## CHAPTER 4 GEOECONOMIC FRAGMENTATION AND FOREIGN DIRECT INVESTMENT

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### Introduction and scope
- Focus: fragmentation of foreign direct investment (FDI), defined as cross-border investment through which foreign investors establish a stable and long-lasting influence over domestic enterprises.
- Objectives:
  - Assess whether FDI is reallocating across countries consistent with fragmentation.
  - Test whether geopolitical factors help explain bilateral FDI flows.
  - Develop a multidimensional index of countries’ vulnerability to FDI relocation and quantify potential costs using empirical analysis and model-based scenarios.
- Context drivers:
  - Rising geopolitical tensions and uneven distribution of gains from globalization increasing skepticism toward multilateralism and appeal of inward-looking policies.
  - Firms’ interest in reshoring and friend-shoring rose contemporaneously with a rise in average geopolitical distance across country pairs.
  - Policy actions cited as relevant: CHIPS and Science Act, Inflation Reduction Act, European Chips Act.

### Recent trends in globalization and FDI; data and measurement
- Global trends:
  - Global FDI declined from 3.3 percent of GDP in the 2000s to 1.3 percent between 2018 and 2022.
  - Slowbalization largely dates to the aftermath of the global financial crisis.
- Data and metric:
  - Investment-level data on new (greenfield) FDI from fDi Markets covering about 300,000 investments from 2003:Q1 to 2022:Q4.
  - Main measure: number of greenfield FDI projects (counts), since investment values are often estimated.
  - Strategic sectors defined at the three-digit industry level for policy-relevant analyses.

### Early empirical signs of FDI fragmentation
- Regional and sectoral patterns (2020:Q2–2022:Q4 versus pre-pandemic average):
  - Aggregate decline: greenfield FDI down by 19.5 percent relative to the post–global financial crisis pre-pandemic average.
  - Flow of strategic FDI to Asian countries started to decline in 2019 and recovered only mildly; by 2022:Q4, strategic FDI to Europe was about twice that going to Asian countries.
  - Foreign investment in R&D and in strategic industries (e.g., semiconductors) shows pronounced divergence; lack of recovery to China evident.
  - From 2020:Q2 to 2022:Q4, FDI declined by almost 20 percent compared to the pre-pandemic average; decline highly uneven across regions.
  - Asia lost market share both as source and host; FDI to and from China declined more than the Asian average.
  - United States and emerging Europe experienced smaller declines or increases in greenfield FDI (for example, inflows to emerging Europe).

- Financial exposure to fragmentation risk (aggregate numbers from cross-border non-FDI holdings):
  - Exposures have roughly doubled over the past 20 years.
  - In aggregate, exposures have now reached 42 percent of GDP, or 24 percent of all non‑FDI cross‑border holdings.

### Geopolitical alignment, measurement, and quantified gravity-model effects
- Geopolitical alignment:
  - Measured by “ideal point distance” (Bailey, Strezhnev, and Voeten 2017) based on UN General Assembly voting similarity.
  - The share of FDI among geopolitically aligned countries exceeds the share going to geographically close countries.
  - Importance of geopolitical alignment has increased over the last decade and more steeply than geographic distance, especially for FDI in strategic sectors.
- Gravity model setup:
  - Poisson pseudo-maximum likelihood with source×year and host×year fixed effects; controls for geographic, cultural, institutional distance, colonial ties, and push–pull factors.
- Key quantitative result:
  - An increase in ideal point distance from the first to the third quartile (equivalent to moving from the distance between Canada and Japan to that between Canada and Jordan) is associated with a decline in bilateral FDI of about 17 percent on average.
  - Effect stronger when EMDEs are either a source or host.
  - Since 2018, geopolitical factors have become more relevant for FDI flows; geopolitical distance matters more for investments in strategic sectors.

