One way in which the 2026 war in Iran will be remembered – if the situation does not escalate further – is that the largest oil supply disruption in history triggered a far smaller oil crisis than expected. A key reason, besides the US withdrawing from the conflict without achieving its objectives, is China's oil reserves. When the war broke out, China stopped importing oil and began drawing on those reserves, which relieved pressure on global oil markets. This matters because it demonstrates that stockpiling and diversification of key commodities – a topic that has received intense attention since COVID – can be very effective.
The EU has identified diversification of key commodities as a political goal, just like the US and China, but compared to them has the longest way to go. For its energy needs, Europe has infamously traded its dependency on Russian gas for a dependency on American liquefied natural gas – which is also more expensive, a cost that continues to weigh on European industry’s “existential” situation. This shows that the war in Ukraine did not produce any serious diversification in European energy supply. For its metals needs, the challenge is greater still. Last week, the G7 announced a 60% target to cap dependency on rare earth imports from any single source – meaning China, which holds a market share of up to 99% in some metals. But how the mining and processing of these materials will scale up, short of major investment projects spanning multiple decades, remains the central question. It is telling that Reuters recently reported on China's vast ecosystem of rare earth laboratories and university programs – and could not identify a single comparable education program outside China.
This week, Kevin Warsh begins his term as the US central bank's new chair. He was chosen by Trump for his belief in AI as a driver of lowering costs across the economy, which would open the possibility of cutting the short-term interest rate. However, there are several reasons why US interest rates – both short-term (set by the central bank, which raises them when inflation is too high) and long-term (set by the bond market, which raises them when inflation expectations are elevated or too much debt is being issued) – are likely to remain high and may go even higher.
First, there has been a global regime change in the past five years: interest rates have stopped declining for the first time in decades. There are several structural reasons for this – from massive government spending to international conflicts, all of which raise inflation and consequently interest rates – and such structural changes are unlikely to reverse without a clear cause, such as a meaningful reduction in debt or a resolution of major conflicts, neither of which seems likely anytime soon.
Second, the global shift towards higher interest rates is generating new mechanisms that reinforce the trend. Japan, for instance, may increasingly sell US assets to protect the value of its currency. If Japanese investors were to sell US government bonds at sufficient scale, it would add further upward pressure on US interest rates. A similar dynamic has emerged as a possibility from the troubled Gulf states – suggesting this is a structural feature of the new global economy, not something specific to Japan.
Third, the US economy has been running close to overheating for several years and still is, which calls for higher interest rates, not lower ones. US employment has been near maximum levels for 55 consecutive months, while the central bank has missed its inflation target for 63 months.
Fourth, while AI – Warsh's rationale for lowering interest rates – may create disinflation over the long term, its near-term effects have been more inflationary: demand for the metals, energy and chips needed to build data centers has driven up the costs of all three.
Last week, a new OECD report on industrial subsidies was picked up across western media, highlighting the finding that Chinese companies receive 3 to 8 times more government support than their western counterparts. However, a careful reading of the OECD report shows this figure is misleading – and that framing China's rise as mainly enabled by government subsidies will lead to the wrong response.
First, the OECD shows that higher subsidies for Chinese companies are entirely dependent on below-market borrowing – in other words, relatively low interest rates on loans from Chinese banks to Chinese companies. When it comes to direct grants and income-tax concessions, western governments subsidize their companies at comparable levels as China. This matters because China's below-market borrowing is, as experts like Michael Pettis have shown, a structural feature of its political-economic system: in China, capital is channeled to companies through state banks at below-market rates to keep the economy dependent on investment-led growth, effectively paid for by Chinese households, who receive artificially low returns on their savings. This is not a targeted subsidy program, but something far more deeply embedded in how the Chinese Communist Party chooses to develop the country - and therefore not something that will be overcome through responses like import tariffs or western subsidies.
Second, and this is what deserves closer attention, the OECD data shows significant variation between industries. The automotive industry is worth examining, because it is the sector that both the US and the EU have targeted with import tariffs, explicitly justified by claims of unfair Chinese subsidies. Research by the Rhodium Group shows that only 5% of the cost advantage of Chinese cars is based on government subsidies. The remaining 95% reflects genuine competitive strengths: the vertical integration of Chinese manufacturers – who produce their own batteries and other components or source them domestically, unlike western firms that rely on complex global supply chains – and higher levels of investment in research and development, supported by lower labor costs and a longer planning horizon.
The implication is that framing the rise of Chinese companies as primarily a subsidy story leads to the wrong response. For instance, since the EU raised import tariffs on Chinese cars in October 2024, the market share of Chinese cars in Europe has continued to grow, while some European manufacturers that produce their cars in China lost market share, as they found themselves penalized by their own governments' tariffs. Rather than focusing on penalizing China for its industrial model, western governments would be wise to address their own competitiveness – and to maintain access to world-class Chinese products in the meantime.
