Leading euro area economists estimated that “the electrical equipment industry stands out as the most affected sector” in the event of a critical inputs supply shock from China and China-aligned countries, in a European Central Bank blog post published on Wednesday 9 October 2024. Photo: Shutterstock

Leading euro area economists estimated that “the electrical equipment industry stands out as the most affected sector” in the event of a critical inputs supply shock from China and China-aligned countries, in a European Central Bank blog post published on Wednesday 9 October 2024. Photo: Shutterstock

A potential disruption in critical inputs from China and China-aligned countries could lead to manufacturing value declines of up to 3.1% in five euro area economies, particularly affecting large firms and specific sectors such as electrical equipment and chemicals, warned leading economists in a recent blog post.

European manufacturing firms rely heavily on China for hundreds of “foreign critical inputs,” and in the event of a disruption to the Chinese supply chain, this dependence could cause significant turmoil in EU industries. To highlight this manufacturing conundrum, economists from the National Bank of Belgium, Bank of Italy, Bank of Slovenia, Bank of Spain and European Central Bank examined the implications of China’s role as a crucial supplier of foreign critical inputs to five euro area countries--Belgium, France, Italy, Slovenia and Spain--in a blog post by the ECB on 9 October 2024.

China’s dominance

According to the economists, China has established itself as the primary provider of FCIs for EU industries, accounting for one-third of such imports from extra-EU countries in 2022. FCIs are defined as components or materials that European firms either cannot produce domestically or have chosen to outsource. These imports are considered critical due to their difficulty to substitute, their high-tech nature and their importance for the green transition.

The European Commission has identified hundreds of such inputs, which include strategic products like microchips, turbine parts, optical equipment and chemical precursors essential for the production of pharmaceuticals and batteries for electric vehicles. Overall, FCIs represented 17% of extra-EU imports, with other notable geopolitical suppliers being Russia and Hong Kong.

Supply chain disruptions

To quantify the potential impact of a disruption in critical input supplies, the economists employed a firm-level partial equilibrium model, using trade and balance sheet data from Belgium, France, Italy, Slovenia and Spain. The model assessed the short-term effects on manufacturing value added from a scenario in which supplies of FCIs from China and other aligned countries were halved.

The analysis concluded that such disruptions would lead to a decline in manufacturing value added of 2.0% for Belgium, 2.5% for France, 2.9% for Spain and 3.1% for both Italy and Slovenia. The research indicated that large firms would primarily drive this decline, accounting for approximately 75% of the total reduction in value added across all countries.

Furthermore, the report noted that the top 1% of firms displayed significant variability in their contribution to this decline, explaining about 15% in Italy and Spain, around 30% in France and Belgium and over 50% in Slovenia.

Sectoral and regional disparities

The analysis revealed substantial disparities in the impact across different sectors. The electrical equipment sector emerged as the most affected, with a median value-added decline of around 7%, significantly higher than the overall median decline of less than 3%. Other industries that experienced declines above the median included chemicals, basic metals, electronics and machinery, collectively representing nearly one-third of the manufacturing value added in the analysed countries.

The report highlighted that while some sectors, such as electronics, showed consistent declines across countries, others, particularly chemicals and machinery, exhibited considerable variation due to differing sub-sector compositions and sourcing strategies.

Regional disparities also emerged within countries, driven by specialisation and concentration in specific sectors. Regions heavily reliant on FCIs from non-EU countries were the most impacted. For example, the Italian Marche region, with its specialisation in electrical equipment production, demonstrated greater vulnerability due to its reliance on foreign critical inputs from China-aligned countries. The concentration of major producers in certain regions further exacerbated this situation, as the presence of large firms magnified their impact on regional value added.

Policy implications

The economists concluded that identifying firms vulnerable to disruptions in critical inputs is essential for policymakers to prepare for potential economic shocks that could affect growth and price stability. They emphasised the importance of microdata in mapping strategic dependencies and quantifying their significance in the event of a supply chain disruption.

A more nuanced understanding of foreign dependencies would aid in identifying potential price pressures and assessing economic and financial stability risks. Additionally, the insights garnered from this research could inform more effective industrial policies and enhance supply chain resilience.

A forthcoming publication by the ECB is expected to provide further detailed analysis from researchers at nine national central banks and the ECB, offering implications of global geoeconomic trade fragmentation for the euro area.

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