### Multidimensional vulnerability index to FDI relocation
- Components (sector–source country level):
  1. Geopolitical index: host exposure = share of investment from each source × geopolitical distance. EMDEs more geopolitically vulnerable because they receive much FDI from advanced economies that are geopolitically closer to each other than to EMDEs.
  2. Market power index: FDI in a sector treated as less vulnerable if host is among the top 10 exporters in that sector; otherwise treated as fully vulnerable. Most economies show low protection from market power; exceptions include large exporters such as China, Germany, US.
  3. Strategic index: share of inward FDI in strategic sectors; overlap between advanced economies and EMDEs.
- Aggregate index formula:
  - Aggregate index = strategic dimension + (geopolitical dimension × market power index).
  - Market power index bounded 0–1; multiplication dampens geopolitical vulnerability where host market power limits relocation.
- Distributional findings:
  - EMDEs are, on average, more vulnerable to FDI fragmentation than advanced economies, but with variation and overlap: 14 percent of EMDEs have a vulnerability index lower than the median for advanced economies.
  - Regionally, Europe is in a better position; other regions show higher and similar vulnerability levels.
- Policy-relevant correlation:
  - Stronger regulatory quality associated with lower aggregate vulnerability and higher exports.
  - Regression coefficient of regulatory quality index = –0.057 (p-value = 0.000) when regressing aggregate vulnerability on regulatory quality controlling for log real GDP, trade (percent of GDP), and FDI inflows (percent of GDP), averaged over 2010–19.

### FDI types, spillovers, and firm-level evidence
- Definitions and exposure:
  - Horizontal FDI: foreign firms enter to directly serve local markets.
  - Vertical FDI: foreign firms enter to produce inputs supplied to affiliates (part of global value chains). Vertical FDI is more exposed to fragmentation and linked to advanced-technology input production.
- Growth and spillovers:
  - Vertical FDI positively associated with economic growth due to concentration among intermediate‑goods producers adopting sophisticated, skill‑intensive technology.
  - Horizontal FDI more associated with final‑goods producers transferring simpler assembly technology.
- Heterogeneity of spillovers:
  - Spillovers depend on host-country human capital, institutional quality, and financial development; differ by mode of entry, type of investment, and forward/backward industry linkages.
- Firm-level evidence (World Bank Enterprise Surveys, 2006–2021, >120,000 firms in 150 countries):
  - Positive within‑industry spillovers to domestic firms observed, but within‑industry productivity gains confined to advanced economies.
  - Domestic suppliers in EMDEs benefit from entry of foreign firms in downstream sectors (local sourcing, increased local demand, learning by doing).
  - No evidence of spillovers to domestic users (foreign upstream firms mostly sell abroad, limiting direct technology spillovers via local buyers).

### Model-based quantification: DSGE scenarios, assumptions, and regional shares
- Modeling approach:
  - Multiregion DSGE model (IMF’s Global Integrated Monetary and Fiscal Model) using bilateral cross‑border flow of inputs into investment as a proxy for FDI-like effects.
- Key scenario assumptions and parameter values:
  - Fragmentation modeled as permanent rise in barriers between China and US blocs; illustrative 50 percent reduction of investment input flows between blocs.
  - Empirical estimates of correlation between FDI flows and labor productivity discipline productivity losses.
  - Model allows up to eight regions.
  - Baseline fragmentation: 50 percent decline in investment input flows between China and US blocs; no barriers with two nonaligned regions (India and Indonesia and Latin America and the Caribbean).
  - Elasticity of substitution across foreign sources of investment inputs:
    - Lower elasticity = 1.5 (benchmark).
    - Higher elasticity = 3.0 (alternative, greater diversion).
  - Uncertainty scenario: investors perceive a 50 percent chance that a nonaligned region will align with the opposing bloc (investors behave as if investment input flows face half the barriers faced by regions in the opposing bloc).
- Model region GDP shares (Percent):
  - United States: 16.0
  - China: 17.5
  - EU+: 15.6
  - Other AEs: 13.8
  - India and Indonesia: 9.6
  - Southeast Asia: 4.0
  - LAC: 6.5
  - ROW: 17.0

### Simulation results and distributional outcomes
- Global output effects:
  - Scenario with US‑centered and China‑centered blocs (India and Indonesia and LAC nonaligned): global output about 1 percent lower after five years relative to no‑fragmentation.
  - Long-term output lower by 2 percent as capital stock and productivity impacts cumulate.
  - Fragmentation could lower global output by up to 2 percent.
- Regional/bloc outcomes:
  - Output losses generally larger in the emerging‑market‑dominated China bloc due to heightened barriers to major investment sources.
  - US bloc also faces nonnegligible losses because some members have strong links to China (for example, Japan and Korea in other AEs and Germany in EU+).
- Nonaligned regions:
  - Two competing channels determine outcomes:
    - Reduced external demand from global slowdown (negative for net exports and investment).
    - Diversion of investment flows (could boost investment and output if substitution/diversion is large).
  - Under benchmark elasticity (1.5), reduced external demand dominates and nonaligned regions experience a small drop in output.
  - Under higher elasticity (3.0), greater diversion can yield a small net increase in investment and output for nonaligned regions.
- Uncertainty amplification:
  - Policy uncertainty for nonaligned economies (investors perceive a 50 percent chance of alignment with a bloc) significantly amplifies losses for nonaligned regions due to reduced inflows from both blocs and negative spillovers.

