China's Export Restrictions vs Global Industrial Policies: How The Rare Earth Gambit Backfired

China's 2010-2015 export restrictions on rare earth elements (critical inputs for everything from smartphones to wind turbines) triggered a global innovation based industrial policy surge

Photo by Monika Kubala on Unsplash

As nations increasingly weaponize critical supply chains, this research reveals how certain types of industrial policy (specifically export restrictions on critical inputs) can spectacularly misfire. China's attempt to exploit its near-monopoly on rare earths instead catalyzed technological breakthroughs that permanently weakened its market power, while inadvertently demonstrating the effectiveness of innovation-focused industrial policies in responding countries. The paper Trade and Industrial Policy in Supply Chains: Directed Technological Change in Rare Earths by Laura Alfaro, Harald Fadinger, Jan S. Schymik, and Gede Virananda takes a look at the finer details.

(Dave’s note: Considering the current US administration preference for export restrictions, tariffs, and cutting spending for industrial policy; you can guess the what’s gonna happen and how little some policy makers learned from China’s successes and failures, considering how little they are interested in what works and very interested in repeating the failures)

The big picture: Rare earth elements possess four characteristics that make them uniquely susceptible to this backfire effect:

• Broad applications at the knowledge frontier: Essential for electronics, aerospace, defense, medical devices, and clean energy

• Extremely difficult to substitute: Due to unique magnetic, catalytic, and luminescent properties

• Inelastic supply: Complex extraction as byproducts, toxic processing, long development times

• Extreme concentration: China controls 60% of mining, 90% of processing

By the numbers:

• 10-45x: Price spike for different rare earth elements (Cerium saw the largest jump)

• 98%: China's share of global REE production in 2009

• 72%: Reduction in China's export quota in July 2010

• 7.4%: Increase in REE-enhancing patents outside China for sensitive industries

• 0.5 p.p.: Annual productivity growth boost for Japanese REE-intensive industries

• 90%: Reduction in global GDP losses due to innovation response

The research methodology:

• Novel input-output table: Researchers constructed the first comprehensive mapping of REE usage across industries using U.S. Geological Survey data

• Patent analysis via AI: Used GPT-4 to classify 30,000+ patents as REE-related and identify whether they improved efficiency or found substitutes

• Multi-country panel data: Analyzed manufacturing across 50 countries from 2002-2018

• Quantitative trade model: Developed new framework combining trade theory with directed technological change

• Balanced literature review: Authors acknowledge mixed evidence on industrial policy effectiveness, citing both successes (upstream sector corrections) and limitations (regional policies that boost employment but not productivity)

Timeline of the crisis:

• July 2010: China cuts export quota by 72%

• September 2010: Senkaku-Diaoyu boat collision triggers Japanese embargo

• January 2011: Export tariffs increased on certain REE products

• March 2012: U.S., EU, Japan file WTO complaint

• 2014: WTO rules against China

• 2015: China removes quotas, replaces with licensing system

Key findings on innovation response:

Patent surge by region (one standard deviation increase in REE sensitivity):

• Europe: 18.4% more REE-enhancing patents

• U.S.: 17.9% increase

• Japan: 25.7% increase

• China: Only 2.9% increase (not statistically significant)

Productivity effects:

• Outside China: 0.466 percentage point higher TFP growth for REE-sensitive industries

• Japan specifically: 1.029 p.p. higher TFP growth

• Within China: -2.142 p.p. lower TFP growth for REE-sensitive industries

Export growth impacts:

• Non-China countries: 0.856 p.p. higher annual export growth for REE-intensive industries

• Europe: 0.661 p.p. increase

• Japan: 1.526 p.p. increase

• China: -0.729 p.p. (negative but not significant)

The mechanism - Directed Technological Change:

• When inputs are gross complements (elasticity of substitution < 1), higher prices increase innovation incentives

• Researchers' estimates: REE-labor substitution elasticity ranges from 0.75-1.28 across industries

• Transport equipment: Lowest elasticity (0.75), highest REE intensity

• Textiles: Highest elasticity (1.28), lowest REE intensity

Specific industry impacts:

Most affected sectors (by total REE requirements):

1. Storage batteries (SIC 3691): $6.93 of REE per $1,000 final demand

2. Fabricated metal products (SIC 3499): $5.91 per $1,000

3. Relays and industrial controls (SIC 3625): $0.58 per $1,000

4. Turbines and generators (SIC 3511): $0.53 per $1,000

Real-world innovation examples from patent analysis:

• GM (2011): Powder coating process reducing Dysprosium/Terbium use by 20%

• Toyota (2016): Reduced Dysprosium in Prius, cut Neodymium 20% by 2018

• Skyworks Solutions (2011): Yttrium substitute for electronic devices

• Tesla, Nissan, BMW: Developed magnet-free motor prototypes

Element-specific details:

• Least substitutable: Dysprosium (complementarity index: 100)

• Most substitutable: Samarium (index closer to 0)

• Price increases: Cerium (45x), Terbium (10x), Europium (10x)

• Key applications: Neodymium magnets (motors), Cerium catalysts (petroleum), Europium phosphors (displays)

Quantitative model results:

With endogenous technology response:

• China's real GDP gain: 0.25%

• Other countries' GDP loss: 0.04-0.05%

• China's welfare gain: 2.6%

Without technology response (counterfactual):

• China's real GDP gain: 3%

• Other countries' GDP loss: 0.54-0.56%

• China's welfare gain: ~5%

The supply chain scramble: The immediate response to China's restrictions revealed the difficulty of quickly diversifying rare earth supplies. California's Mountain Pass mine, once the world's primary REE source before closing in the early 2000s, rushed to reopen in 2015 but promptly went bankrupt in 2016 before restarting under new ownership in 2018 (with Chinese miner Leshan Shenghe holding a non-voting minority stake). Australia's Lynas began Malaysian processing operations in 2013 after six years of development, while Chinese companies simultaneously began mining operations in Myanmar. Japanese firms, caught between supply uncertainty and price volatility, chose to hoard existing inventory rather than release stockpiles, fearing depletion without guaranteed fresh imports from China.

The hidden catalyst: China's export restrictions inadvertently became the world's most effective industrial policy stimulus for rare earth innovation. Countries that had long ignored calls to develop domestic REE capabilities suddenly found themselves implementing crash programs to reduce dependence. Japan launched public-private partnerships for REE recycling and substitution research. The EU classified rare earths as critical raw materials and funded research consortiums. The U.S. reactivated dormant defense production authorities. Rather than strengthening China's leverage, the restrictions unified global efforts to break its monopoly—a textbook case of strategic overreach spurring exactly the response Beijing hoped to avoid.

A tale of two policies: The research reveals a striking contrast in industrial policy effectiveness. China's export restrictions (designed to force global production to relocate domestically) largely failed as innovation abroad offset the supply shock. Meanwhile, the innovation-focused industrial policies implemented by Japan, Europe, and the U.S. in response proved highly successful, generating lasting productivity gains and technological breakthroughs. The difference? While China tried to leverage market power through supply restrictions, other countries invested in expanding technological possibilities. The paper's evidence suggests that industrial policies promoting innovation and R&D can be highly effective, especially when responding to supply chain vulnerabilities.

Behind the numbers: The researchers employed sophisticated quantitative methods to reach their conclusions, setting trade elasticity at 6 (standard in the literature) and calibrating an innovation spillover parameter of δ = -1, where negative spillovers actually increase innovation incentives by raising input bundle prices. They combined data from multiple sources including WIOD trade tables, UN Comtrade, UNIDO industrial statistics, Google Patents, and Penn World Tables. Their novel estimation approach uses patent ratios to estimate substitution elasticities—a breakthrough necessitated by the absence of comprehensive REE expenditure data. The model validation shows simulated results closely match empirical patterns for innovation, productivity, and exports across all regions studied.

What it means for policy: This research reveals important nuances about industrial policy effectiveness. Export restrictions on technologically critical inputs with complementary characteristics can backfire spectacularly, triggering innovation that permanently erodes market power. However, the study also validates innovation-oriented industrial policies (basically countries responded with targeted R&D support, public-private partnerships, and strategic research funding) saw significant productivity gains. The lesson isn't that industrial policy doesn't work, but rather that its effectiveness depends critically on the type of intervention and the characteristics of the targeted sector. For policymakers, the key insight is that promoting technological capabilities often proves more effective than attempting to exploit market power through supply restrictions. The very characteristics that make inputs attractive targets for economic coercion, also make them prime candidates for innovation-driven solutions when supplies are threatened.

Recent developments: China reimposed restrictions on six REEs and permanent magnets in April 2025, following earlier bans on Gallium, Germanium, and Antimony exports to the U.S. in late 2024, but global manufacturers are now far better prepared.

Bottomline: This research demonstrates that industrial policy effectiveness depends critically on its design and target. When countries weaponize control over critical inputs through export restrictions, they risk triggering innovation that breaks their monopoly. But when countries respond with innovation-focused industrial policies (as Japan, Europe, and the U.S. did) they can achieve lasting productivity gains. China's rare earth restrictions became a textbook case of how one type of industrial policy (export restrictions) can backfire by inadvertently spurring more effective industrial policies (innovation support) elsewhere.