The name of a small office at the top of a drab skyscraper in the centre of Vilnius has set off a geopolitical firestorm that threatens billions of dollars in trade.

This is the Taiwanese Representative Office in Lithuania, a diplomatic outpost so new that the chief of mission’s business cards still carry the address of his previous posting in Latvia.

At issue is the fact that the name of the mission explicitly refers to the disputed island of Taiwan — and not, as is more common, its capital city of Taipei. To Eric Huang, who heads up the office, this makes complete sense. “We are representing Taiwan, not the city of Taipei,” he says.

But for the Chinese, the opening in Lithuania of what amounts to a de facto embassy represents a big step towards formal recognition of Taiwan, which Beijing claims as part of its territory. And it has retaliated furiously to this perceived provocation, not just by stopping direct imports from the Baltic country but by taking aim at global supply chains — stopping German companies, for instance, from using Lithuanian components in China.

For many policymakers in Europe, Asia and the US, the tactics that China is deploying in the dispute with Lithuania mark a watershed moment for the global economy. Although China has long used various types of economic coercion in political disputes with countries from Canada to Australia, this represents the first time the Chinese government has tried to prescribe where companies can, or in this case cannot, source parts for goods they make in and sell to China.

The precedent being set by China should send shockwaves, say officials in the Baltic country. “It is Lithuania today,” says economy minister Ausrine Armonaite. “It may be any other country tomorrow.”

The stakes are particularly high for the EU. It is the first time China has unleashed the full power of its economic coercion toolkit against an EU country, testing the bloc’s ability to prioritise its joint strategic interest over individual countries’ or companies’ short-term gains. Seeing the workings of its single market threatened, the EU has filed a case against China at the World Trade Organization, which the US, Australia, Japan, UK, Canada and Taiwan are all seeking to join.

“It is a test for how far China will go with its punishments, how far Taiwan will go in trying to make up for the economic damage, how far the EU will go in standing together, how far the US will go in shielding Lithuania from the fallout,” says Jakub Jakobowski, a senior fellow with the China programme at the Eastern Studies Centre (OSW) in Warsaw.

Lithuanian businesses may not wait around to see the results of that test. Kristijonas Vizbaras, a Lithuanian entrepreneur who has co-founded a series of companies, is already examining whether to move manufacturing for his family’s new sensor venture from his home country to Belgium.

“It hit like a bomb. Everybody was completely flat-footed,” says Vizbaras, explaining that in Lithuania’s laser sector about one in two parts sold end up in China eventually.

“We fully support Taiwan as a democratic country. But we are extremely angry at our government and how they acted,” he adds. “We have to de-risk and divert our future expansion plans out of Lithuania. This is what we are doing, and what a lot of other businesses are doing.”

Behind Lithuania’s decision

Long known as perhaps the most vocal critic of Russia and its increasingly aggressive stance, Lithuania has developed growing sympathy for Taiwan and its efforts to resist being pulled into the orbit of another authoritarian state, China.

But officials in Lithuania’s former government, in power in Vilnius until October of 2020, say their initial discussions focused only on a mission named after Taipei. A new government changed tack, unveiling the new name last July even as Lithuania confronted not just the Covid-19 pandemic but a hybrid attack from Belarus forcing migrants over the border as well as Russian sabre-rattling in nearby Ukraine.

“It was a bit surprising. I still don’t know why they did it. We should save our ammunition, and not fight on several fronts at the same time,” says one former senior official.

Foreign minister Gabrielius Landsbergis says it was never Lithuania’s intention to cause a diplomatic fuss. “We didn’t pick a fight; a big country decided to teach the world a lesson,” he says.

Landsbergis presents the move as part of Lithuania’s values-based foreign policy, which aims to support democracy and freedom around the world. Lithuania, which only regained independence in 1990 after almost half a century of annexation by the Soviet Union, sets stock in standing up to authoritarian states, adding China to a list that includes neighbouring Russia and Belarus as well.