### Strategic alignment, bargaining dynamics, and bloc incentives
- Alternative alignment choices materially affect outcomes:
  - If EU+ remains nonaligned, costs are significantly lower for EU+ and China bloc economies relative to EU+ joining a bloc.
  - If nonaligned regions must choose, joining the advanced‑economy‑dominated US bloc tends to be better for them given the US bloc’s role as a major source of investment flows—especially under uncertainty.
- Bloc incentives and potential transfers:
  - Blocs gain when they attract nonaligned regions and lose when nonaligned regions join the opposing bloc.
  - Gains to existing bloc members could outweigh losses to joining regions, suggesting scope for transfers (for example, favorable trade and investment treatment or fiscal measures) to encourage alignment.

### Timeline, sectoral sensitivity, and trade-fragmentation calibration (selected items)
- Timeline highlights (policy actions and events affecting US–China trade tensions; select items presented exactly as in source):
  - US imposes 25% tariff on $34 billion in Chinese imports.
  - 25% tariff retaliation on $34 billion in US imports.
  - 25% tariff retaliation on $60 billion in US imports.
  - Additional 25% tariff on $200 billion in Chinese imports.
  - Phase One trade agreement (signed early 2020).
  - US export controls prohibiting sales of advanced chips and chip‑making technology to China.
  - President Biden signs Creating Helpful Incentives to Produce Semiconductors and Science Act, and Inflation Reduction Act.
  - EU’s proposed European Chips Act aims to boost the bloc’s semiconductor industry to 20 percent of global production capacity by 2030, with more than €43 billion in investments.
- Trade fragmentation calibration and sectoral sensitivity:
  - Estimated impacts of geopolitical alignment on sector‑level bilateral trade for 189 countries across 10 broad manufacturing sectors using structural gravity regressions; fragmentation increases alignment within blocs, reduces alignment across blocs, and doubles the estimated sensitivity of trade barriers to geopolitical alignment.
  - Sectoral effects concentrated notably in Food, Transport equipment, and Other manufacturing—sectors that account for a large share of FDI‑intensive global value chain trade.

### Policy implications and recommendations
- Central message:
  - A fragmented global economy is likely to be a poorer one; strategic decoupling entails large economic costs for initiating countries, their rivals, and potentially nonaligned countries.
- Policy guidance:
  - Robust defense of global integration warranted given large and widespread economic costs from strategic decoupling.
  - Diversification in international sourcing of inputs away from domestic sources can enhance supply‑chain resilience without imposing costs on the world economy.
  - Rules‑based multilateral system must adapt and be complemented by credible “guardrails” to mitigate global spillovers and by domestic policies targeted at those adversely affected by global integration.
  - Minimize policy uncertainty (especially for nonaligned countries) via improved information sharing through multilateral dialogue.
    - Example: develop a framework for international consultations (for instance, on the use of subsidies to provide incentives for reshoring or friend‑shoring of FDI) to help identify unintended consequences, mitigate cross‑border spillovers, and promote transparency.
  - Countries can reduce vulnerability to FDI relocation by implementing policies and regulations to promote private sector development (for example, structural reforms, investment promotion agencies, and infrastructure improvements).

*Source: Chapter 4, "GEOECONOMIC FRAGMENTATION AND FOREIGN DIRECT INVESTMENT," World Economic Outlook, April 2023.*

### Introduction

### ch4 - Introduction

### Context and scope
- Rising geopolitical tensions and the uneven distribution of the gains from globalization have contributed to increasing skepticism toward multilateralism and to the growing appeal of inward-looking policies.
- The chapter focuses on one channel of geoeconomic fragmentation: the fragmentation of foreign direct investment (FDI), defined as cross-border investment through which foreign investors establish a stable and long-lasting influence over domestic enterprises.
- The chapter investigates whether FDI is reallocating across countries consistent with fragmentation and whether geopolitical factors help explain bilateral FDI flows. It develops a multidimensional index of countries’ vulnerability to FDI relocation and quantifies potential costs using empirical analysis and model-based scenarios.

