Dragoman Digest

Brussels signs long-awaited trade deal with South America
It remains far from certain that the agreement will ever actually be ratified
The EU Commission and South American trade bloc Mercosur agreed to a free trade deal last week. Mercosur encompasses Argentina, Bolivia, Brazil, Paraguay and Uruguay. Under the agreement, Mercosur will remove tariffs for over 90 percent of EU goods including machinery, vehicles, telecom equipment and alcohol. In exchange, the EU will grant products from Mercusor preferential access into its huge consumer market. The deal, which the parties have been negotiating since 1999, was ostensibly concluded in 2019. New environmental demands from the EU, coinciding with massive deforestation in the Amazon rainforest, delayed the agreement. European proponents of the deal say that it will help to reduce reliance on China and create a buffer to any potential tariffs imposed by incoming US President-elect Trump. The timing of the agreement, just over a month out from Trump’s inauguration, is hardly coincidental.

The agreement still faces several potentially major hurdles. The deal faces strong opposition from the EU’s protectionist agricultural lobby, which claims the agreement will undermine European environmental, health and animal welfare standards. EU farmers are already grappling with more competition from Ukraine’s vast agricultural sector. Trenchant agricultural resistance will harm the chances of the deal’s passage through the EU Parliament, where agricultural lobbies are well represented. To become law, the agreement will also need the support of the EU Council. Under qualified majority voting rules, four countries representing at least 35 percent of the EU’s population can block the deal. So far, France (15 percent of the EU’s population) and Poland (8 percent) have vowed to oppose it.


The US dethrones China as ASEAN’s top export destination
Various factors at play including Chinese mercantilism and weak consumption
In Q1 of 2024, the US emerged as the top destination for ASEAN exports, surpassing China for the first time in six quarters. ASEAN’s exports to the US between January and March totalled US$67.2 billion, compared to China’s US$57 billion. The shift in ASEAN’s export profile is particularly evident among certain countries. Malaysia, for instance, saw an 8 percent increase in exports to the US compared to the same time period last year, while those to China declined by 6.3 percent. Thailand’s exports to the US rose by 9.8 percent, whilst its exports to China fell by 5.1 percent. Vietnam, one of the few ASEAN countries to experience an uptick in exports to China, registered a 9 percent increase. However, this still paled in comparison to the 24 percent rise in Vietnam’s exports to the US.

The shift in ASEAN’s exports is emblematic of a broader global trend in supply chains. The US and EU are seeking to derisk and diversify their supply chains away from China. Both Chinese and Western companies previously operating in China are now actively re-routing supply chains through ASEAN. This makes eminent sense given ASEAN’s proximity to China, perceived geopolitical neutrality, robust manufacturing ecosystems and relatively large pools of skilled labour.

Concurrently, numerous factors are serving to depress China’s demand for goods produced in ASEAN. China’s increasingly stagnant economic conditions have put downwards pressure on already parsimonious consumption. China’s emerging growth model which prioritises manufacturing and self-sufficiency, has reduced demand for manufactured goods. Indonesia is one of the rare examples of an ASEAN state that has a trade surplus with China. This is primarily driven by the exports of natural resources like nickel which China has high demand for, but minimal domestic supply.


Looming EU battery laws cause trepidation amongst Chinese producers
Regulation appears deliberately designed to give European-based producers a much-needed leg-up
Chinese EV battery producers are bracing for the impact of the EU’s Batteries Regulation. The regulation, which is still under formulation, will set stringent emissions requirements on the carbon footprint of batteries sold in the EU. Under the law, the EU will require producers to report the carbon footprint of their batteries by February 2025 before specifying this on a “battery passport” by 2027. By February 2028, batteries exceeding a yet to be determined maximum carbon threshold will be excluded from sale in the EU.

Chinese producers are particularly concerned over the regulation’s methodology for calculating emissions produced in the battery production process. Energy used during the manufacturing process typically accounts for over 60 percent of a battery’s carbon footprint. The Batteries Regulation will only calculate emissions based on the average national electricity mix in the country of manufacture or the electricity mix of power stations directly connected to a manufacturing plant. Because green captive power plants are rare in China, its coal-heavy grid will serve as the reference point for most manufacturers. This is despite the significant variance in the electricity mix of different Chinese provinces. Some such as Sichuan are dominated by hydropower.

