Trade has been an engine of growth for Asia and the world. The rise of geopolitical tensions in recent years—first amid US-China trade tensions and now accelerating in the wake of Russia’s invasion of Ukraine—has brought concerns that this engine of growth could go into reverse as strategic competition and national security considerations take precedence over the shared economic benefits of global trade. This chapter documents early signs of trade fragmentation in the form of rising trade restrictions and uncertainty and provides empirical analyses showing that higher trade policy uncertainty leads to adverse macroeconomic outcomes. Longer-term, model simulations suggest that a sharp fragmentation scenario, in which the world divides into separate trading blocs, would carry large, permanent output losses that are especially high for Asia, given its significant role in global manufacturing and trade. There are also early signs of financial fragmentation, which would add to the costs of fragmenting trade.
Trade Fragmentation: What Is at Stake and Early Signs
Greater trade integration has raised productivity and living standards around the world over the past few decades. The growth of global value chains has also resulted in economies becoming increasingly interdependent. This trend toward increased integration and interdependence has played a key role in the economic success of Asian economies but has now also left the region especially vulnerable to fragmentation risks.
What is at stake: Asia has come to play a key role in global production, with value added originating from the region satisfying about 50 percent of external demand in North America and 35 percent in Europe in 2018, up from 41 percent and 28 percent, respectively, in 2000 (Figure 3.1, panel 1). As a result of becoming a global production hub, Asia is also now a key trading partner for commodity exporters around the world who depend crucially on Asian demand for raw materials. For example, Asia accounts for close to 50 percent of global demand in key commodities, including mineral fuels and green transition minerals (Figure 3.1, panel 2).
Trade Fragmentation: What Is at Stake and Early Signs
Trade Fragmentation: What Is at Stake and Early Signs
Trade Fragmentation: What Is at Stake and Early Signs
Asia’s ability to supply the world is largely underpinned by well-developed regional value chains. Almost two-thirds of intra-Asian trade consists of trade in intermediate goods, which is significantly higher than the global average (Figure 3.1, panel 3).
Early signs: Rising geopolitical tensions over the past few years have been accompanied by growing signs of trade fragmentation around the world, raising concerns that trade flows may increasingly be driven by strategic competition and national security considerations, potentially at the expense of economic efficiency.
Even though trade outturns have recently been strong, including due to the temporary pandemic driven reorientation of demand away from services and toward goods (August 2022 External Sector Report: Pandemic, War, and Global Imbalances), early signs of trade fragmentation pressures are clearly visible in data on trade-related uncertainty, which spiked in 2018 amid US-China trade tensions. After moderating temporarily, trade uncertainty increased again with Russia’s invasion of Ukraine, as sanctions on Russia created uncertainty around future trade relations (Figure 3.1, panel 4).
Actual trade restrictions imposed by countries have also been on a rising trend, with data from Global Trade Alert showing a significant increase in new restrictions since 2018, mirroring the increase seen in trade-related uncertainty (Figure 3.1, panel 5).2 Furthermore, the sectoral composition of trade restrictions has been rotating. The share of restrictions that target high-tech sectors has been steadily increasing since the global financial crisis, potentially reflecting the increasingly prominent role of these sectors in both economic competition and national security.3 Restrictions targeting the energy sector increased sharply in the wake of Russia’s invasion of Ukraine, while those aimed at high-tech sectors also remained high (Figure 3.1, panel 6).
The Effect of Trade Policy Uncertainty
Increased trade-related uncertainty as seen in recent years is concerning because even in the absence of actual new policy actions toward fragmentation, uncertainty can dent economic activity. In particular, uncertainty around trading relationships creates an incentive to “wait and see,” leading firms to pause investment and reduce firm entry into exporting (Caldara and others 2020; Handley and Limão 2022). Higher trade uncertainty can also increase inflation by raising import prices (Handley and Limão 2017) or by inducing firms to increase their markups (Fernández-Villaverde and others 2015).
