By Eric Vandenbroeck and co-workers

Past Changes, Future Problems

The economic news from Europe over the past month has been bleak. Throughout the eurozone, gross domestic product is either stagnant or in decline. Business surveys from September show that Germany’s economy – the engine of the European Union – has entered recession as it struggles with high energy costs and weak industrial output. Reports about intensified Russian attacks on Ukrainian port infrastructure will only make matters worse, especially as the conflict in the Middle East escalates. Spikes in the price of energy and food cannot be ruled out.

And yet, the underlying issues facing the global economy stem from deeper challenges, which owe partly to the way the global economy has changed over the past few decades. These changes highlight the structural vulnerabilities in international trade systems and supply chains that were established long before the current crises.

In Europe, the biggest change after the Cold War ended was deindustrialization. After China joined the World Trade Organization in 2001, European companies raced to outsource their manufacturing to countries with lower labor costs. Europe’s industry has since suffered greatly, especially in sectors that are energy-intensive – a problem that has only intensified since Russia’s invasion of Ukraine in 2022. The surge in energy prices that year has since declined, but executives in the chemicals, steel and aluminum industries argue that European competitiveness has yet to recover. While Europe has been working to switch from natural gas to liquified natural gas, this conversion in energy-intensive sectors is not only expensive but also sometimes difficult, if not impossible. (For example, while steel production using LNG is possible, it is not very effective.) Compounding the problem is that the wars to the east and southeast have compelled Europe to strengthen its military capabilities. To do that, Europe must prioritize the rehabilitation of these crucial industries, focusing on reindustrialization as a strategic imperative that will benefit its economies and defenses alike.

Naturally, this is easier said than done. Rising energy and labor costs have dramatically cut European manufacturing. Since the global financial crisis of 2008, there has been a sharp decline in such key industries as cars, chemicals, textiles, electronics and food processing throughout the European Union. The bloc’s share of global gross value added fell to a low of just over 13 percent, according to Eurostat. By 2022, that number had climbed back to 15 percent – lower than its peak in the mid-1990s but still the highest it has been since 2004.

Reindustrialization will require significant investment, especially in areas vital to economic resilience and strategic independence. The COVID-19 pandemic (and its economic discontents) added a new sense of urgency to efforts to restore businesses as a way to mitigate the risks inherent to global supply networks. Thus, since 2020, foreign direct investment in Europe has grown, with an important rise in cross-border investment projects, notably in the EU's manufacturing sector. (There was a temporary drop after Russia invaded Ukraine.)

Even so, the costs of reshoring are considerable, particularly in industries where governments do not provide incentives. There’s plenty of data to suggest that FDI has expanded most in sectors where authorities give more assistance, especially for megaprojects in strategically critical industries such as semiconductors, electric vehicles and pharmaceuticals. But state support is not enough. True reindustrialization requires more than just money; it needs strong infrastructure, skilled labor, raw materials, energy and a well-developed industrial ecosystem – measures that go beyond incentives and introduce ways to support small and medium-sized enterprises and innovation that could contribute to improving the business environment as a whole. Without addressing these issues, FDI projects risk falling short of their potential to contribute meaningfully to reindustrialization.

One thing Europe (and others) has going for it is that even before the pandemic (while investment was low) companies had already undertaken other efforts to mitigate supply chain risk, including global free zones and special economic zones – designated areas within countries that offer businesses advantages such as reduced taxes, relaxed regulations and streamlined customs processes. These zones tend to attract FDI because they provide a highly favorable environment for manufacturing, trade and logistics. And since they are often located strategically near trade routes, ports and airports, they also tend to reduce operational costs, increase market access and enhance business flexibility.

It should come as no surprise, then, that global free zones attracted record-breaking FDI in 2023, accounting for nearly 5 percent of all FDI projects worldwide. It’s unclear exactly how many such zones there are globally – estimations vary depending on governance, incentives, target sectors, services offered and, critically, the organization reporting the number – but most reports note a trend toward “new-generation zones,” which are usually bigger, more integrated with local economies and less reliant on fiscal incentives than earlier zones. What is clear is that Europe has significantly fewer SEZs than Asia and Africa. European SEZs are more regulated and less incentivized, and they often target high-value businesses such as technology, pharmaceuticals and sophisticated manufacturing. Thus as state-incentivized cross-border investments expanded in Europe, so did investments in European SEZs.

State inducements aside, the growing trend of SEZs in Europe can also be attributed to the geopolitical risks that have reshaped global trade routes. The Northern Corridor, which passes through Russia, is not used nearly as much as it once was, thanks to the Russian invasion of Ukraine. Trade via the world’s oceans and the Red Sea, meanwhile, has similarly become an unreliable security risk. This has opened up opportunities for the Middle Corridor, a route connecting Europe and Asia through the Caucasus and Central Asia whose traffic doubled from 2022 to 2023 compared with pre-pandemic data.

But there are several problems that must be addressed before the corridor realizes its potential. It's fraught with logistical and infrastructural obstacles, including inefficiencies in port operations, underdeveloped rail systems and bottlenecks at key border crossings. It is also comparatively primitive, so the limited exchanges of digitized data hampers cargo movement, contributing to delays and increased costs. If the Middle Corridor is to be globally competitive, it will require a substantial amount of investment and even more cooperation among the states through which it passes. Problematically, most of these countries are in Central Asia, the Caucasus and the Black Sea region, which can have wildly different priorities and ideas on how to capitalize on infrastructure investment.

The EU will have to be proactive to make sure the trade route is reliable and efficient and aligns with its interests. To that end, it has already taken diplomatic steps to maintain dialogue with Central Asian countries and has promised to invest in the Middle Corridor, especially its railways. But improving port operations in, say, Georgia and Turkey, may be beyond the EU’s control. Not only are they not members of the EU, but recently, they have been turning away from the West and even been at odds with the bloc, becoming recipients of Chinese investment, at least as far as port infrastructure is concerned.

To some degree or another, the success of the Middle Corridor will be determined by the security of the corridor’s entry point to Europe: the Black Sea. The sea houses several SEZs along its coast that facilitate – and, if things are going well, enhance – regional trade. The corridor may be able to function, but it will never be able to thrive, let alone integrate with European supply chains, unless Europe can ensure freedom of navigation and safeguard Black Sea shipping routes. This is why Brussels seems to have prioritized working on maritime security there and has become so focused on its military capabilities.

To keep the Black Sea open and free, the EU will have to closely collaborate with NATO, which also has a strategic interest in Black Sea stability. However, Turkey – a NATO member – tends to pursue a more autonomous foreign policy. Unlike many others in the group, it maintains relations with Russia and has strengthened economic ties with China, making it a pivotal but difficult partner for the EU and NATO. Ideally, the EU would be able to engage in nuanced diplomacy, leveraging Turkey’s position in the Middle Corridor while addressing divergent foreign policy goals. However the EU policy is compromised by member states that have their foreign policy agendas, which will make the promotion of the Middle Corridor even more difficult.

And there’s not much appetite for difficulty right now. European businesses’ inclination toward SEZs, which rely on the largesse of their respective governments, reflects a growing caution about escalating geopolitical risks. When businesses are squeamish, it usually indicates a belief that global tensions will continue to rise, not fall. This bodes ill for a continent trying to develop a cohesive economic strategy that at once reindustrializes its economies and improves its defensive posture within NATO.

 

 

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