It doesn’t have the same superpower cachet as the US-China trade war, but Indonesia and Malaysia are moving towards a high-stakes confrontation with the European Union (EU) that has been brewing for years.

Over the last two years, an increasingly environmentally conscious EU has moved to phase out imports of palm oil for biofuel because, it argues, the commodity’s production causes mass deforestation. Indonesia and Malaysia are the world’s two largest producers of palm oil, with the sector accounting for between 2-3% of Indonesia’s gross domestic product (GDP).

In March, the EU further restricted the number of biofuels made of palm oil that may be counted toward the bloc’s renewable-energy goals. By 2020 member states must ensure at least one-tenth of their fuel consumption comes from renewable fuels, but palm oil-based products won’t count. By 2030, the EU aims to stop all imports of palm oil.

Then, on August 14, the EU escalated the situation when it reintroduced tariffs on subsidized palm oil imports from Indonesia, following an probe which found Jakarta’s subsidies for domestic producers distorted the market and were “a threat of material injury” to European firms.

The tariffs, which range from 8% to 18% depending on the Indonesian producer, offer protection to European biofuel firms that have suffered since the EU scrapped duties on Indonesian imports last year on orders of the World Trade Organization (WTO).

The provisionally re-imposed tariffs will last until December, but could be extended for five years. Days before the EU’s announcement, Jakarta threatened to retaliate by increasing its tariffs on EU dairy imports from between 5-10% to 20-25% if Brussels went ahead with its new duties.

A palm oil farmer displays palm oil seeds in Kampar, Riau province, Indonesia. Photo: AFP/Wahyudi

“The EU can impose something on us as long as the parameter is fair, but if the parameter is not fair, then that is an act of protectionism and trade war,” Enggartiasto Lukita, Indonesia’s trade minister, was quoted saying in local media. “We can’t just be quiet when there is unfairness.”

Indonesia and Malaysia are mulling a joint punitive response. Following a visit by Indonesia’s recently re-elected President Joko Widodo earlier this month, Malaysian Prime Minister Mahathir Mohamad told the Nikkei Asian Review on August 19 that the two countries were still “thinking about” taking the EU to the International Court of Justice.

Last month, the two nations also spoke about taking the European bloc to the World Trade Organization (WTO) by November over claims its phasing out of palm oil imports is “discriminatory.”

Indonesia argues that the EU is employing protectionist policies aimed at curbing Southeast Asian-produced palm oil to benefit European-made vegetable oils such as sunflower and rapeseed. WTO rules allow countries to try to influence other nations’ environmental policies through trade terms, though not solely for protectionist purposes.

“This is about world trade, and we have to look into trading practices first. If it breaches any international law, of course, we will go to the international court,” Mahathir said.

The EU’s decision to phase out palm oil imports by 2030 is predicated on the bloc’s finding that its cultivation has caused the highest level of deforestation of any crop worldwide, allegedly responsible for 70% of new acreage cleared for cultivation, compared to just 4% for corn and soybeans.

The Council of Palm Oil Producing Countries, which represents Malaysia and Indonesia along with other nations, claims the EU is using “scientifically flawed” evidence to come to its conclusions. Jakarta and Kuala Lumpur have called on the EU to instead help them make palm oil farming sustainable, rather than abandon it altogether.

A palm oil factory in Sumatra, Indonesia, one of the main industries on the island. Photo: iStock

The Malaysians have gone on the rhetorical offensive against the move. The former Minister for Plantation Industries and Commodities referred to the EU’s policy as “crop apartheid.”

A recent Bloomberg op-ed written by an academic with the assistance of Malaysia’s Prime Minister’s Office called it “blatant hypocrisy” and “a form of modern colonialism that has no place in today’s world.”

The same piece, originally wrongly attributed to Mahathir, called on Britain, once it leaves the EU in late October, to distance itself from the bloc’s palm oil ban. In return, Malaysia has promised London a bilateral free trade deal, which Britain will need if it leaves the bloc through a so-called “no-deal” Brexit.

