Industrial policy has made a comeback. Policymakers are increasingly seeking to reshape their economies by targeting specific industries, firms or economic activities using tools such as subsidies. But because political and trade tensions around government support are mounting, subsidies, even if driven by noble aims, often come at a high cost.

Properly designed subsidies are an important policy tool to address market failures and achieve legitimate policy objectives. But because domestic subsidies have effects on others, they have long posed difficulties for global trade. Cooperation among governments, rather than non-cooperation or confrontation, is critically important to bring about greater clarity with regards to the amount and design of these subsidies and their potential spillovers beyond the subsidizing economy. Data and analysis could inform discussions of whether revised international rules, including at the World Trade Organization (WTO), are required, either to further discipline certain behaviours or to provide additional flexibilities. Greater certainty could help to dial down trade tensions and to sidestep the risk of leaving key policy challenges unanswered.

Subsidies do not come cheap, even when they are well-intentioned

Rising and pressing global challenges stemming from the aftermath of the COVID-19 pandemic, climate change, the digital transition, resilience of supply chains and geopolitical competition have reignited the debate on what the right balance is between state intervention and market forces. Recently, policymakers in larger economies have come out on the side of subsidies and other industrial policy instruments to support certain goals.

However, resolving the question of subsidies is far from straightforward. There are sound economic rationales for some government support, such as backing research and development on COVID-19 vaccines or the green transition. But the economics of subsidies are not black and white — rather, many subsidies exist in a nuanced realm of grey due to their mixed effects. Thus, they may both help to advance legitimate policy objectives and create positive spillovers, and cause various forms of harm. One thing is certain, however. Even in the best of circumstances, subsidies do not come cheap — not only for the subsidizing country, but often for the rest of the world as well.

At the domestic level, subsidies can heighten fiscal pressures and divert resources from other urgent needs. From an environmental perspective, years of fisheries subsidies, fossil fuel subsidies and agricultural subsidies have damaged biodiversity and the climate. For non-subsidizing economies, competing firms and workers, subsidies can distort trade and investment, erode existing trade commitments and deepen the sense of unfairness that comes with knowing that those with deep pockets can tilt competition in their favour. On top of this, there is the risk of rent-seeking and protectionism sneaking in.

Non-cooperation has consequences

Firms and governments that find themselves on the receiving end of such negative spillovers are unlikely to remain idle. In an environment of non-cooperation, five consequences may ensue — none of them beneficial:

• First, copycat behaviour may occur among those governments that can afford it. According to a Global Trade Alert report, a set of subsidies by one economy is typically followed six months later by similar subsidies from another economy.
• Second, tit-for-tat competition may be triggered, with finance ministries or local authorities trying to outdo each other with ever larger subsidies, potentially igniting a global subsidy race. The semiconductor sector is a case in point. As a complement to such subsidies, export restrictions or other measures may be introduced, as for the critical minerals needed for the green transition, according to the Organization for Economic Cooperation and Development (OECD).
• Third, countervailing measures aimed at offsetting the negative spillovers of subsidies in home or third-country markets may proliferate, with the risk of increased costs and lose-lose outcomes.
• Fourth, circumvention and evasion of countervailing duties may occur, with firms engaging in wasteful, and sometimes even illicit behaviours, to try to avoid losing market share.
• And fifth, there is the risk of controversies, which may have repercussions on global trade and investment, as well as on the attainment of the very objectives that the subsidies were aiming to achieve in the first place. Commentators have already warned that, for example, there is a risk that frictions and obstacles resulting from green subsidies may escalate, rendering the transition to net-zero gas emissions more expensive or lengthy.

Given the magnitude of government handouts and their potential systemic effects, the need to address the international spillover effects of subsidies is now more urgent than ever. So, what can be done?

More transparency, analysis and dialogue can help

The starting point towards better policies and to help de-escalate tensions is better information on subsidies. Following the publication of a joint report on subsidies, trade and international cooperation in 2022, the International Monetary Fund (IMF), OECD, World Bank and WTO set up a joint online platform for subsidies data that provides links to existing data sources from each organization.

