The European Union has increased its enforcement against subsidies provided by foreign governments. China is in the focus. The stated goal is to keep the EU markets “competitive”. Why do governments care about competition?

Elżbieta: Governments seek to protect competition because competition supports healthy markets. In a market-driven economy, healthy markets usually mean better welfare for citizens and economic resilience.  

How does competition help with that?  

1. First, competition drives businesses to offer lower prices, better quality and more choice, benefitting citizen’s welfare.
2. Second, businesses are pushed to improve and create new products, making them more innovative.
3. Third, competition promotes efficiency: competition helps ensure that limited resources are directed to where they are most needed and best utilised. This includes consumers buying products that give them best value for money (allocative efficiency), businesses reducing costs and waste (productive efficiency) and businesses investing in future needs (dynamic efficiency).

What do subsidies do to competition and markets?

Anselm: Subsidies can have positive or negative effects on market outcomes. Their impact depends on whether markets are operating “efficiently” or experiencing “market failure.”  

A market is efficient when firms compete vigorously and prices fully reflect the value and scarcity of products and resources. In efficient markets, subsidies always distort competition. For example, in a competitive market for mobile phone operators, if one operator receives a capital injection to expand its network coverage while its rivals do not, it puts the rivals at a disadvantage and may discourage them from remaining in the market or investing in next generation technology.

Conversely, subsidies can effectively address market failures. A market failure occurs when private markets do not allocate resources optimally, leading to outcomes that are suboptimal for society. This can happen when market prices do not reflect the full costs or benefits of a product or service, such as environmental impact or public health benefits.  

Example: Renewable energy projects generate environmental benefits for society, such as reducing greenhouse gas emissions. However, private markets fail to fully account for these benefits because renewable energy companies cannot incorporate the broader societal impact into the prices they charge individual customers. Subsidies can help correct this underproduction of beneficial projects by providing additional incentives to suppliers.

Domestic subsidies are funded by a country’s own taxpayers, while foreign subsidies are funded by taxpayers from other countries. Should this not make foreign subsidies less of a concern compared to subsidies given domestically?

Elżbieta: There can indeed be a short-term benefit to foreign subsidies. Subsidised firms may offer lower prices, temporarily benefiting consumers. These lower prices are funded by taxpayers in other countries, with no direct cost to domestic taxpayers.

However, in the long term, domestic firms may suffer because they cannot compete at those lower price levels and may be forced out of the market.

Example: A European construction firm struggles to win public tenders due to the subsidised lower prices offered by competitors. Eventually, the construction firm exits the market. With fewer players remaining, competition decreases, ultimately leading to higher prices for consumers in the future.

The long-term effects are especially concerning in industries critical to public infrastructure, such as trains, airplanes, construction, and IT infrastructure components. These sectors involve large, complex projects with often a long duration that demand companies maintain advanced capabilities over many years to meet rigorous requirements. Without adequate incentives to sustain these capabilities, firms may shift their focus to other sectors, leading to the erosion of domestic expertise.

Other than forcing an otherwise efficient competitor to exit the market, what are the negative effects of foreign subsidies?

Elżbieta: There are several other ways in which foreign subsidies distort competition and reduce welfare. Economists collectively refer to these as “theories of harm.”¹  

Subsidies can keep inefficient firms in the market or enable less efficient firms to enter, thereby undermining the quality of competition. Capital, labour, and materials remain tied up in unproductive firms instead of being reallocated to more efficient competitors.  

Example: Jingye Group, a steelmaker with links to the Chinese government, acquired British Steel in 2020 after bankruptcy. This delayed the exit of an inefficient competitor and distorted the steel market.  

Subsidies can also give foreign bidders an unfair advantage in competitive M&A processes, enabling them to outbid better-suited acquirers. This undermines the potential for creating synergies, reducing excess capacity, etc.  

Example: A foreign financial investor, backed by subsidies, outbids a strategic investor for a European technology company. This results in no synergies being created and reduces the industry's long-term efficiency.

