Geo-economic Fragmentation: from impossible to inevitable?

Sanctions and trade wars, energy blockades, and restrictions on technology transfer are new realities, towards which the world economy is steadily moving. The tensions between democratic and authoritarian countries are growing, and political reasons increasingly often outweigh fears of collateral economic losses. Ascenario in which the world undergoes new geo-economic fragmentation, which had seemed quite fanciful until recently, is becoming increasingly likely, despite the obvious damage it may do, especially to developing countries in Asia (IMF experts believe that the Asia-Pacific region will lose up to 1.5% of total GDP). The Russian invasion of Ukraine, and the subsequent sanctions war, has been a powerful push toward this scenario, even though these are not its main and only catalysts.

It is not the first time that IMF experts have expressed concern about the potential geo-economic fragmentation of the global economy — its division into competing economic blocs, reducing interaction with each other (we have already written about this). This risk has become even more evident given the large-scale sanctions against Russia by the West, which have not been supported by emerging-market countries, especially Asian ones.

However, the Russian invasion of Ukraine and the following sanctions are not the first incident to push the world onto this dangerous path. The 2018 trade war between the United States and China was one such episode. In a recent Asia-Pacific Economic Review (largely focused on the risks of geo-economic fragmentation), IMF experts used a specially-designed model to calculate that the increased uncertainty in trade policy during this trade conflict led to a decline in investment (with a two-year lag) of about 3.5%, reduced global GDP by 0.4% and raised the global unemployment rate by 1%. Uncertainty in international trade carries huge risks for the global economy: economic agents choose a wait-and-see strategy, suspend investment and reduce participation in exports. Inflation grows due to higher import prices, economic activity declines even when politicians do not impose any restrictive measures, and economies become self-contained.

The integration of the Asia-Pacific region into the global economy has played a major role in the economic success of many countries in the region, and Asia as a whole has become a key player in the global economy. According to IMF calculations, in 2018, goods created in the region covered 50% of the import needs of North America and 35% of Europe’s. At the same time, the region's transformation into the world's factory has made it the world's top commodities consumer. But it is precisely because of this situation, that the Asian economy would be particularly vulnerable to geo-economic fragmentation.

The level of uncertainty in the trade policies of states becomes a trigger for geo-economic fragmentation.

Some level of uncertainty and protectionist restrictions has always been present in international trade, but the risks have remained calculable and manageable. In the trade war between China and the United States, the level of uncertainty reached highs not witnessed since World War II. The Russian invasion of Ukraine in 2022 has increased the level of uncertainty once again and made a scenario of geo-economic fragmentation even more likely. Due to the Russian invasion of Ukraine and the imposition of large-scale sanctions against Russia, IMF experts have outlined two possible scenarios for the global economy.

In the first scenario, countries that abstained from or opposed trade restrictions continue to trade with both Russia and countries that supported the sanctions. In this case, the Asian economies’ losses from sanctions will be small, while the Russian economy will suffer the most. The second scenario involves the imposition of secondary sanctions against countries which oppose trade restrictions and continue to trade with Moscow. This would lead to the division of the world into two geo-economic blocs. In this case, the Asia-Pacific region would experience significant negative economic effects: the global economy could lose up to 1.2% of GDP, but a relatively large portion of these losses would be incurred by Asian countries. Those countries would lose up to 1.5% of GDP as a result of their greater dependence on international trade. Experts note that some countries in the region may benefit from the redistribution of trade flows, but the vast majority of these states will face a significant and irreversible decline in their output. Losses will be higher in countries that are more economically tied to states from the other bloc,due to the loss of access to export markets and the disruption of complex logistical and production chains, which connect countries from the different potential blocs.

However, it is not only the difference in approaches to the sanctions policy, on which the analysis of the IMF review is based, that is pushing the world towards geo-economic fragmentation. Russia’s use of energy blackmail and a gas blockade against Europe during the current conflict, which has now grown into a serious energy and economic crisis, as well as the shock of Russian aggression against Ukraine are urging Western countries to revise their approaches to international trade. This has proved to be not only a source of prosperity, but also an instrument of pressure and threat. For example, this summer Germany adopted a law on trade control with authoritarian states, which requires German companies to check suppliers for potential violations of human rights or environmental laws.

For democracies in international trade, values become an important factor when balancing the economic benefits of choosing a trading partner. As the current conflict shows, the values gap can turn trade into a source of risk when trade dependence begins to be used as a weapon. Recent opinion polls in Germany show that 87% of Germans believe that the German government should ensure that Germany is economically independent of authoritarian countries. After Russia invaded Ukraine, Germans began to actively discuss what to do if China were to invade Taiwan. According to ZDF estimates, Germany is even more economically dependent on China than Russia. As such, possible sanctions against Beijing if Chinese military aggression were to break out, would hit the German economy very hard. According to polls, 49% of Germans believe that Germany should reduce its economic ties with and dependence on China in the near future.

China, however, has similar concerns. The Chinese economy is currently built on exports, and Beijing seeks to reduce the share of this within its GDP by stimulating domestic consumption. Mounting tensions with the United States and the growing risks of fragmentation are pushing China to accelerate its transition to a new economic model.

China's drive for self-sufficiency has its reasons. For example, in October 2022, the Biden administration imposed a ban on exports to China of super-powered AI chips, equipment for their production, and a number of other semiconductor technologies. Moreover, these restrictions apply not only to American-made chips but also to any chips produced using American equipment and technology. A week later, the U.S. imposed additional restrictions on its citizens working in Chinese chip factories. The United States' position is that these restrictions will not only maintain Washington's leadership in the field of technology, but will also help to protect America's democratic values, as China uses AI to violate human rights.

Economics and politics are intertwined in increasingly rigid and intractable ways. Therefore, a scenario in which the world is geo-economically fragmented in a manner similar to that of the second half of the twentieth century, when the socialist camp and the capitalist countries formed two separate domains of the world economy, is becoming increasingly plausible, despite the enormous economic losses it would bring.