The analysis uses the country-specific measures of trade policy uncertainty taken from the World Trade Uncertainty Index from Ahir, Bloom, and Furceri (2022) and local projection methods (Jordà 2005) to extend the empirical evidence on the macroeconomic impact of trade policy uncertainty to a panel of countries.4 The results suggest that an increase of one standard deviation in trade policy uncertainty, which corresponds approximately to the increase seen between March and June 2018 in the buildup to US-China tariffs, reduces investment by about 2.5 percent within three years (Figure 3.2, panel 1). Higher trade policy uncertainty is also associated with a decline in broader economic activity, with GDP falling by 0.4 percent and the unemployment rate rising by 1 percentage point. Notably, exchange rates depreciate in countries that see an increase in uncertainty, as foreign exchange markets incorporate higher risk premiums (Engel and West 2005), leading import prices to rise (Figure 3.2, panel 2). The analysis controls for changes in nontariff barriers; a simultaneous increase in trade uncertainty and actual trade barriers is likely to result in even more adverse macroeconomic outcomes.5
Evidence from a large cross-country panel of firms corroborates trade policy uncertainty’s large and significant impact on investment and allows exploration of heterogeneity in the effect of trade policy uncertainty across countries and firm characteristics.6 The analysis shows that average firms’ investment declines by about 5 percent two years after an increase of one standard deviation in the World Trade Uncertainty Index.7 The effect is others (2022), the world uncertainty index of Ahir, Bloom, and Furceri (2022), credit to nonfinancial corporations, lags of GDP and changes in the dependent variable, and country and time fixed effects.even larger for emerging market economies, where uncertainty tends to have a larger impact on credit extension, amplifying the decline in investment (Carrière-Swallow and Céspedes 2013), and for countries with a higher level of trade openness (Figure 3.2, panel 4). Financial constraints also amplify the real effects of uncertainty, with a larger impact for firms with low liquidity and high debt to assets because the cost of and access to external finance deteriorates (Alfaro and others 2019; Caggiano and others 2021).8
Long-Term Losses from a World Divided into Trading Blocs
Higher trade policy uncertainty is already having negative economic effects in the short term, but how much larger could losses be in the long term if more severe fragmentation scenarios divide the world into trading blocs? To answer this question, some illustrative fragmentation scenarios were simulated using a sectoral, computable, general equilibrium model with firm heterogeneity and input-output links. The model captures long-term productivity losses as trade is cut of between economies, with gains from specialization and scale being unwound and some firms being forced to exit (Caliendo and others 2017). Because the model does not capture all possible channels through which trade fragmentation can affect output, estimates should be taken as a lower bound of the potential loss associated with fragmentation in trade.9 The analysis focused initially on the fragmentation of trade in two broad sectors that have seen an increase in restrictions in recent years and that are closely related to energy and broader national security concerns, respectively: extractive industries (which include fossil fuel extraction) and high-tech manufacturing (which encompasses electrical machinery and equipment and transport equipment). Fragmentation in these sectors is defined as the elimination of sectoral trade between countries in different blocs.
Any discussion of the longer-term consequences of trade fragmentation will need to make some assumption about the dividing lines that might arise. There are multiple possible scenarios, none of which are necessarily more likely or unlikely than another. In this spirit, the following describes the consequences of a purely hypothetical global economy divided along the lines implied by the votes cast on the March 2, 2022, United Nations General Assembly motion to condemn Russia’s invasion of Ukraine. The general features that emerge, and the order of magnitude of the losses under sharp fragmentation are similar across a range of other scenarios, including those considered in Cerdeiro and others (2021).
The starting point is fragmentation in energy and high tech between Russia and positive-voting countries, with negative-voting and abstaining countries assumed to continue trading with both Russia and positive-voting countries in these sectors. Long-term changes in GDP from this scenario are negligible for Asia and Pacific countries and the world, with large losses experienced only in Russia because the country is cut of from high-tech trade and loses export markets. Losses are, on the other hand, substantial in a further downside scenario in which the world divides into two blocs, with trade in high-tech and energy sectors cut of between countries casting a positive vote and those casting a negative vote or abstaining. Under this scenario, permanent global annual losses are estimated at 1.2 percent of GDP, with larger losses in Asia and Pacific countries at 1.5 percent of GDP, reflecting the key role trade plays in Asia (Figure 3.3, panel 1, green color). Although a handful of Asia and Pacific economies may see benefits from trade diversion as competitors lose access to some of their key destination markets, the vast majority experience significant, permanent declines in output. Losses are larger in countries where trade with the other bloc is significant in the affected sectors (including China, Korea, and Vietnam) because of both the lost access to export markets and the splintering of complex production networks that currently straddle both blocs (Figure 3.3, panel 2). More generally, most of the long-term losses stem from restricting high-tech trade, given the relatively low elasticity of substitution of these sectors, while energy exporters (such as Australia and Indonesia) see smaller losses, given the higher elasticity of substitution of their exports.