The platform, launched last May, aims to facilitate access to information, a first step towards finding common ground among governments on the appropriate use and design of subsidies. It explains the different types of subsidy data available in the four organizations, as well as the structure of the different subsidy databases, and provides detailed descriptions of their content and of underlying data collection methodologies. From the WTO perspective, one key goal is to facilitate access to WTO notifications on subsidies by making them available in a more research-friendly format, something which experts have rightly identified as a minimum requirement for statistical analysis.

Working both separately and jointly, the IMF, OECD, World Bank and WTO intend to continue to develop and extend the platform and to deepen their analysis, for example on assessing the fiscal effectiveness of subsidy schemes and their cross-border spillover effects, or on improving the rules and policy design governing subsidies. They will also be inviting researchers and the academic community to collect data and do more research and analysis.

The four organizations have in place a series of mechanisms to foster dialogue on subsidies. Thus, the IMF provides policy advice through its regular surveillance mechanisms; the OECD maintains an ongoing conversation with its members on issues related to subsidy design, impacts and options for reform; the World Bank's country, regional and global engagements support analysis and advocacy; and the WTO serves as a forum to discuss and resolve trade-related problems. Alternative options in other configurations, possibly involving finance and trade ministers, may also be useful to enable debate on the relevant issues arising from subsidy spillovers.

Updated WTO rules can play a key role

Existing WTO rules, including the Agreement on Subsidies and Countervailing Measures (SCM Agreement), have overall served governments well for over two-and-a-half decades as part of a broader system of trade rules that has underpinned trade-led growth and prosperity around the world. But these disciplines were agreed many years ago, and most expert commentators have pointed out that they need revision.

The rules in the SCM Agreement aim to address the trade distortion that can be caused by subsidization. In so doing, they seek to limit the extent to which trade flows are determined by government treasuries. To be subject to WTO rules, a subsidy — which, according to the SCM Agreement, is defined as a financial contribution by a government or any public body within the territory of a WTO member which confers a benefit — must be limited to certain enterprises, which is to say that it must be “specific”. The idea behind the specificity rule is that it is such targeted subsidization that is most likely to distort trade flows.

The SCM Agreement prohibits specific subsidies that are contingent on export performance or local content, as these subsidies are designed to affect trade directly, and thus are more likely to have adverse effects on the interests of other WTO members. Other specific subsidies, such as production subsidies, fall within the actionable category, which means that they are not prohibited, but are subject to challenges via the WTO Dispute Settlement System or to national countervailing duties if they cause adverse effects to the interests of another WTO member.

Policymakers and commentators have identified several problems with the SCM Agreement, mainly because some of its rules are either “not constraining enough” or “too constraining”. There are certain unresolved topics, however, that sit at the core of some of the current trade frictions. The absence of specific rules to address the potential trade distortions caused by subsidies to and by state-owned enterprises and their conduct, particularly in the context of non-market systems, is one such issue. Striking the right balance between green subsidies and trade rules has become another pressing point. There is also a basic fairness angle underpinning this discussion: the problem of subsidies is mainly a rich economy's game, as most developing countries have neither the fiscal nor the policy space to engage in a handout competition, leaving them in the role of simple bystanders, at best.

Increasingly, calls to update, strengthen or rebalance global subsidy rules have intensified, not only in the area of industrial subsidies, but also in agriculture, where there are longstanding concerns about the adequacy of existing rules to rein in highly distorted markets. The WTO's recently concluded Agreement on Fisheries Subsidies, intended to curb harmful subsidies, and continued negotiations on this topic are important steps in the direction of limiting the negative spillovers of subsidies, in this case on the lives and livelihoods of fishermen and women around the world, as well as on the health of the oceans.
 

Many preferential trade agreements include rules to discipline subsidies, some incorporating provisions that go beyond WTO rules to address the key challenges currently confronting policymakers. But to deal with global spillover effects, all of those concerned need to be around the same table, and to be able to draw upon data and analysis to support their deliberations. A shared understanding of the issues at play and the options to address them could then form the basis of a revised global framework to better govern subsidies in today's world.