## wpiea2023245-print-pdf — Introduction

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### Geoeconomic fragmentation (GEF): overview and drivers
- GEF is defined as a policy-induced reversal of international economic integration.
- Recent drivers: COVID-19 pandemic; Russia’s invasion of Ukraine; national security concerns; domestic competitiveness; supply chain resilience; climate change.
- Observed effects:
  - Investment and financial flows increasingly driven by geopolitical alignment rather than economic distance.
  - Trade re-routing through third countries and relocation of production due to supply-chain reliability concerns.
  - Important commodities and advanced technologies subjected to restrictions or sanctions, including energy, grains, rare earth minerals, vaccines, computer chips, potential dual-use products.

### EU openness, integration, and benefits
- Openness and FDI:
  - The EU is highly open; intra-EU trade accounts for over half of trade.
  - Trade openness continued to rise in the EU while it declined sharply in China since the mid-2000s and edged down in the US over the past decade.
  - The EU’s stock of foreign direct investment as a share of GDP—both inward and outward—is high relative to other countries and regions.
- Documented benefits (exact figures preserved):
  - Openness to imports increased real incomes in the EU by 7¾ percent (€1.2 trillion) compared to a situation without imports.
  - Small and medium-sized enterprises engaging in extra- and intra-EU trade employ over 13 million workers.
  - More than 615,000 (87 percent of total exporting EU companies) sell outside the EU.
  - Over 1 million firms export within the EU (accounting for 35 percent of the total value of intra-EU exports).
  - About half the related jobs are in the service sector.

### Global trends: liberalization, slowbalization, and trade/FDI patterns
- Three-decade deep liberalization began around the 1970s and ended in the early 2000s; WTO established in 1995.
- Global FDI peaked on the eve of the global financial crisis; global trade has undergone “slowbalization” since then.
- Factors moderating trade and FDI include falling tariffs to lower bounds, completed transition economies, moderation of commodity prices (particularly energy), weaker global growth, rising unit labor costs in developing economies (including China), and automation.
- Policy changes affecting FDI:
  - FDI declined sharply from 2017 following the 2017 US Tax Cut and Jobs Act and OECD BEPS initiatives, leading to repatriation of US direct investment and unwinding of related financial holding companies.

### Rising restrictions and GEF policies
- Recent measures:
  - Almost 3000 new harmful restrictions on trade or FDI were implemented worldwide in 2023—nearly three times the number introduced in 2019—and far exceeding liberalizing measures.
  - New measures imposed on the EU and its members have trended up since the mid-2010s, mainly concentrated on goods trade.
  - The EU’s effective tariff rate has remained stable and low, highlighting the importance of “behind-the-border” restrictions.
- EU actions and fiscal implications:
  - Mechanisms for screening inward FDI introduced/expanded by individual EU countries; an EU-wide cooperation mechanism exists since 2020 focusing on critical inputs, infrastructure and technology.
  - Financial support to producers (equity injections, subsidies, tax relief) is the most common form of restriction; for China and EU countries at the national level, financial support accounts for more than 90 percent of all measures.
  - On- and off-budget fiscal cost of state aid in the EU averages 1 percent of countries’ GDP (even prior to COVID and the energy price shock), with wide variation across countries.
  - EU FDI Screening Regulation: by 2022, 18 members had a screening mechanism; 55 percent of requests for FDI authorization in 2022 were formally screened, 9 percent of which were approved subject to conditions, 1 percent blocked.

### EU exposure to fragmentation: trade, value chains, and substitutability
- Direct bilateral trade patterns:
  - More than half of EU direct exports are destined for other EU members.
  - An additional quarter of EU direct exports (about 3 percent of EU GDP) is absorbed by non-EU countries that voted in favor of the 2022 UN Resolution on Ukraine.
  - Direct exports to the “AAA” bloc (against/abstained/absent on the UN vote) are modest as a share of GDP.
- Global value chain measures (exact figures preserved):
  - Backward participation (share of foreign value added embedded in gross domestic exports): EU 16 percent; US ~10 percent of gross exports; China 17 percent.
  - Forward participation (share of domestic value added embedded in gross exports of downstream partners): around 15 percent for the EU; majority used by non-EU “in favor” bloc.
  - Ultimate foreign input reliance (whole economy): rose from around 12 percent of domestic value added in 2004 to 18 percent by 2011, driven mainly by rising reliance on the “AAA” bloc.
  - Manufacturing foreign input reliance: rose from 19 percent of manufacturing GDP in 2004 to 28 percent by 2011, driven by the “AAA” bloc and with dependence on a single country (China) more concentrated.
  - Ultimate foreign market reliance also rose over time, mainly due to greater dependence on the “AAA” bloc.
- Fragile intermediate goods:
  - Fragile intermediate goods represent on average about 40 percent of extra-EU imports by value; around half of these are supplied by countries in the “AAA” bloc; mainly consist of transformed goods.
  - Extra-EU fragile imports are more exposed to the “AAA” bloc than US fragile imports.
- Services trade:
  - Heavily focused on geo-politically aligned countries: ~50 percent with other EU members and ~37 percent with other “in favor” countries; services trade with the AAA bloc is modest.
- Financial exposure:
  - Aggregate EU exposure to the “AAA” bloc is relatively small: 3 percent of portfolio investment, 4 percent of FDI, and 2 percent of bank assets in the “AAA” bloc (stocks of foreign liabilities).
  - Caveat: financial centers, multinational holding companies, and resident companies owned by foreign entities may obscure true linkages.