### Recent trends in globalization and FDI
- Global FDI declined from 3.3 percent of GDP in the 2000s to 1.3 percent between 2018 and 2022.
- The slowdown in globalization ("slowbalization") dates largely to the aftermath of the global financial crisis.
- Firms’ interest in reshoring and friend-shoring has shown a sharp spike contemporaneous with a rise in average geopolitical distance across country pairs.
- Policy actions cited as relevant to reconfiguring supply chains include the CHIPS and Science Act, the Inflation Reduction Act, and the European Chips Act.

### Data and measurement
- The chapter uses investment-level data on new (greenfield) FDI from fDi Markets covering about 300,000 investments from the first quarter of 2003 to the fourth quarter of 2022.
- The number of greenfield foreign direct investments is used as the measure of FDI; investment values are often estimated and the main analysis therefore relies on counts.
- Strategic sectors are defined at the three-digit industry level for analyses of investments of special policy interest.

### Early signs of FDI fragmentation (empirical patterns)
- The flow of strategic FDI to Asian countries started to decline in 2019 and recovered only mildly; by the fourth quarter of 2022, strategic FDI to Europe was about twice that going to Asian countries.
- Foreign investment in R&D and in specific strategic industries, such as the semiconductor industry, shows more pronounced divergence, with lack of recovery of FDI to China particularly evident.
- From 2020:Q2 to 2022:Q4, FDI declined by almost 20 percent compared to the post–global financial crisis pre-pandemic average; this decline has been highly uneven across regions.
- Asia became less relevant both as a source and host, losing market share vis-à-vis almost all other regions; FDI to and from China declined by even more than the Asian average.
- In contrast, the US and emerging Europe experienced smaller declines or increases in greenfield FDI (for example, inflows to emerging Europe).

### Channels and potential impacts
- FDI accounts for about 12 percent of domestic capital stock globally, on average.
- Vertical FDI (cross-border investment linked to global value chains) is more likely to be affected by geoeconomic fragmentation and is associated with economic growth due to its knowledge-intensive nature.
- Multinational entry benefits domestic firms: in advanced economies, increased competition from foreign firms pushes domestic firms to become more productive; in emerging market and developing economies, domestic suppliers benefit from technology transfers and increased local demand for inputs from foreign firms in downstream sectors.
- Firms expressing interest in reshoring and friend-shoring tend to be larger, more profitable, and more knowledge-intensive.

### Vulnerability and mitigation
- A multidimensional index combining geopolitical distance, share of strategic sector investment in total FDI inflows, and degree of market power suggests emerging market and developing economies are, on average, more vulnerable to FDI relocation than advanced economies.
- Several large emerging markets across different regions show high vulnerabilities to relocation of FDI.
- Better regulatory quality is associated with lower vulnerability; policies and regulations to promote private sector development could mitigate exposure to FDI relocation.

### Model-based scenarios and aggregate costs
- Fragmentation is modeled as a permanent rise in investment barriers between opposing geopolitical blocs centered on the two largest economies (China and the US), with nonaligned economies potentially facing heightened uncertainty.
- Illustrative multiregion DSGE scenarios suggest FDI fragmentation—modeled as a permanent rise in cross-bloc barriers to importing investment inputs—could substantially reduce global output, by about 2 percent in the long term.
- Losses are likely unevenly distributed, with emerging market and developing economies with reduced access to advanced economies particularly affected through both lower capital formation and reduced productivity gains.
- Some economies could gain from diversion of investment inputs, but such benefits could be significantly offset by spillovers from lower external demand.
- Nonaligned regions could have some negotiating power vis-à-vis geopolitical blocs, but uncertainty regarding their alignment could restrict their ability to attract investment.

### Key empirical and analytical approach summary
- Empirical analysis includes country-level estimation of the relationship between GDP growth and FDI, separately for horizontal and vertical investment, and firm-level analysis combining investment-level FDI data with cross-country firm-level surveys to identify spillovers to firm labor productivity within and across sectors along value chains.
- Robustness considerations: greenfield investment counts correlate strongly with gross FDI inflows; analysis excludes international financial centers in robustness checks to mitigate phantom FDI concerns.

*Source: Chapter 4, "GEOECONOMIC FRAGMENTATION AND FOREIGN DIRECT INVESTMENT," World Economic Outlook, April 2023.*

### 1. In Strategic Sectors

### 1. In Strategic Sectors

### FDI Reallocation Patterns (2020:Q2–22:Q4 versus 2015:Q1–20:Q1)
- The chapter documents a regional reallocation of greenfield foreign direct investments (FDI) with deviations measured from an aggregate change of 19.5 percent decline.
- Key patterns:
  - Outward US FDI to China declined by much more than the average global decline; US FDI to other regions—particularly to emerging Europe—was more resilient.
  - Figure-based evidence highlights winners and losers across source and destination regions, indicating compositional shifts in FDI flows since major geopolitical and health shocks.

