Caught in the middle

The great power competition between China and the US will shake up the world order and the global economy. Germany needs to carve out a new position for itself. The changes in the international environment will also pose a challenge for global companies.

The dispute between China and the US has entered a new phase and is now centred not around globalisation but the great power competition. The focus has shifted from trade to more active industrial policy, a more restrictive view of technology transfer and harsher regulatory treatment for foreign companies. This is because China wants to occupy a leadership role and become a major hub of innovation. The US sees these ambitions as a threat to its national security. Both countries will try to improve their innovative strength and competitiveness while reducing their reliance on imports. Against this backdrop, Germany needs to carve out a new position for itself, both politically and economically.

The dispute will have far-reaching consequences for the global economy as supply chains will change and access to strategic components will be restructured. The great power competition will dominate economic policy over the next decade and help to determine the potential for growth, both at macroeconomic level and for many companies. As a major exporter, Germany is dependent on functioning supply chains and on access to sales markets and key raw materials. It is caught in the middle of the dispute as the US and China are its two biggest trading partners. So what should Germany do?

Germany's biggest trading partners in 2020

Percentage of exports

Germany's biggest trading partners in 2020
Sources: German Federal Statistical Office, Union Investment; information from 2020.

1. Focus even more on its own strengths and digitalisation

Germany has already been left behind in many areas, including artificial intelligence, quantum computing and semiconductor technology. However, the problem is not that Germany is not investing enough in research. The focus of research is what counts. While a third of German research spending is ploughed into the automotive sector, the equivalent figure in the US is just 5 per cent. By contrast, 22 per cent of US research investment goes into information and communications technologies but only 6 per cent in Germany.

Germany not a leading player when it comes to key technologies for the future

Number of patents in different technology sectors (%, 2014–2017)

Germany not a leading player when it comes to key technologies for the future
Sources: OECD, Union Investment; information from 2018.

Going forward, China and the US will step up their investment in research and development even more. This is a race that Germany cannot realistically win. Instead, it should remember where its strengths lie, such as in engineering, which provides the basis for Industry 4.0. One obstacle is that digital infrastructure is very poor in many areas. Network expansion is absolutely essential for future innovation. Germany therefore needs to put all of its efforts into digitalisation. Environmental technology is another area of opportunity. Political support is needed in order to develop a dedicated European market with domestic supply networks. Good examples include the European Battery Alliance and the European Clean Hydrogen Alliance.

2. Protect networks and improve the culture of innovation

China is focusing on domestic innovation. This could create a risk for Germany’s small and medium-sized enterprises (SMEs) because, in return for market access, China is increasingly demanding the relocation of development departments to China. This threatens one of the great strengths of German industry, namely the unique innovation network comprising both large companies and SMEs. If large German companies move their research departments to China, this network could be weakened. Germany should be cautious about technology transfer and the relocation of research departments. It would be better for the country to build up its own innovative strength and to create an environment in which innovation can thrive, for example in terms of financing for start-ups.

3. Lay down clear rules for companies accessing the EU and strengthen the internal market

Past experience tells us that Chinese companies have the potential to become serious rivals in the global market. China is ideally placed to make this happen. The protected domestic market means that companies face little competitive pressure and, at the same time, offers economies of scale, low costs, favourable funding conditions and government support. As a result, companies are able to generate above-average profits that they can invest in research and development in order to improve productivity and product quality. This puts them at an advantage in world markets, for example in terms of costs. Moreover, China continues to protect emerging industries by limiting access for foreign competitors.

This could also jeopardise Germany’s traditional domains, such as the automotive and engineering industries. The country therefore needs to protect itself, including by means of active industrial policy. Size is the key to success in some areas. This is true not only for companies but also for markets. The aim should be to create attractive markets that have political backing at European level. Furthermore, Germany should encourage the ongoing development of the European single market and help to boost its competitiveness, for example in the service sector.

Does Germany need to pick a side?

For a long while, Germany’s strategy when it came to economic policy largely consisted of two elements: stable fiscal policy on the one hand and open markets for German products on the other. The changes in the global business and regulatory environment raise doubts about whether this strategy is fit for the future. Given the demographic trend, Germany needs to work on its innovativeness so as not to jeopardise the robust international competitive position that it has established in many areas. That is why a higher level of investment than in the recent past seems like a good idea, both at national and at European level.

The dispute between the US and China is likely to result in two independent spheres of influence and technology, each with its own norms and standards. How should Germany position itself? Politically speaking, it has much more in common with the US than with China. An alliance with the US would therefore be sensible in many areas. But it should certainly not be unconditional. It would also be a bad idea for Germany to completely turn its back on China because it is the most attractive growth market for German companies and will remain so in the long term.

The new environment will certainly be challenging for German companies as the restructuring of global supply chains will have consequences in many cases, for example due to export restrictions. Moreover, the two separate spheres of influence could result in significantly higher operating expenses. Larger companies will probably be better placed than smaller companies to adapt to the new business environment.

As at: 3 September 2021.

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