### FDI and geopolitical alignment
- fDi Markets evidence and patterns:
  - About two-thirds of EU outward FDI projects over the past two decades went to countries in the top two quintiles for geopolitical proximity to the EU.
  - EU outward FDI became more responsive to geopolitical distance since 2017, controlling for host-country per capita income and fixed effects.
  - FDI integration with the non-EU “in favor” bloc recovered strongly after the euro debt crisis; EU FDI integration with the “AAA” bloc has remained weak.
  - EU outward FDI to Russia has been halted since the start of the war in Ukraine.

### Energy exposure and consequences
- Pre-war reliance and reorientation:
  - Russia provided about one-fifth of EU gas in 2020.
  - As piped gas stopped flowing from Russia, EU gas prices (TTF) soared to many multiples of previous levels.
  - EU reliance on Russian piped gas fell to around 5 percent by H1:2023 after diversification.
  - Wholesale prices remain considerably higher in the EU and Asia than previously and than in the US.
- Economic importance and impacts:
  - In 2019, 1.7 percent of the EU’s domestic value added was derived from energy intensive manufacturing (paper and paper products; chemicals and chemical products; other non-metallic mineral products; basic metals).
  - Energy-intensive sectors accounted for 1.2 percent of total employment in 2019, with higher shares in several CESEE countries.
  - Since the onset of the war in Ukraine, output of energy-intensive manufacturing has been considerably weaker than other sectors.

### Innovation, intellectual property (IP), and multinational production (MP)
- IP flows and patterns:
  - The EU is the second-largest exporter of ideas (IP), surpassed only by the US.
  - More than half of EU IP receipts originate from countries within the EU, reflecting payments from goods-intensive EU countries (EUG) to more knowledge-intensive EU countries (EUK).
  - The EU relies on IP imports from the US, but much less so from China.
  - Within the EU, Germany and the Nordics are net IP recipients; Ireland is a large net payer/importer.
- Comparative advantage and MP role:
  - R&D intensity in manufacturing is highest in Korea and the US, then Japan; China has increased manufacturing R&D but retains a manufacturing advantage.
  - The EU spans the innovation-production spectrum, forming an innovation-production ecosystem distinct from the US and China.
  - MP allows production-location choice and generates cross-border profit flows (royalties); GEF policies can target both goods and knowledge flows.

### Model simulations: scenarios and key quantitative outcomes
- Literature-based estimates:
  - World splintering into US- and China-centered blocs while other large countries remain nonaligned: long-term global output would decrease by 2 percent.
  - Increased geopolitical distance associated with a 15 percent reduction in cross-border portfolio flows and bank claims.
  - Fragmenting mined-commodity markets into “China/Russia+” and “US/EU+” blocs would lower world GDP by ¼ percent; larger output loss for the “China/Russia+” bloc and sizable inflation effects in “US/Europe+”.
  - Segmenting markets for minerals critical to the green transition lowers global investment in renewables and EVs by 30 percent.
  - Trade decoupling reduces EU output and trade and raises prices; welfare losses are up to five times larger in the short term when prices and inputs are rigid.
- Global innovation & MP calibrated scenarios (exact outcomes preserved):
  - Deep fragmentation into four autarkic blocs: output losses between 5-10 percent across regions; for the EU, goods-related losses around 9 percent of GDP dominate; profit loss is small.
  - Expanding the EU-centered bloc to include Türkiye and the UK reduces welfare loss under strict autarky.
  - Bilateral US-China tensions:
    - Scenario 2a (rising bilateral goods trade costs US-China): modest welfare costs; MP channel remains and China remains an MP hub.
    - Scenario 2b (increased outward MP costs for US multinationals producing in China): lowers US royalties and raises manufacturing costs in China; EU impact limited due to Single Market home bias in MP.
    - Scenario 2c (raise cost of importing each other’s goods + raise outward MP costs): similar but larger effects than 2b; EU little affected.
    - Scenario 3 (EU replicates US trade and MP measures on China and China reciprocates): EU welfare losses around ¼ - ½ percent of GDP relative to remaining on the sidelines.
  - Industrial policies and subsidies:
    - Scenario 4a (US subsidizes inward MP to encourage domestic manufacturing): US real income declines by around 1¾ percent (mostly from falling profits); EU gains around ¾ – 1 percent of GDP due to greater innovation opportunities.
    - Scenario 4b (EU also subsidizes inward MP): EU would lose via forgone royalties and higher cost/fewer varieties; losses larger for more innovative EU countries.
    - Scenario 5a (US subsidizes R&D): US and all other countries generally benefit through increased blueprints and varieties; other innovative countries (including EU knowledge producers) could experience welfare loss.
    - Scenario 5b (EU also subsidizes innovation): EU gains from higher royalties but loses from diverting resources from manufacturing; net effect mixed.
  - Deepening intra-EU integration (scenario 6): reducing remaining bilateral MP and goods trade costs among EU members by 10 percent yields large welfare gains—on the order of 7 percent of GDP—accruing to both EU innovating and manufacturing countries; limited spillovers to other regions.