The rapid pace of China’s energy transition will undoubtedly help matters. But it is expected to be quite a few years before China can decarbonise its grid to European levels. So far, Chinese companies have limited options to adapt to the standards of the Batteries Regulation. Patchy market regulation makes direct connection to green power installations difficult. Provincial governments are yet to come to an agreement on a model where grid operators will be compensated for direct power connections. Captive power plants also go against the grain of China’s overarching ambition, which is to unify fragmented markets into a national market. Battery producers such as CATL have attempted to get around the issue by installing rooftop solar generation at their factories. So far, rooftop solar only meets three percent of the company’s industrial power. Barring a more accommodative final rule on maximum carbon thresholds, Chinese exports may have some of their current cost advantage eroded.
 

Tokyo and Seoul prioritise domestic production of critical materials
Countries seek to chip away at massive reliance on Chinese imports
Japan and South Korea are attempting to build out their capabilities for processing minerals and producing materials used in critical technologies. Last year, Japan’s Sojitz announced a joint venture with Mexico’s Mexichem Fluor which plans to construct a factory to produce anhydrous hydrogen fluoride. China dominates the production of anhydrous hydrogen fluoride - a chemical used in chipmaking. The companies aim for the facility to produce up to 40 percent of Japan’s annual demand for the chemical. The project will take advantage of the government’s ongoing 527-billion-yen (US$3.42 billion) subsidy program aimed at supporting projects of this ilk. Meanwhile, South Korean steelmaker POSCO last year launched the country’s first lithium hydroxide plant through a joint venture with Australian lithium miner Pilbara Minerals. Lithium is used in a range of critical technologies including EV batteries. Seoul is aiming to reduce reliance on any single country for lithium, as well as nine other critical minerals, to less than 50 percent by 2030.

These moves are aimed at reducing dependence on China. Japan and South Korea each rely on Chinese imports for over 99 percent of their magnesium supply, 90 percent of graphite and 79 percent of lithium hydroxide, exposing them to trade disruptions. Beijing’s export bans on shipments of several critical minerals to the US last week provided a sharp reminder of potential vulnerabilities. So far, the buildout of mineral and material production sites in Japan and South Korea has been slow. This is partly due to the high barriers of market entry, including price volatility. China fuels volatility as part of its strategy to intimidate investors. Lithium hydroxide futures on international exchanges have floated around US$10,000 per tonne this year, a far cry from the prices of over US$80,000 reached in 2022. China’s refining technology, developed over decades, also provides it with a massive cost advantage over newcomers. Meaningfully reducing China’s stranglehold will take decades rather than years assuming it can be achieved at all.


China and Saudi Arabia deepen already robust economic relationship
Domestic and strategic factors are driving the growing economic tie-up
This year, China has increased its attention on Saudi, diluting the traditional pre-eminence of the Kingdom’s economic ties with the West. In the first 10 months of 2024, Chinese exports to Saudi Arabia reached US$40.2 billion, up from US$34.9 billion across the same period last year. A third of China’s US$21.6 billion of investments into Saudi Arabia in 2024 went into green energy, renewable component and battery manufacturing projects. In September, Aramco, Saudi’s national oil company, and China National Building Material Group announced plans to build a manufacturing facility in Saudi Arabia to produce wind turbine blades, hydrogen storage tanks, low-carbon building materials and energy storage solutions. The traffic is not all one way. Aramco has also in recent years invested billions in China, including US$9.82 billion into a petrochemical complex in Fujian province. This is part of a strategy to lock in Chinese demand from Arabian crude feedstock given increasing Russian shipments.

The growing partnership supports the strategic objectives of both countries. Saudi Arabia has made a concerted effort to cultivate a wider range of partners beyond the US and Europe. This is partly driven by the Saudi's distress when Washington declined to respond militarily to the 2019 (under Trump #1) attack on Aramco facilities at Abqaiq – claimed by Iranian-backed interests. Chinese investment also supports Saudi Vision 2030 ambitions to diversify its economy away from oil. China, on the other hand, wants to expand its economic reach into non-Western markets amid growing concerns over Western tariffs. Despite booming commerce between both nations, Riyadh has overall been cautious about transgressing perceived US red lines. Saudi has notably limited collaboration with China in defence and more recently in AI.