Long-Term Losses from Fragmenting World Trade along the Lines of the UN Vote on Ukraine
Long-Term Losses from Fragmenting World Trade along the Lines of the UN Vote on Ukraine
Long-Term Losses from Fragmenting World Trade along the Lines of the UN Vote on Ukraine
Concerns have recently focused on the energy and high-tech sectors, but it is also possible that restrictions could be applied more broadly. To assess this possibility, the analysis considers a scenario in which nontariff barriers in other sectors are also increased between blocs, in addition to the elimination of trade in the energy and high-tech sectors. The increase in nontariff barriers in other sectors is calibrated to match the level of nontariff barrier restrictiveness estimated to have prevailed at the height of the Cold War, between the end of World War II and the late 1970s (that is, before nontariff barriers started to come down during the 1980s).10 Annual permanent global losses in this case are estimated at 1.5 percent of GDP, with losses for Asia and Pacific countries mounting to 3.3 percent of GDP (Figure 3.4, panel 1, red color). For some economies, these losses would unwind all the gains from worldwide tariff reductions since 1990, including the Uruguay Round and preferential tariff reductions (Caliendo and others 2017). Several Asia and Pacific economies are affected more severely by this second layer, relative to when restrictions were limited to energy and high-tech sectors, because Asia’s export basis goes well beyond those two sectors, particularly in South and Southeast Asia.
Financial Fragmentation: What Is at Stake and Early Signs
Financial Fragmentation: What Is at Stake and Early Signs
Financial Fragmentation: What Is at Stake and Early Signs
Will Financial Fragmentation Add Further Downside Risks?
Although the chapter focuses on trade fragmentation, there is also a growing concern regarding financial fragmentation. Like most countries, Asian economies have become more financially integrated with the rest of the world, benefiting from inward capital flows to fund domestic investments, outward investments in opportunities abroad, and broader diversification and international risk sharing. Financial fragmentation could thus entail short-term costs from a rapid unwinding of financial positions, and long-term costs from lower diversification and from slower productivity growth because of lower foreign direct investment.
The total gross stock of cross-border assets and liabilities of Asian advanced economies has increased to more than 500 percent of GDP in 2020, partly driven by financial centers like Hong Kong Special Administrative Region and Singapore.11 Asian emerging market and developing economies have also seen an increase in cross-border holdings from 25 to 110 percent of GDP between 1990 and 2020 (Figure 3.4, panel 1). These large cross-border holdings could add to vulnerabilities if geopolitical considerations result in the forced unwinding of positions. This is because countries’ large total stock positions are partly underpinned by significant exposures across world regions (Figure 3.4, panel 2). In particular, more than half of Asian portfolio investments abroad are in the United States, Europe, and other Organisation for Economic Co-operation and Development economies, and about one-fifth of US foreign direct investment positions are allocated to Asia.
Although data are more limited than in the trade sphere, there are arguably early signs of financial fragmentation. The IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions, which documents trade and capital flow measures being implemented by countries, shows a significant increase in the number of new capital flow control measures imposed by countries in 2020 in the aftermath of the pandemic (IMF 2022). Most notably, 2020 saw a large increase in restrictions imposed on foreign direct investment inflows, a key complement to the development and functioning of global value chains (Figure 3.4, panel 3). While partly coinciding with the onset of the pandemic, greater geopolitical tensions have been linked to this proliferation of foreign direct investment restrictions (Evenett 2021). Indeed, the number of mentions of the phrase “national security” in Annual Report on Exchange Arrangements and Exchange Restrictions reports has increased rapidly in recent years (Figure 3.4, panel 4). And while partial data through 2021 show a decline from the 2020 peak, the number of new foreign direct investment measures remains high, compared with historical averages.
Private sector investment decisions also seem to be responding to increased uncertainty and tensions by putting more weight on geopolitical considerations: mentions of key words like “reshoring,” “nearshoring,” and “onshoring” have increased significantly in company earning calls and annual reports (Figure 3.4, panel 5).
Conclusion
Early signs of fragmentation have been visible for a while, with trade policy uncertainty spiking in recent years, countries imposing ever more trade restrictions (especially in the high-tech and energy sectors), and national security concerns resulting in new restrictions being placed on inward foreign direct investment. Russia’s war in Ukraine has further raised geopolitical tensions, bringing to the fore risks that trade and financial flows will increasingly be driven by geopolitical rather than economic considerations. The analysis presented in this chapter highlights the potentially large economic losses—for the world and especially for Asia—that could arise if these trends toward greater fragmentation continue, especially in the case of the sharpest fragmentation scenarios in which the world divides into distinct blocs.