### Geopolitical Alignment and FDI
- Geopolitical alignment is measured using the “ideal point distance” (Bailey, Strezhnev, and Voeten 2017), based on similarity of UN General Assembly voting patterns.
- Main findings:
  - The share of FDI among countries that are geopolitically aligned is larger than the share going to geographically close countries.
  - The importance of geopolitical alignment has increased over the last decade and increased more steeply than geographic distance, especially for FDI in strategic sectors.
  - The shift toward geopolitically aligned partners is evident in outward US FDI: some relative winners (for example, Canada, Korea) are politically closer to the US than relative losers (for example, China, Vietnam), suggesting geopolitical factors have driven part of the recent shift.

### Quantified Impact of Geopolitical Distance (Gravity Model Results)
- Empirical specification: Poisson pseudo-maximum likelihood gravity model with source×year and host×year fixed effects; controls for geographic, cultural, institutional distance, colonial ties, and other push–pull factors.
- Key quantitative result:
  - An increase in the ideal point distance from the first to the third quartile of its distribution (equivalent to moving from the distance between Canada and Japan to that between Canada and Jordan) is associated with a decline in bilateral FDI of about 17 percent on average.
  - The average effect is much stronger when emerging market and developing economies (EMDEs) are either a source or a host country.
  - Since 2018, coincident with rising US–China trade tensions, geopolitical factors have become more relevant for FDI flows.
  - Geopolitical distance matters more for investments in strategic sectors.

### Vulnerability to FDI Relocation: Multidimensional Index
- The chapter constructs a multidimensional vulnerability index combining three subindices at the sector–source country level:
  1. Geopolitical index: host-country exposure based on the share of investment from each source multiplied by geopolitical distance.
     - EMDEs are more geopolitically vulnerable than advanced economies because they receive much FDI from advanced economies that are geopolitically closer to each other than to EMDEs.
  2. Market power index: treats FDI in a sector as less vulnerable if the host is among the top 10 exporters in that sector; otherwise treated as fully vulnerable.
     - Most economies show low protection from market power; exceptions include large exporters such as China, Germany, US.
  3. Strategic index: share of inward FDI in strategic sectors; shows substantial overlap between advanced and EMDEs.
- Aggregate index construction:
  - Aggregate index = strategic dimension + (geopolitical dimension × market power index).
  - Multiplication by market power (bounded 0–1) dampens geopolitical vulnerability where host-country market power limits relocation options.
- Distributional findings:
  - Overall, EMDEs are more vulnerable to FDI fragmentation than advanced economies, though with variation and some overlap (14 percent of EMDEs have a vulnerability index lower than the median for advanced economies).
  - Regionally, Europe is in a better position; other regions show higher and similar vulnerability levels.
- Policy-relevant correlation:
  - Stronger regulatory quality tends to be associated with lower aggregate vulnerability and higher exports.
  - Regression result: coefficient of the regulatory quality index equals –0.057 (p-value of 0.000) in a regression of the aggregate vulnerability index against regulatory quality controlling for log real GDP, trade (percent of GDP), and FDI inflows (percent of GDP), averaged over 2010–19.

### FDI Spillovers: Horizontal versus Vertical and Industry Linkages
- Definitions:
  - Horizontal FDI: foreign firms enter to directly serve local markets.
  - Vertical FDI: foreign firms enter to produce inputs supplied to affiliates (part of global value chains).
- Relevance to fragmentation:
  - Vertical FDI is more exposed to fragmentation risk than horizontal FDI because higher trade barriers make vertical FDI less attractive and target advanced-technology input production often subject to reshoring policies.
- Growth and spillover evidence:
  - Vertical FDI is positively associated with economic growth because it concentrates among intermediate-goods producers adopting sophisticated, skill-intensive technology.
  - Horizontal FDI is more associated with final-goods producers that tend to transfer simpler assembly technology.
- Spillovers depend on host-country characteristics:
  - Heterogeneous effects of inward FDI depend on host-country human capital, institutional quality, and financial development.
  - Spillovers vary by mode of entry, type of investment, and within- versus across-industry linkages (forward/backward linkages and competition-driven technology diffusion).