But the EU won’t easily back down to Malaysia and Indonesia’s rhetoric and divide-and-rule tactics in Europe.

Brussels is desperate to play a much bigger role on the world stage, and capitulation would be seen as a sign of weakness in what is one of the EU’s first major principled global trade stands, especially if the bloc wants to be seen as an independent actor from the US and China.

Moreover, environmentalism has taken on more political relevance following European elections in May, which returned an even greater number of Green politicians to the European Parliament. The president-elect of the European Commission, Ursula von der Leyen, even had to promise a bold “green deal” to win enough votes from environmentalist parliamentarians.

Malaysia's Prime Minister Mahathir Mohamad salutes the royal guard of honor during the opening ceremony of the parliament in Kuala Lumpur on July 17, 2018. Photo: AFP/Mohd Rasfan
Malaysia’s Prime Minister Mahathir Mohamad salutes the royal guard of honor during the opening ceremony of the parliament in Kuala Lumpur on July 17, 2018. Photo: AFP/Mohd Rasfan

While certainly political in Europe, politics are also driving Jakarta and Kuala Lumpur’s confrontational positions on trade. Malaysia’s election in 2018 saw the nation’s first ever change of government, where the United Malays National Organization (UMNO) which has run the country through coalitions since independence lost out to Mahathir’s Harapan coalition.

One big reason why the Harapan coalition triumphed was because Mahathir – who led UMNO as prime minister between 1981 and 2003 before defecting to the political opposition – was able to win over enough of UMNO’s traditional rural Malay supporters.

For instance, the poor Malay farmers and smallholders connected to the Federal Land Development Authority (FELDA), a government agency charged with resettling rural inhabitants, often on palm oil plantations, were until last year’s election seen as UMNO’s “rural fortress.”

Yet the Harapan coalition won 19 out of the country’s 52 FELDA constituencies at the poll. To keep these constituents on side – especially now that a renovating UNMO will cooperate with the Pan-Malaysian Islamic Party to win back supporters in the Malay heartlands – Mahathir’s coalition will need to show that it stands for the interests of rural Malays, even if that means jeopardizing relations with a key trade partner.

A similar situation exists in Indonesia. At April’s presidential election, the incumbent Joko Widodo easily beat his opponent Prabowo Subianto by 55.5% to 44.5%.

But Widodo faced strong criticism from rivals other his alleged mismanagement of the rural economy and his supposed dependency on urban constituencies. Many feared that Prabowo could steal North Sumatra, a major palm oil-producing region which Widodo had won handsomely at the 2014 election.

In the end, Widodo won the race, but only after making costly promises to rural voters. In 2018, he almost doubled the number of recipients of the “family hope program”, in which the government hands out roughly US$55 every quarter to mainly rural families, representing nearly 10 million households or roughly 15% of the population.

On the campaign trail, Widodo promised another $28 billion for subsidiary projects if he won a second term. It probably also helped that Moeldoko, chairman of the Indonesian Farmers Association, a powerful lobby group, was strategically appointed as Widodo’s chief of presidential staff last year.

President Joko Widodo opened the The 21st Jakarta International Handicraft Trade Fair 2019 at the Jakarta Convention Center Session Hall on April 24, 2019. Photo: AFP Forum/ Eddy Purwanto

While Indonesia and Malaysia will likely have stable democratic governments for the next few years, their sustained popularity will depend on defending rural constituents, many of whom rely on palm oil for their livelihoods.

The Council of Palm Oil Producing Countries claims that at least two-fifths of palm oil’s work output in Malaysia and Indonesia is done by smallholders, not big agribusinesses. But while Jakarta and Kuala Lumpur might be able to sound tough fighting the EU’s actions, there isn’t actually much they can do.