Collaborative solutions are needed to avoid the adverse effects from greater fragmentation and to ensure that trade continues to act as an engine of growth. The focus should be on rolling back damaging trade restrictions and reducing policy uncertainty through clear communication of policy objectives and processes to address legitimate national security concerns, while addressing competitiveness weakness through structural reforms that lift productivity (August 2022 External Sector Report: Pandemic, War, and Global Imbalances). Within Asia, there is a role not only for deepening existing agreements (Constantinescu, Mattoo, and Ruta 2018) but also for ensuring that overlapping trade agreements do not contribute to fragmentation but rather are an avenue to promote open and stable trading relationships.12 Achieving this positive potential requires that each agreement be open to participation by others willing to take on similarly ambitious obligations. Complementing regional agreements with reforms at the multilateral level, while also restoring a fully functional World Trade Organization dispute settlement system, can not only mitigate any potential negative impacts of discriminatory policies on other trading partners but also help resolve some of the underlying sources of tensions. Above all, however, active engagement and dialogue between policymakers from around the world, including in multilateral forums, will be vital to avoid the sharpest and most harmful fragmentation scenarios.
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Global Trade Alert tracks announcements made by governments that unilaterally change the relative treatment of foreign versus domestic commercial interests. The restrictions covered include those related to the rise in bilateral tariffs between China and the United States, which previous estimates suggest cut global GDP in 2022 by about 0.4 percent compared with a counterfactual without the imposition of these barriers (see Scenario Box 1.2. in Chapter 1 of the October 2019 World Economic Outlook).
High-tech sectors include all sectors classified as high technology or medium-high technology in OECD (2011).
To date, the empirical evidence on the impact of trade uncertainty has focused on the United States (Caldara and others 2020). The country-level model includes controls for growth expectations, the index measuring trade restrictions from Estefania-Flores and
See Estefania-Flores and others (2022) and the October 2021 Regional Economic Outlook: Asia and Pacific, Chapter 4.
The firm-level model also estimates impulse responses for investment based on Jordà (2005), controlling for firm-quarter and country-sector fixed effects and lags of investment spending. In a first step, it estimates the average (unconditional) effect of an increase in World Trade Uncertainty Index on firms’ investment. In the second step, it uses a difference-in-difference specification to analyze how this investment response after a World Trade Uncertainty Index shock varies for country and firm characteristics by interacting the World Trade Uncertainty Index with a dummy variable that equal to 1 when countries are classified as emerging market and developing economies, and when companies’ mean trade exposure, liquidity, or debt to asset are above or below the median value within its industry.
There are several reasons why the effect is larger than in the country-level results. First, firms included in the sample used for the firm-level analysis are only listed firms that are typically more “global” and exposed to trade. Second, the average effect on firms’ investment varies substantially across firms and tends to be larger for smaller firms (which accounts less in overall value added) that are more credit constrained. Finally, the country and time coverage in the firm-level analysis is smaller than that of the country-level analysis.
The results are generally robust to changes in the sample of economies. For example, the results on investment (both country-level and firm-level) are unchanged if China and its closest trading partners are removed. Similarly, the results are robust when the spike in trade uncertainty associated with the US-China tensions is excluded from the sample. Finally, the results on the differential impact for emerging market and developing economies, trade openness, and firms’ financial constraints are similar but smaller in magnitude.
Other channels include, for example, short-term losses stemming from fragmenting energy markets (Albrizio and others 2022) and from demand shortfalls, and long-term losses because of lower knowledge diffusion (Cerdeiro and others 2021).
Estimates of nontariff barriers are from Estefania-Flores and others (2022). The analysis used the elasticity of exports to tariffs and the nontariff barrier index to translate the nontariff barrier index into ad valorem equivalents. The median ad valorem equivalent stood at about 75 percent between 1950 and 1980, about twice as large as the median of about 40 percent for 2019.
Excluding financial centers (Hong Kong Special Administrative Region and Singapore) gives a similar trend, though the level of assets and liabilities, at about 380 percent of GDP, is lower for Asian advanced economies.
The Comprehensive and Progressive Agreement for Trans-Pacific Partnership, Regional Comprehensive Economic Partnership (both in operation), and the Indo-Pacific Economic Framework (under discussion) overlap in their participation and coverage of issues but have unique strengths. Regional Comprehensive Economic Partnership participants are cutting tariffs among countries that account for 30 percent of the global population and production. With four Western Hemisphere participants, the Comprehensive and Progressive Agreement for Trans-Pacific Partnership bridges the Pacific with ambitious commitments in frontier policy areas such as investment and e-commerce. Although apparently light on market access and other traditional free trade agreement provisions, initial discussions toward the Indo-Pacific Economic Framework involve countries that account for about 40 percent of global GDP and would promote cooperation on issues such as the digital economy, supply resilience, decarbonization, and infrastructure.