*Source: Chapter 4, “Geoeconomic Fragmentation and Foreign Direct Investment,” World Economic Outlook: A Rocky Recovery (April 2023), International Monetary Fund.*

### CHAPTER 4 GEOECONOMIC FRAGMENTATION AND FOREIGN DIRECT INvEsTMENT

### CHAPTER 4 GEOECONOMIC FRAGMENTATION AND FOREIGN DIRECT INvEsTMENT

### Firm-level evidence on FDI spillovers
- Sample and scope:
  - World Bank Enterprise Surveys covering over 120,000 firms in 150 countries from 2006 to 2021.
- Within-industry spillovers:
  - Positive spillovers to domestic firms in the same industry are observed.
  - Positive within-industry spillovers to firms’ labor productivity are confined to advanced economies (AEs), where firms react to fiercer competition from multinationals by becoming more productive.
- Cross-industry spillovers:
  - Domestic suppliers benefit from entry of foreign firms in downstream sectors (sourcing inputs locally, increasing local demand, learning by doing).
  - Positive supplier spillovers are driven by FDI in emerging market and developing economies (EMDEs).
  - There is no evidence of spillovers to domestic users, even in EMDEs (foreign upstream firms mostly sell abroad, limiting direct technology spillovers via local buyers).

### Model-based quantification: setup and assumptions
- Modeling approach:
  - Multiregion DSGE model (IMF’s Global Integrated Monetary and Fiscal Model) used to explore long-term implications of potential FDI fragmentation.
  - Model does not have explicit foreign ownership of productive capital; bilateral cross-border flow of inputs into investment is used as a proxy for FDI-like effects.
- Key modeling assumptions and parameter values:
  - Scenarios illustrate a 50 percent reduction of such investment input flows between blocs.
  - Empirical estimates of the correlation between FDI flows and labor productivity discipline associated productivity losses.
  - Model allows for up to eight regions.
  - Baseline fragmentation scenario represents barriers generating 50 percent decline in investment input flows between China and US blocs, with no barriers with two nonaligned regions (India and Indonesia and Latin America and the Caribbean).
  - Elasticity of substitution across foreign sources of investment inputs considered in two cases: lower elasticity 1.5 (benchmark) and higher elasticity 3.0 (alternative case with greater diversion).
  - Uncertainty scenario: investors perceive a 50 percent chance that a nonaligned region will align with the opposing bloc (investors behave as if investment input flows to/from these regions face half the barriers faced by regions in the opposing bloc).

### Regions and GDP shares used in scenarios (Model Region GDP Share (Percent))
- United States: 16.0
- China: 17.5
- EU+: 15.6
- Other AEs: 13.8
- India and Indonesia: 9.6
- Southeast Asia: 4.0
- LAC (Latin America and the Caribbean): 6.5
- ROW (rest of the world): 17.0

### Simulation results and distributional outcomes
- Global output effects:
  - In a scenario where the world splinters into a US-centered bloc and a China-centered bloc (India and Indonesia and LAC remain nonaligned), global output is about 1 percent lower after five years (relative to the no-fragmentation scenario).
  - Long-term output is lower by 2 percent as capital stock and productivity impacts cumulate.
  - Fragmentation could lower global output by up to 2 percent.
- Regional and bloc-level outcomes:
  - Output losses are generally larger in the emerging-market-dominated China bloc (heightened barriers to major sources of investments).
  - US bloc also experiences nonnegligible losses, driven by some members’ strong links to China (for example, Japan and Korea in other AEs and Germany in EU+).
  - Nonaligned regions: outcomes depend on two competing channels:
    - Reduced external demand from global slowdown (weighs on net exports and investment).
    - Diversion of investment flows (could boost investment and output if substitution/diversion is large).
  - Under benchmark elasticity (1.5), the first channel dominates and nonaligned regions experience a small drop in output.
  - Under higher elasticity (3.0), greater diversion can yield a small net increase in investment and output for nonaligned regions.
- Uncertainty amplification:
  - Policy uncertainty for nonaligned economies (investors perceive a 50 percent chance of future alignment with a bloc) significantly amplifies losses for nonaligned regions, as they face reduced inflows from both blocs and negative spillovers to other regions.

### Strategic alignment and bargaining dynamics
- Alternative alignment choices materially affect outcomes:
  - If EU+ remains nonaligned, costs are significantly lower for both EU+ and China bloc economies (relative to EU+ joining a bloc).
  - If nonaligned regions are forced to choose, joining the advanced-economy-dominated US bloc tends to be better for them given the US bloc’s role as a major source of investment flows—especially under uncertainty.
- Blocs’ incentives and potential transfers:
  - Blocs gain when they attract nonaligned regions and lose when nonaligned regions join the opposing bloc.
  - Gains to existing bloc members could outweigh losses to joining regions, suggesting scope for transfers (for example, favorable trade and investment treatment or fiscal measures) to encourage alignment.