Subsidies can also cause production or R&D to shift outside Europe, resulting in job losses and weakening strategic industries.

Example: In 2005, Nanjing Automobile Corporation moved MG Rover's production to China. This may impact the UK labour market and tax revenues.

Shirley Fodor, Editorial Committee Member: “What the EU is attempting to do is extend the extraterritorial application of laws, which undermines the principle of state autonomy. The risk is not just reputational—if companies begin complying with the laws of countries where they have only a minimal presence, they are effectively ‘volunteering’ to adhere to all laws as they currently stand. This is not what is contemplated under public and private international law. How will enforcement be carried out? Who will oversee it?”

What role do state-owned enterprises (SOEs) play in this context?

Anselm: State ownership, in itself, does not pose an issue. However, SOEs often receive capital or loans from their government owners. If this support is not provided on market terms, it can give SOEs an unfair advantage over private companies. The concern lies not in the ownership itself but in the preferential access to capital or debt.  

You pointed out that foreign subsidies offer short-term benefits but can cause long-term harm. Considering that some of the EU’s most urgent policy goals—such as achieving carbon neutrality, upgrading infrastructure, or increasing Europe’s military defence capabilities—require swift action, should foreign subsidies in these areas be accepted if they contribute to achieving these objectives?

Elżbieta: This could be a valid argument, at least from an economic perspective. In the short term, foreign subsidies can lower prices and benefit consumers, with immediate and measurable effects. However, the long-term risks are uncertain. While harm to the domestic economy is possible, it is not guaranteed. Assessing the likelihood of these risks and carefully weighing the trade-offs is essential.

Anselm: If the short-term benefits outweigh the long-term risks, accepting subsidies might seem reasonable.

However, why would a foreign government subsidise something that benefits European consumers without a strategic objective, be it in the short run or long run? Foreign governments are strategic actors, and subsidies are rarely altruistic. They are often used to pursue long-term geo-strategic goals, such as achieving technological leadership in a specific global market.  

If EU regulators conclude that the short-term benefits justify accepting these subsidies, it suggests a divergence in how the EU and the foreign government evaluate the likelihood and impact of long-term effects.  

Europe is facing high inflation, and its infrastructure requires significant upgrades. Lower prices for trains, IT infrastructure, and other critical sectors could provide much-needed relief.

Rather than blocking foreign subsidies outright, would it be more effective to establish an insurance system where EU governments support domestic companies? For example, this could involve guaranteeing contracts or providing other forms of support if foreign competitors gain dominance.

Elżbieta: This approach would be very costly and likely ineffective. Guaranteeing survival for domestic industries through government intervention creates a moral hazard. If companies know they will be helped out, they may stop investing or striving to win clients.

A better solution is diversification. I pass Rosenthaler Platz in Berlin every day on my way to the office. There is a wise window display that says, “Lege nicht alle Eier in einen Korb”—Don’t put all your eggs in one basket.

Europe should diversify. Allow subsidised foreign companies into the market but avoid relying solely on them.

Example: Instead of Member State governments buying all trains from a subsidised foreign supplier, split the order. Buy half from the foreign supplier and half from a European supplier. This ensures European companies maintain capacity, develop skills, and invest in technology, while Europe still benefits from lower prices.

Implementing this would not be easy, of course. The European Commission may not be able to impose specific tendering rules, but contracting authorities could maybe adopt this approach. Splitting tenders into smaller lots does increase workload and costs for the authority, but it helps ensure long-term competitiveness.

Anselm: By the way, this is similar to private companies’ procurement strategies. Automotive firms often use dual- or multi-supplier strategies to avoid dependency on one supplier. Governments upgrading their infrastructure should wherever possible do the same.  

The EU has been criticised for enforcing anti-subsidy rules in a protectionist way. Some argue that foreign countries have a right to compensate their companies for disadvantages, such as limited access to talent, technology, or trade barriers. After all, the EU subsidises its industries too. For example, between March 2020 and December 2022, the European Commission approved nearly EUR 3.05 trillion in state aid (source: State Aid Scoreboard 2023). What do you make of this criticism?

