demand since the mid-1990s has been impressive (see chart 8). In many sectors, China's share of final demand in EU now surpasses the U.S.'s share in 1995. These dependencies extend beyond the sectors cited and are indirectly present in all European sectors that rely on their inputs for their own production.

Protectionism is not in the EU's DNA, as evidenced by Eurostat data indicating that 72% of EU imports in 2023 entered with zero tariffs. That combined with the growing reliance on Chinese value-added explains why EU authorities prefer to focus on 'derisking' rather than 'decoupling' from China.

Chart 7

Chart 8

The EU's Technological Dependence Still Skews To The U.S.

Technology plays a significant role in Europe's dependence on the U.S. and China. Research shows that the EU economy relies more on the U.S. for technology, primarily due to the global reach of American technologies(see "Global Influence of Inventions and Technology Sovereignty," Zew Policy Brief, Feb. 2024). However, Europe depends on both countries in this aspect.

Interestingly, the erosion of Europe's trade surplus has coincided with a reduced propensity for the region to invest savings, particularly in research and development (R&D) and technology. Instead savings have been redirected toward domestic balance sheet cleansing, following the Global Financing Crisis and the Eurozone debt crisis, and foreign investment. Consequently, Europe has fallen back in terms of global patent applications relative to other countries, and especially China(see chart 9). In absolute terms, the number of European patent applications has stagnated since 2019 (see chart 10).

Chart 9

Chart 10

Moreover, Europe is largely absent in certain important disruptive technologies, such as blockchain, computer vision, and genome editing, in contrast to the U.S. and China. That is even though many of the patents for these technologies originated from research conducted in European universities (see "A New Dataset To Study A Century Of Innovation In Europe And In The US," Research Policy, 2024). Europe's absence from these new technologies has raised fears that its long term commercial competitiveness is in danger of falling victim to the "middle technology trap", whereby R&D and innovation are concentrated in lower-growth, medium-technology sectors which are dominated by entrenched companies that are little-troubled by new entrants or disruptive innovations. Europe's automotive sector is often cited as an example of that scenario.

Blame for the growing technology gap between Europe and the U.S. and China is often attributed to a lack of financing for innovation and failure to scale-up of innovative firms (see "How to escape the middle technology trap," published by the European Policy Analysis Group). This is one reason why we continue to advocate for a capital markets union, with the aim to strengthen the capital base of small and midsize enterprises. Yet, Europe's growing technology deficit and declining competitiveness are not inevitable.

We believe the EU economy has options to reverse its decline in competitiveness, and moreover, that the levers at its disposal align with the openness that is inherent to the DNA of the EU. They include further European integration, notably through the unification of energy and capital markets, the simplification of business regulation, the fostering of investment in domestic industries, and the creation of initiatives that support innovation and innovative companies.

If Europe can grasp those opportunities, it may yet escape the jaws of the middle technology trap.

Research contributor: Paul Ulbrich

Related Research

S&P Global Ratings research

• Slow-Motion Shakeup? Asia’s Role In Global Supply Chains Is Slow To Change, Aug. 28, 2024.
• The Next European Commission’s Policy Choices: A Credit Perspective, July 17, 2024.
• NextGenerationEU And The Capital Markets Union Can Boost Europe’s Dwindling Productivity, April 10, 2024.

Other research

• While The US And China Decouple, The EU And China Deepen Trade Dependencies: Peterson Institute for International Economics, Aug. 27, 2024.
• The Past, Present And The Future Of European Productivity: Presented At The European Central Bank Forum On Central Banking, Antonin Bergeaud, July 3, 2024.
• Dwindling Investments Become More Concentrated- Chinese FDI in Europe: 2023 Update: Rohdium Group And MERICS, June 6, 2024.
• Global Influence Of Inventions And Technology Sovereignty: ZEW Policy Brief, Philipp Boeing, Elisabeth Mueller, February 2024.
• Accelerating Europe: Competitiveness For A New Era: McKinsey Global Institute, January 2024.
• Understanding EU-China Economic Exposure, Single Market Economics Briefs: European Commission, January 2024.
• A New Dataset To Study A Century Of Innovation In Europe And In The US: Research Policy, 53(1), 104903, Antonin Bergeaud and Cyril Verluise, January 2024.
• EU Innovation Policy--How To Escape The Middle Technology Trap: European Policy Analysis Group, Clemens Fuest, Daniel Gros, Philipp-Leo Mengel, Giorgio Presidente, Jean Tirole, February 2024.
• New Global Estimates Of Import Demand Elasticities: A Technical Note: Economic And Social Commission For Asia And The Pacific (A Commission Of The U.N.), July 15, 2020.
• Trade Elasticities, Heterogeneity, And Optimal Tariffs: The Journal Of International Economics, Anson Soderbery, September 2018.
• Estimating Trade Restrictiveness Indices: Economic Journal, Hiau Looi Kee, Alessandro Nicita, Marcelo Olarreaga, February 2009.