Both nations need the EU as a trading partner more than the EU needs them. Almost 10% of all Indonesian exports are shipped to the EU, yet the EU sells less than 1% of its goods to Indonesia. Bilateral trade in goods between Malaysia and the EU, now its third largest trading partner, was worth $44.1 billion last year. Of this, Malaysia enjoyed a trade surplus of US$12.7 billion.

Indonesia’s threat to increase tariffs on EU dairy products to 20-25 % won’t likely be a major deterrent to the bloc’s position on palm oil; the bloc’s dairy exports accounted for a little over 2% of its total shipments to Indonesia last year.

Malaysia, meanwhile, has threatened to back away from purchasing $1 billion worth of military hardware from European states and dangle its planned procurements elsewhere. But losses to the arms sector are unlikely to faze EU environmentalists pushing for the palm oil ban nor deter the majority of member states uninvolved in the weapons trade.

Claims that Jakarta and Kuala Lumpur will take the issue to the WTO, and even the ICC, are similarly quixotic. WTO officials in Geneva have already ruled that trade policy can be used to address environmental sustainability concerns, as long as applied measures are not bald protectionism.

In fact, the WTO specifically noted that the Indonesia-European Free Trade Association Comprehensive Economic Partnership Agreement, signed in December last year, includes conditionality on Indonesia’s environmental progress.

Moreover, any compliant filed to the WTO would likely take years to adjudicate, especially if Indonesia and Malaysia argue that the EU’s ban is motivated by protectionism, with a decision finally made after irreversible damage had already been done to their palm oil sectors.

The two nations’ palm oil exports to the EU are already in decline. The Netherlands, long the EU’s largest palm oil importer, saw its deliveries of the product from Malaysia decline 9.1% between 2017 and 2018, and fell another 8.4% in the first half of this year, according to Malaysian Palm Oil Council data.

Rising Asian demand represents a potential hedge. Malaysia’s exports to India, already the largest importer of its palm oil, doubled in the first six months of this year, while exports to China, its second largest market, rose by more than 10%.

But by confronting the EU, Indonesia and Malaysia risk making other sectors of their economies causalities to palm oil. While palm oil is an important export to the EU, often the two nations’ biggest single exported good to the bloc, it is worth less than 20% of their total trade with Europe.

Last year, Indonesia exported some $18.5 billion worth of goods to the EU, with palm oil accounting for about $2.1 billion of the total – or just 12%, down from about 17% in 2016. By picking a bigger trade fight, Jakarta risks jeopardizing the other 88% of that trade.

Longer-term thinking is arguably in order. Indonesia is Southeast Asia’s largest economy, and the world’s 16th biggest, yet it was only the EU’s fifth largest trading partner within the Association of Southeast Asian Nations (ASEAN) bloc in 2017.

The EU has indicated it is keen to broaden that trade. Following the signing of bilateral free trade agreements with ASEAN members Vietnam and Singapore this year, Brussels is eager to push ahead with talks with Thailand, the Philippines, Malaysia and Indonesia.

While FTA talks with Malaysia were postponed in 2012, only two years after they began and unlikely to recommence anytime soon, the EU is having better luck with Indonesia. The eighth round of talks of a so-called EIFTA took place in June in Jakarta, and another round is set for early December.

A protester displays a placard during a protest against the EU’s bid to ban palm biofuels, Kuala Lumpur, January 16, 2018. Photo: AFP/Mohd Rasfan

The escalating palm oil dispute will no doubt disrupt these talks. But Jakarta likely knows that while its palm oil exports to the EU are worth around $2 billion per year – and already declining year-on-year – a FTA with the EU would almost immediately boost Indonesian exports to the bloc by between 17.3-17.7%, or around $7.5 billion, according to an EU assessment report released in April.

Moreover, an EU-Indonesia FTA could increase Indonesia’s global export figures by up to 2.2% as it “will lead to trade diversion with third countries in addition to the creation of new trade,” the report assessed.

But while it does not make good economic sense for Indonesia and Malaysia to pick a trade fight with the EU, it makes certain political sense for Mahathir and Widodo’s elected governments.