### Policy implications and recommendations
- Main message:
  - A fragmented global economy is likely to be a poorer one; strategic decoupling entails large economic costs for the initiating country, its rivals, and potentially nonaligned countries.
- Policy guidance:
  - Robust defense of global integration is warranted given large and widespread economic costs from strategic decoupling.
  - Diversification in international sourcing of inputs away from domestic sources can enhance supply-chain resilience without imposing costs on the world economy.
  - The rules-based multilateral system must adapt to the changing world economy and be complemented by credible “guardrails” to mitigate global spillovers and by domestic policies targeted at those adversely affected by global integration.
  - Efforts should be devoted to minimizing policy uncertainty (especially for nonaligned countries) via improved information sharing through multilateral dialogue.
    - Development of a framework for international consultations (for instance, on the use of subsidies to provide incentives for reshoring or friend-shoring of FDI) could help identify unintended consequences, mitigate cross-border spillovers, and promote transparency.
  - Countries can reduce vulnerability to FDI relocation by implementing policies and regulations to promote private sector development.

*Source: CHAPTER 4 GEOECONOMIC FRAGMENTATION AND FOREIGN DIRECT INvEsTMENT (World Economic Outlook chapter content).*

### 1. Impact of Nonaligned EU+, with and without Uncertainty

### 1. Impact of Nonaligned EU+, with and without Uncertainty

### Impact on GDP and bloc incentives
- Figure 4.17 shows percent deviations from the nonaligned scenario with uncertainty for bloc members when nonaligned regions join blocs:
  - Axis labels in the figure include negative and positive deviations: –4, –3, –2, –1, 0, 1 (for EU+China bloc panel) and –2.5, –2.0, –1.5, –1.0, –0.5, 0.0, 0.5 (for Both nonaligned/Both join China bloc/Both join US bloc panel).
  - Remaining nonaligned with certainty tends to limit losses.
- Notes and definitions in the figure:
  - EU+ = European Union and Switzerland.
  - The nonaligned include India and Indonesia and Latin America and the Caribbean.
- Stylized outcome and policy implication:
  - Blocs have incentives to attract nonaligned regions and discourage nonaligned from joining the opposing bloc.

### Nonaligned joining blocs: comparative impacts
- Relative impacts shown in subpanels for bloc membership outcomes:
  - China bloc
  - US bloc
  - China bloc, with new members
  - US bloc, with new members
  - Small-scale deviations represented: –0.2, –0.1, 0.0, 0.1, 0.2, 0.3, 0.4 (in the panel labeled Nonaligned joining China bloc/Nonaligned joining US bloc).

### Measures to attract diverted FDI in a fragmented world
- Fragmentation that promotes friend-shoring of FDI can create opportunities by diverting investment flows; countries can increase attractiveness via:
  - Undertaking structural reforms (Campos and Kinoshita 2010).
  - Establishing investment promotion agencies to reduce information asymmetries and ease bureaucratic procedures (Harding and Javorcik 2011; Crescenzi, Di Cataldo, and Giua 2021).
  - Improving infrastructure (Chen and Lin 2020).

### Timeline and escalation of US–China trade tensions (Box 4.1)
- Key dated policy actions and events (timeline entries and exact values as shown):
  - US imposes 25% tariff on $34 billion in Chinese imports.
  - 25% tariff retaliation on $34 billion in US imports.
  - 25% tariff retaliation on $60 billion in US imports.
  - US-China trade war resumes, with Huawei added to entity list and additional 25% tariff on $200 billion in Chinese imports.
  - Phase One trade agreement (signed early 2020).
  - US Treasury designates China a currency manipulator.
  - Truce in trade war.
  - Tariff wars undone, with exemptions/bans.
  - Extended ban on investments in Chinese companies with ties to the Chinese military.
  - President Biden signs Creating Helpful Incentives to Produce Semiconductors and Science Act, and Inflation Reduction Act.
  - Indo-Pacific Economic Framework for Prosperity launched with a dozen partners.
  - New export controls prohibiting sales of advanced chips and chip-making technology to China.
  - Sanctions imposed on 28 former Trump administration officials.
  - World Trade Organization authorizes China to impose compensatory tariffs after US refusal to adjust antisubsidy duties inconsistent with World Trade Organization.
  - World Trade Organization rules against the US in Section 232 tariffs on steel and aluminum and Hong Kong SAR labeling disputes.
- Strategic policy actions affecting technological frontiers:
  - US export controls to restrict China’s access to advanced computing and semiconductor items.
  - CHIPS and Science Act and the Inflation Reduction Act impose high domestic-content requirements to advance US leadership in key technologies.
  - Proposed US Chip 4 alliance seeks a semiconductor supply chain independent of China.
  - EU’s proposed European Chips Act aims to boost the bloc’s semiconductor industry to 20 percent of global production capacity by 2030, with more than €43 billion in investments.