“Sometimes those principles and values are not very much liked by our neighbours or some other countries. But we cannot just choose to go another way. It is our way. We understand very well it is not the way that is easiest,” President Gitanas Nauseda told the Financial Times last summer. An EU official scoffs: “They see themselves as leaders of the free world.”

But the name change also came after a number of moves had already antagonised Beijing last year, including Lithuania withdrawing from the 17+1 format China used to deal with countries from central and eastern Europe, a ban on using Huawei equipment to build 5G networks, and a parliamentary motion calling China’s actions against Uyghurs in Xinjiang “genocide”.

Landsbergis insists that Lithuania did not take the decision in the hope of receiving some form of compensation from the Taiwanese. “We are not selling the name of the representative office,” he says.

Still, support has come. Taiwan set up a $200mn fund to invest in Lithuania; it is also offering $1bn in loans to joint projects between the two countries. Armonaite says Lithuania is looking to boost investments in semiconductors, IT, and biotech using the funds.

The US, in turn, has given Lithuania $600mn in export credits that Vilnius can use to buy technology or goods as well as support its companies, recognition for its action on what is Washington’s main foreign policy goal of containing China. “US support has been steadfast. The US and many other countries clearly see this as a challenge not just for Lithuania or the EU, but for the world,” a state department official says.

Turning the screw

China claims Taiwan as part of its territory and threatens to invade if Taipei resists submitting to its control indefinitely. Beijing pressures all third countries, international organisations and companies to treat Taiwan as part of China. As a result, all but 14 countries have cut official diplomatic ties with Taiwan and the country is frozen out of international organisations.

China’s retaliation against Lithuania has been far from subtle, even if Beijing has refused to acknowledge it even exists. “The claim of so-called ‘coercion’ against Lithuania is fabricated out of nothing,” a foreign ministry spokesman said last week. Ministry spokesman Zhao Lijian said: “Lithuania should stop confusing right and wrong and maliciously hyping things, let alone trying to gang up with other countries against China.”

The Baltic country suddenly disappeared from the list of countries in China’s customs code while multiple companies — from Lithuania, Germany and elsewhere — reported difficulties getting components labelled as made in Lithuania into China.

“Right now, China is blocking all parts. They are looking through all German auto parts and saying ‘this LED strip was glued in Lithuania, send it back’. You can’t do business that is interlinked to global supply chains from Lithuania,” says one Lithuanian-based supplier.

The measures fit into a long history of China leveraging its big and growing market to punish foreign countries or companies over political agreements. Partial trade bans have been imposed on Japan, Norway, Australia, and Canada while Beijing has throttled the flow of Chinese tourists to countries it has had acute disputes with. China has even permitted public demonstrations calling for boycotts of Japanese cars and goods.

But analysts have noted a sharp increase in Beijing’s use of such punitive measures over the past four years, as well as more signs of European countries and companies being targeted. “The trajectory is really worrying,” says Jonathan Hackenbroich, a policy fellow at the European Council on Foreign Relations in Berlin.

Companies in Lithuania are developing workarounds, according to officials and business executives in Vilnius, including disguising the origin of parts and treating work in Lithuania as a service that does not have to be declared.

“The priority is to ensure that the products that end up in China do not contain unique Lithuanian parts, meaning those that are labelled and distinguishable,” says a supply chain expert at an international consultancy with knowledge of German companies’ operations.

A far bigger question is how the dispute could change investment and supply chain decisions not just for Lithuania but more broadly multinational companies. “If China succeeds in weaponising European value chains now, it will be encouraged to do this in the future, and it might influence decisions about new investments,” says Jakobowski.

He sees China’s new coercion technique as part of a broader policy of getting big foreign companies to locate ever bigger parts of their supply chains in China. “This is part of the bigger decoupling game,” he adds.

In Lithuania, there is a hope that companies can readjust and find other partners just as they have when neighbouring Russia has thrown its weight around. Businesses, however, are trying to view it from both sides. “We can’t avoid the world’s second-biggest economy. We moved towards China for the past 30 years and can’t jump away in a day,” says Vidmantas Janulevicius, president of the Lithuanian confederation of industrialists. “But we can’t be dependent on one country. It’s a very good wake-up call for Europe that we need to have diversified supply chains.”

