Should the U.S. ban imports of Chinese electric vehicles?

The Biden administration recently ordered an investigation into the national security threat posed by Chinese connected-vehicle technology.

The outcome, if taken to an extreme, could result in a ban on the import of Chinese vehicles into the United States.

But there is much more driving the decision than national security concerns. For an administration that has embraced a revival of industrial policy, the investigation is the latest sign that it is intent on nurturing critical infant technologies such as microchips, artificial intelligence, quantum computing and, now, the booming market in electric vehicles. Bloomberg estimates the EV market will grow to $8.8 trillion by 2030, with the United States accounting for 21%, or $1.8 trillion.

And the investigation comes just as China is seeking to reinvigorate its sagging economy using an approach it has relied on for decades—make cheap goods and sell them to willing trading partner around the world. Only this time, those trading partners may not be so willing.

The embrace of industrial policy is happening despite its risks. The rules at the core of industrial policies like these tend to result in the creation of national champions that lead to an inefficient allocation of scarce capital, and, as a result, complacency among firms that hide from competition.

As such, should a pause or outright barrier on entry of Chinese EVs into the U.S. market happen, this should not lead companies to become complacent.

Read more of RSM’s insights on manufacturing and the economy.

Rather, the companies must continue prioritizing innovation, efficiency, consumer focus, and agility to keep pace with the evolution of the automotive sector. They must continue to integrate sophisticated technology into the production of goods even if that means reaching beyond national borders.

The move by many advanced economies to adopt industrial policy to confront the Chinese economic challenge will increasingly be a source of increased tensions. Part of China’s solution to its slowing growth—to export excess manufacturing capacity and deflation—is simply not going to be accommodated like it might have been in past decades.

Competition and conflict generated by these choices, illustrated here by the attempt to protect an infant industry within the context of national security and economic security, are indicative of the new era of international security, economics and politics that will shape global order.

China’s growth model reaches an end

China is ensnared in an era of debt and deleveraging that represents the functional end of the growth model that has fueled its economy for decades.

While this deleveraging has not yet evolved into a full-blown crisis, there is an undeniable need for Chinese households, firms, local and state governments to draw down the prodigious quantities of debt on their respective balance sheets. That process will reshape the domestic economy and will hurt China’s relations with the major global economies.

Essentially the debt overhang in commercial and residential real estate is acting as a drag on overall growth that once came from the modernization of infrastructure, housing, and manufacturing.

Because two thirds of that triad are now defined by diminishing returns, the Chinese find themselves in a difficult situation: They are reluctant to further rebalance their economy toward its households, which would involve difficult and substantial redistributions of wealth that are not favored by the government.

In addition, given the size of China’s current account surplus and its national savings, which are greater than 40% of its gross domestic product, there is no way that the debt-fueled investment boom can continue. Any new debt, in effect, has nowhere to go. Now, as the 10% growth rate of previous decades slows substantially, secular stagnation has set in, which requires a different policy response.

Rather than reflate domestic consumption, which would maintain growth as the deleveraging continues, the government has decided to redirect risk capital back toward the manufacturing sector.

Boosting industrial production is designed to protect employment in the manufacturing sector while exporting the burden of adjustment to its trading partners.

But China’s trade partners, unlike previous decades when they welcomed cheap goods, have little interest in playing along this time. And for China, the policy could ultimately backfire and increase domestic debt.

To put that in perspective, consider that China’s share of global manufacturing stands near 31%, which is almost twice its share of global gross domestic product, which is 18%. Compare that with the United States, whose share of global manufacturing is roughly 15% in comparison with its 23% of global GDP

Given that China’s share of global consumption is approximately 13% in contrast with the 27% share of the United States, or the 17% of the European Union, one can see that Beijing does not retain the domestic capacity to absorb that excess production, nor does it intend to.

In short, China intends to export its way out of its debt and deleveraging era through the U.S., European Union and major regional trading partners, which would absorb that excess production and accept a reduced share of global manufacturing while at the same time accepting the deflation that comes with it.

With the U.S. and other major economies turning to industrial policy to capture a greater share of overall global manufacturing capacity, something is going to have to give.

The result is an escalation in global economic and geopolitical tensions.
This almost certainly means that the U.S., EU and the other major economies will place barriers to entry to their domestic markets using national security and the protection of infant industries as the reason for doing so.

That’s where electric vehicles come in, as the United States considers limiting the entry of cheap Chinese electric vehicles into the North American market, whether they are made in China, or assembled in Mexico.

If that were to happen, one would strongly expect the E.U, U.K and the other major industrial powers to follow suit.

The U.S. electric vehicle market

The U.S. automotive sector currently sells an average of 15 million to 16 million new vehicles a year, with battery electric vehicles (EVs) comprising about 8% of total sales.

According to the Bloomberg’s BNEF data, the number of battery electric and plug-in hybrid vehicles on the road in the U.S. neared 5 million last year—less than 2% of the total fleet. But that is expected to grow to close to 17% by 2030 and 40% by 2035.

Battery and plug-in hybrid EV sales, which reached 1.4 million last year, are projected to climb to 8 million by 2030, which would be over 50% of total vehicle sales.

Even though the pace of EV sales growth may be debatable, it is undeniable that the U.S. EV market, the second largest after China, has substantial growth opportunities and is highly attractive to global automakers.

EV transition is not easy, for both EV startups seeking investments for technology development and scaling production, and established automakers striving to balance investments in electric vehicle production at the right pace while maintaining profitable internal combustion engine (ICE) models.