Anselm: Let’s start with basic principles. Regions with inefficient production conditions—like limited access to talent or a poor geography for producing certain goods—should not produce those goods. This follows the principle of comparative advantage: regions should focus on what they produce efficiently and trade for the rest.

Subsidies make sense only when addressing market failures, like underinvestment in R&D or sustainable technologies. These benefit not just companies but society as a whole, and  markets fail to account for these broader benefits, which are not reflected in prices. Subsidies are justified in such cases.

Governments, whether domestic or foreign, should not subsidise firms simply to compete in Europe unless there is a clear market failure. Subsidising inherently inefficient production—like growing oranges in Greenland—is a waste of resources.

Elżbieta: That assumes an ideal world, where trade is frictionless, governments cooperate, and efficiency prevails. In reality, trade conflicts and strategic policies create a “second-best” world. Here, countries prioritise supply chain resilience or national security, even if it leads to inefficient domestic production.

The global semiconductor industry is a good example. Under ideal conditions, semiconductors were produced in a globally efficient supply chain, with inputs coming from the most cost-effective regions. But concerns over supply chains and national security have led governments to reshore parts of production. These policies are driven by politics, not market efficiency, creating frictions and inefficiencies.

Governments face choices on how far to go in prioritising resilience over efficiency. For example, most countries aim for food security, but growing fresh fruit year-round in Finland would be extremely costly. Subsidising inefficient production for security reasons moves further away from optimal allocation.

Anselm: This is where regulations like the Foreign Subsidies Regulation (FSR)² or the Basic Anti-Subsidy Regulation³ come in. If a foreign supplier is an effective competitor only because of subsidies, these regulations aim at prohibiting or remedying the subsidies. Anti-subsidy rules aim to bring markets closer to the “first-best” solution of efficiency and specialisation—at least in theory.

From an economic perspective, can foreign subsidies even be harmful also in sectors where there is a lot of subsidies handed out at home, e.g. pharmaceutical R&D?

Anselm: It depends. Again, from an economic point of view, subsidisation is a sound strategy if subsidies are provided to address a market failure.

When a government domestically provides subsidies to address such market failures, it should—in theory—not affect the analysis of whether a foreign subsidy is distortive. Subsidies that address market failures, which are often universal (i.e., occur in any country), can be beneficial from an economic perspective.

In other words, it should not serve as a defence for a foreign government to claim that the EU provided a subsidy in the same sector, provided the EU subsidy was aimed at fixing a market failure—and vice versa.

However, the situation changes if EU subsidies are given for non-economic reasons, such as ensuring localised production for supply chain resilience. These have a distortive effect.

Example: If an EU government subsidises antibiotics production for resilience, and India does the same, both subsidies might distort competition by expanding production in regions without a comparative advantage. The overall effect on welfare is negative, i.e. the consumers and tax-payers would be better off without these subsidies. The benefit is a more resilient domestic industry.

What is your outlook for future trade and investment governance?

Anselm: The WTO is in disarray. It is no longer functioning effectively because the U.S. has stopped appointing judges, leaving conflict resolution inactive. Ideally, we would have a truly international multilateral trade order with open market access governed by a global body, but that is currently out of reach.

Unilateral measures like the FSR can make sense as a second-best solution, but they also create a significant amount of red tape. I am not fully convinced they will have strictly beneficial effects, though time will tell.

Elżbieta: Global trade is becoming increasingly fragmented, and it is frustrating.

We are wasting resources by moving towards suboptimal solutions, like second- or third-best options, instead of letting countries focus on what they do best and trading freely. I hope this is a temporary phase. But as of now, it is hard to be optimistic about the prospects.

‍

Elżbieta Głowicka and Anselm Mattes are Directors at the Berlin office of E.CA Economics, an economic consultancy firm. The views expressed here do not necessarily coincide with those of E.CA Economics.