Industrial policy – old dog, new tricks? New EU fiscal deficit rules, a second preview on the French elections, and overcapacities in China

Industrial policies and subsidies have made a strong comeback recently, particularly in major economies like the US, China, India, Germany, and Brazil. Governments are actively engaging in determining industrial priorities and providing subsidies to strategic industries, aiming to foster innovation and the spread of technology: Our deep-dive analysis this week on new tricks being embraced, on short-term gains and longer-term challenges and why we believe that for the EU, smart, horizontal, conditional, and complementary policies are crucial. The outcome of the EU elections last week was a wake-up call for many (a politician) and triggered, for instance, snap elections in France in late June/early July – one of our What to Watch stories this week. We stay on the election topic: in our latest podcast episode, we speak with Ana Boata, Head of Economic Research at Allianz Trade, and Senior Economist Jasmin Groeschl, about the different scenarios for the European Parliament and what to expect during the upcoming 5-year mandate. Further research for you on how the European Commission plays bad cop on fiscal deficits with several member states being called out for exceeding the official high-water mark for debt ?(it remains to be seen just how forcefully the new fiscal rules will be applied) and the latest on excess capacity in China stirring G7 concerns.

Industrial policy: old dog, new tricks?

The analytical deep-dive for you here.

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Industrial policies and subsidies are back with a bang, especially in major economies such as the US, China, India, Germany, and Brazil. Governments are increasingly getting involved in setting industrial priorities and supporting strategic industries through subsidies to promote innovation and technology diffusion. The 2,642 industrial policy measures implemented in 2023 were driven by efforts to secure strategic competitiveness and mitigate climate change, as well as an increasing emphasis on national security. But industrial policy is not a perfect solution and can even be counterproductive, leading to tit-for tat reactions. And fiscal capacity is the main constraint for financing industrial policy. Subsidies averaged 0.3% of GDP in EU27 economies in 2023. As more and more countries face constraints from budget deficits, public debt, and fiscal pressures, this emphasizes the need for well-considered fiscal policies to promote innovation while being mindful of potential economic distortions.

For investors and businesses, the return of industrial policy offers short term gains for some but can also create longer-term challenges. Over the short run, transition-related and tech sectors will gain the most from industrial policies, especially low-carbon technologies, metals (steel, aluminum, and critical materials), advanced technologies, semiconductors, and defense-related sectors. Companies should benefit from a significant profitability boost: The average renewable/green tech manufacturer could see its gross profit margin double by 2025 compared to a baseline without tax credits. Industrial policy will also allow investors to play the commodities playbook at the expense of corporates and consumers. As the supply-demand gaps for some metals are becoming increasingly evident and inflationary risks loom, prices will increase in the future. Large corporates looking to finance projects eligible for industrial policy subsidies through green bonds could also benefit from significantly lower financing costs as industrial policies could lower risk. However, investment can eventually turn into over-investment and lose its efficiency. And industrial policy could lead to a crowding-out effect as large corporates are taking the lion’s share of receipts. For instance, only seven very large global firms will benefit from 75% of the CHIPS program grants that have already been allocated (USD29.3bn). This needs to be addressed by smarter, more efficient industrial policies.

The EU’s industrial policy faces challenges as it aims to balance the green and digital transition, maintain the Single Market, foster innovation, and retain national control over policies. The EU’s industrial strategy focuses on key sectors such as semiconductor technologies, hydrogen, industrial data, space launchers and zero-emission aviation to achieve targets such as producing 10mn tons of green hydrogen by 2030 and securing a 20% share of the global microchips market. EU cross-border projects are supported with EUR80bn in approved investments across the chips, battery, and hydrogen sectors, while allocating 32.6% of the total EU budget between 2021 to 2027 towards climate tech. But technological neutrality in EU industrial policy has led to less targeted support for innovative technologies compared to the US. Moving forward, EU policymakers should mainly target countries with high emissions and carbon prices just at or below the EU ETS price of USD61.3, such as Germany, France, Spain, Italy, or Poland. To achieve strategic competitiveness, climate goals and resilient supply chains, the focus should be on industry, energy supply and agriculture.

In this context, we argue that the EU needs to design smart, horizontal, conditional, and complementary policies that help the bloc leap forward instead of chasing the US and China. The bloc should (i) focus on horizontal policies, designing a mobility policy instead of a standalone EV policy for example; (ii) coordinate policies considering member states’ specializations and taking advantage of complementarities between countries and sectors; (iii) implement strong conditionality on sustainability and domestic content of projects before unlocking public support, without increasing red tape, (iv) ensure policymakers are made accountable for industrial policies through relevant KPIs and design policies with multiple stakeholders, including scientists and civil society, (v) place the innovation ecosystem at the core and think “two steps ahead” instead of chasing the US and China and (vi) share risks and profits with the private sector through blended industrial policy (PPS, mixed financing).

The analytical deep-dive for you here.

What to Watch this week

You’ll find all the stories here.

• European Commission plays bad cop on fiscal deficits. France, Italy, Poland, Belgium, Hungary, Slovakia, and Malta have been named and shamed for running fiscal deficits above -3% of GDP. But we will only find out in mid-July how forcefully the new fiscal rules will be applied – and how much wiggle room is offered to the EU members. For Italy, an Excessive Deficit Procedure would mean a significant fiscal adjustment in the structural balance (~1% of GDP per year) and up to 0.05% of GDP in fines. In France, the fiscal deficit is likely to remain above -4.5% of GDP in 2025-26 no matter who wins the parliamentary elections in July.?
• French elections: The fiscal pinch of the Front Populaire. Polls indicate that the left-wing alliance could secure around 28% of votes in the first round, more than President Macron’s Renaissance alliance (18%) but less than the right-wing alliance (33%). The left-wing alliance aims to unleash EUR160bn of spending, funded by substantial tax increases, with a net fiscal cost of around EUR55bn or close to 2% of GDP. The French government bond spread would widen to 120bps in 2024, nearly double the increase expected under a far-right government, and GDP growth would be hit by a contained -0.3pp in 2025 as tighter financial conditions more than offset the growth-boosting effect of fiscal expansion. But the public deficit would rise above -6% of GDP, and negative economic impacts could build up over time amid lower potential growth and a loss of competitiveness.
• Overcapacities in China call for higher outbound investment. This month’s G7 statement is the latest to raise concerns about excess capacity in China, where the industrial capacity-utilization rate has declined from 77.2% in Q1 2021 to 73.6% in Q1 2024, the lowest level since 2016 (outside Covid-19). A cyclical imbalance is again at play today amid still-soft domestic demand and supply-side stimulus. The domestic context is giving Chinese exporters room to further lower prices to maintain or expand overseas market share, or to make up for higher tariffs. And China’s trade surplus is set to rise further, particularly with emerging economies who account for nearly 60% of Chinese exports. Increasing outbound investment could be a win-win solution to mitigate the trade surplus but is likely to face geopolitical pushback.

You’ll find all the stories here.