A recent slowdown in EV sales growth, driven by rising interest rates and vehicle prices making consumers more cost-conscious, highlights the uncertainty for EV demand. Even with the $7,500 EV tax credit, the upfront cost of EVs remains higher than their ICE cousins.

New restrictions on sourcing battery components and critical minerals from foreign entities reduced the number of qualifying models to just 13 at the start of the year.

EV sales growth has already prompted several original equipment manufacturers to reduce prices and scale back on production and supply chain commitments.

In addition to demand uncertainties, the sector faces higher costs of production. Labor costs, for instance, are rising across the board, not just for the Detroit Three but also for the entire industry as automakers and suppliers adjust to higher unionized wage standards established by recent contract renegotiations.

Transition requires significant investments in EV technology development and retooling and launching of EV assembly lines. And it takes time to build out supply chains tailored to electric vehicle technology. Following the Inflation Reduction Act, investments in EV manufacturing facilities and battery production have surged.

This investment growth will eventually increase production capacity and localize critical EV technology components. Until these investments become operational, however, the industry will depend on sourcing certain battery technologies and materials from China.

Competition and economic conflict of the type that we think is about to begin will almost certainly result in the U.S. having to look elsewhere for such technologies.

Chinese market dynamics and U.S. tariffs

Chinese automakers embarked on developing their EV sector more than a decade ago and now have a significant lead across the value chain, from pioneering battery technology to securing reliable sources of materials.

This advantage stems from many factors: lower production costs, well-developed electronics research and development, a robust manufacturing ecosystem, access to domestically mined and processed critical minerals, large domestic market, and, most important, hefty government subsidies.

According to Bloomberg, this governmental support has catalyzed the launch of more than 500 EV companies, enabling Chinese automakers to dominate their home market. Now, waning domestic growth and the slowdown of the Chinese economy are forcing companies to look for global expansion.

Notably, in the fourth quarter, China’s BYD automotive brand surpassed Tesla in EV sales, and China eclipsed Japan as the world’s leading car exporter with 5 million exported units. Most of the sales went into Europe, causing the European Union to launch an anti-subsidies probe into the Chinese-produced EVs.

In the U.S., heavy 27.5% tariffs on Chinese car imports have kept Chinese automakers out, but this barrier may not last for much longer. An increasing number of Chinese automakers and suppliers are setting up production facilities in Mexico.

These factories could soon enable Chinese vehicles manufactured in Mexico to enter the U.S. market. Whether these vehicles will qualify for USMCA requirements or face new import restrictions remains to be seen.

Problems with protectionism

This is not the first time that U.S. trading partners have held a comparative advantage. In the 1960s and 1970s, more fuel-efficient foreign cars captured significant market share when the oil embargoes caught the West off guard, sending economies in the West into a series of deep economic crises.

It was not until the 1980s that Detroit could even think of competing with foreign automakers.
The decline of the once-complacent U.S. auto industry suggests that free trade is beneficial in terms of maintaining competitiveness, expanding the market for other U.S. products, and maintaining the world-wide demand for the dollar.

Deviation from that condition should be done with utmost care.

Two centuries of economic and empirical evidence show the significant problems with protectionism. Economists have found that the U.S. retreat from international trade in recent decades has in fact hurt the middle class and the very people such barriers were supposed to protect.

Contrary to conventional wisdom that the displacement of manufacturing employment was caused by trade, it was rapid change in technology as well as changes in preference and taste that caused job losses in some areas of the economy. But still, free trade continues to be used as a scapegoat for technological and cultural change which could lead to inefficient and sub-optimal politically driven economic outcomes.

Which again leads us back to the Chinese EVs. The question of blocking the import of cheaply made cars made in China into North America and Europe remains fraught with the ramifications of potential retaliation.

The advanced economies of Europe and North America specialize in high-value-added sectors where wages and technological requirements are high and should not fear foreign competition. In fact, competition is a source of innovation and it led American automakers to regain their edge.

The return of that edge can best be observed by the superior technology integrated into American autos versus its foreign competitors currently.

If the use of national security concerns and the nurturing of infant industries results in era of economic and industrial complacency, then industrial policy will fail.

While one can understand the reasons why the administration wants and intends to follow through on addressing the mercantilist challenge by China policy, design and implementation is much more nuanced than is commonly acknowledged. Efforts to implement such policies should be done with care and subject to strenuous oversight and review.

The takeaway

Structural economic problems inside China and its ineffective and misguided policy response will result in greater economic and security tensions.

Attempts to export its burden of adjustment to the U.S., E.U., India and its major trade partners will be correctly interpreted as a beggar-thy-neighbor trade policy and fought vigorously.

That approach might have worked 30 years ago at the outset of the era of hyper-globalization.

But in this era of industrial policy, it will only stoke an increase in trade, investment and geopolitical tensions.

It is highly likely that in the near term that the United States and its major trading partners are going to move to limit entry of Chinese electric vehicles into their wealthy consumer markets.

We expect that the rationale and policy actions will almost certainly be replicated in other value-added areas of the economy in general and artificial intelligence and quantum computing in particular.

For better or worse, the advent of industrial policy in the West and the end of the Chinese economic model are going to result in an increase in tensions in the near term.

The logic of industrial policy, however well-intentioned, will likely result in further demands for protection. Such protection can lead to complacency and a lack of innovation on the part of firms that find rent seeking via the policy channel is cheaper than engaging in sustained competition.

It is critical that firms and policymakers do not confuse the need for industrial policy as a mask for a non-competitive firms that refuse to engage in sustained innovation.

There is no substitute for productivity-enhancing capital expenditures and an understanding that the only constant in modern commerce is change. Innovation is not an option, but a fundamental requirement to compete in the modern economy.