The right fight?

The EU has tried to respond swiftly, launching the WTO case against Beijing. But it is struggling to balance the need to defend the single market with the reality of business dependence on China.

In December, the EU unveiled plans to allow it to take swift retaliation against economic coercion — especially from China and Russia — through 12 possible countermeasures, including levying tariffs and banning chemical imports. France has made adopting the anti-coercion instrument one of the key parts of its current six months leading the council of EU member states. Thierry Breton, the EU internal market commissioner, is set to visit Vilnius in the coming days.

“When it was felt that the single market was the target then the attitude [in the EU] changed,” says Landsbergis. He adds that thanks to the WTO case “we are entering a much more stable situation”.

But not all EU states have appreciated Lithuania’s approach, with some accusing it of acting unilaterally against such a big power just as the continent deals with Russia amassing more than 100,000 troops on its border with Ukraine and in neighbouring Belarus. “I don’t really see what was to be gained by forcing an issue that the Chinese are so sensitive about,” says one official in a EU member state.

China is trying to exploit the unease in some EU capitals about Lithuania’s move, says Hackenbroich. “Given that division and the lack of tools to respond on the European side, and the capability and willingness to exploit dependency on the Chinese side, China is in a better position.”

Some officials believe that the EU needs to dramatically up its game in responding. “If China now leverages their market to use our companies for sanctions against other countries, we have a big problem,” says an EU diplomat in Asia. “This is something the US does already, so EU companies will be on the receiving end of such secondary measures from the world’s two economic superpowers.”

The US frequently uses economic sanctions that apply extraterritorially. For example, its ban on semiconductor supplies to Huawei that use US equipment bars TSMC of Taiwan, the world’s biggest contract chipmaker, from producing chips for the Chinese technology group because it uses US tools.

The EU has a law designed to counter such pressure but it is largely dormant. The so-called Blocking Statute was devised in response to US sanctions against Cuba and Iran, which also apply to non-US companies. Analysts say it needs to be broadened for use against China. “This is going to be a much bigger challenge for the EU in the future because EU companies will, when in doubt, always prioritise market access to China,” Hackenbroich says.

The position of Germany is particularly crucial, and the country itself seems divided. Its main business lobby group, the BDI, called Beijing’s move against Lithuania “a devastating own goal.” But the German-Baltic chamber of commerce told the Lithuanian government that some companies would have “no other choice than to shut down production in Lithuania.”

Tobias Lindner, state secretary at the German foreign ministry, set out his government’s position at an event earlier this month: “Trade policy is a matter for the EU. Period. And whoever imposes sanctions on Lithuania is imposing sanctions on the whole of the EU.”

But diplomats say others in Berlin have privately tried to push a softer line. “What we have had, especially from the German government, calling up people in Brussels to try to tone down the response, has been very unhelpful,” says one EU diplomat.

A German executive in the Baltics argues that the EU desperately needs to come up with a proper strategy for dealing with China, but questions whether the name of the Taiwanese office in Lithuania is the right case to force the issue. “We have much bigger stakes than this,” he says. “We should not fight over minor things [when] we have challenges 100 times bigger.”

Lithuania is putting on a brave face for now. Armonaite, the economy minister, says that for all the furore, no company has yet left, and that Lithuania’s economy is still expected to grow strongly this year.

But there is also a sense that unless a compromise is reached with Beijing, there is a danger that companies avoid Lithuania for future investments while the WTO case drags on for years. Janulevicius says it is likely to be a difficult two to three years. “The result, we will see only in 5-7 years’ time. It’s a big reputational issue,” says one Lithuanian automotive supplier.

Huang is in no doubt what will happen if there is no pushback against China’s new coercion tactics. “If we cave to pressure this time, they will pursue it again,” the Taiwanese representative says. “Then China will rule the world.”

Additional reporting by Guy Chazan in Berlin