### Financial exposure to fragmentation risk (Box 4.2)
- Construction and measurement:
  - Exposure measure defined as the stock of non–FDI foreign assets (liabilities) invested in (borrowed from) countries with diverging geopolitical views.
  - Cross-border non-FDI financial linkages constructed using IMF CPIS statistics and Bank for International Settlements Locational Banking Statistics, with bilateral portfolio holdings reallocated following Coppola and others (2021).
  - Political proximity measured by ideal point distance normalized into a continuous variable taking value 1 for the politically closest country and 0 for the most distant country; bilateral holdings weighted by this index to generate politically discounted foreign assets and liabilities.
  - Exposure = undiscounted positions − politically weighted counterparts.
- Key quantitative findings:
  - Exposures are large and have roughly doubled over the past 20 years.
  - Gross foreign investment positions (assets plus liabilities) as a share of GDP have more than doubled since 2001, while politically weighted positions have not grown as fast.
  - In aggregate, exposures have now reached 42 percent of GDP, or 24 percent of all non-FDI cross-border holdings.
- Distributional patterns:
  - Exposures are concentrated on the asset side in advanced economies and on the liability side in emerging markets.
  - Exposures vary significantly across the Group of Twenty (G20); country labels in the referenced figure use ISO country codes (examples shown: SAU, CHN, ITA, ARG, MEX, RUS, IND, IDN, TUR, DEU, AUS, KOR, BRA, ZAF, USA, GBR, CAN, FRA, JPN).

### Trade fragmentation, sectoral sensitivity, and income effects (Box 4.3)
- Method and calibration:
  - Estimated impact of geopolitical alignment on sector-level bilateral trade for 189 countries across 10 broad manufacturing sectors using structural gravity regressions.
  - Geopolitical alignment measured by the foreign-treaty s-score from ATOP (Leeds and others 2002).
  - Calibration uses a multicountry, multisector general equilibrium trade model; fragmentation scenario increases alignment within US, China, and nonaligned blocs, reduces alignment across blocs, and doubles the estimated sensitivity of trade barriers to geopolitical alignment.
- Sectoral findings:
  - Divergences in geopolitical alignment act as a barrier to trade.
  - The effect is concentrated in some sectors, notably food, transportation equipment, and other manufacturing, which account for a large share of FDI‑intensive global value chain trade.
  - Figure 4.3.1 reports log change impacts of a one-standard-deviation decrease in geopolitical alignment on tariff-equivalent trade barriers across sectors; sectors listed include Agriculture/Fishing, Mining/Quarry, Food/Beverages, Textiles/Apparel, Wood/Paper, Pet./Chem./Nonmetal, Metal, Electrical/Machinery, Transport equipment, Other manufacturing.
- Distributional macroeconomic impacts:
  - Geoeconomic fragmentation lowers output for most countries, especially for emerging market and developing economies.
  - For the median emerging market economy in Africa and central Asia, real income losses due to geoeconomic fragmentation are more than twice as large as for the median advanced economy.
  - Figure 4.3.2 reports changes in real per capita income due to fragmentation by region: AEs, EM Asia, EM Europe, LAC, ME&CA, SSA (percent changes showing medians, 25th–75th percentiles, and extremes).

*Source: IMF staff calculations and supporting boxes and figures from the chapter.*

### CHAPTER 4 GEOECONOMIC FRAGMENTATION AND FOREIGN DIRECT INvEsTMENT

### CHAPTER 4 GEOECONOMIC FRAGMENTATION AND FOREIGN DIRECT INvEsTMENT

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*Source: CHAPTER 4 GEOECONOMIC FRAGMENTATION AND FOREIGN DIRECT INvEsTMENT (chapter bibliography).*

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_Source: https://www.imf.org/-/media/files/publications/weo/2023/april/english/ch4.pdf_