### Impact of an Energy Price Wedge (GTAP-E CGE model results)
- Modeling approach and assumptions:
  - GTAP-E global multi-sector CGE model, calibrated to 2017, with 141 countries and 65 sectors.
  - Scenario assumptions: (i) permanent reduction in Russian energy exports raising average world fossil-fuel prices; (ii) region-specific gas price wedge keeping EU gas prices above US prices, modeled as iceberg tariffs with revenue discarded.
- Quantitative scenario results (exact figures preserved):
  - Persistent—and in the case of gas, differentiated—increases in fossil fuel prices are found to permanently reduce EU value-added by about 4 percent per year.
  - Distributional effects:
    - Global energy exporters gain; energy importers lose.
    - Russia benefits from higher energy prices that more than offset the fall in its energy exports.
    - Effects in the US are modest.
  - Sectoral impacts:
    - Largest EU declines in value added occur in energy-intensive manufacturing and services.
    - Non-energy-intensive manufacturing increases modestly on average due to a fall in the real exchange rate.
    - Mining and extraction respond positively.
  - Within-EU variation:
    - More fossil-fuel intensive countries (including in CEE) are generally more affected; services in Greece heavily affected.
- Stylized facts from simulations:
  - Protectionist policies evaluated solely on economic grounds bring economic losses for the EU.
  - Deep fragmentation into strict autarkic blocs is very costly by cutting off cross-bloc exchanges of goods and knowledge and precluding multinational production.
  - Refraining from taking action as others restrict trade or subsidize domestic manufacturing is less costly for the EU than replicating those measures.
  - Persistently higher fossil fuel prices cause a sizable drop in EU GDP, with energy-intensive activities most impacted.
  - Deepening the Single Market by lowering costs of cross-border trade and MP could yield a large increase in GDP benefiting EU innovators and manufacturers.

### Policy considerations and recommendations (preserving exact policy language)
- Support an open, rules-based trading system and address concerns within that framework:
  - Ensure climate-related policies, including the Carbon Border Adjustment Mechanism, are compliant with World Trade Organization rules.
- Use narrowly targeted restrictions on FDI where fragmentation has already set in; avoid broad protectionism which would increase exposure to localized shocks and reduce foreign market size for EU products.
- Adopt “targeted de-risking” rather than “outright decoupling”:
  - Underpin targeted de-risking with detailed economic security risk assessments.
  - Work with private sector to identify critical dependencies not fully internalized by individual firms.
  - Possible responses: diversify suppliers, hold inventories, improve recycling, and where feasible homeshore essential products.
  - Set a high bar for intervention; interventions should meet criteria such as low technical substitutability, lack of suppliers from less-risky regions, and socially harmful disruptions.
  - Broaden trade and development partnerships with less-risky countries (including via comprehensive trade agreements and the EU’s Global Gateway Initiative).
- Protecting and deepening the Single Market to strengthen resilience:
  - Remove remaining internal barriers to increase mobility of capital, labor, and services.
  - Complete the capital markets union to mobilize funding for climate and digital investments.
  - Conclude the banking union to raise competition and more efficient use of bank capital.
  - Harmonize taxes and subsidies across countries to boost investment in cross-border infrastructure and discourage “state aid shopping.”
  - Ease cross-border supply of services and reciprocal recognition of qualifications to enhance competition, lower prices, and reduce adaptation costs to shocks.
- Industrial policy constraints to preserve a level playing field:
  - Restrict industrial policies to addressing externalities and market distortions and make them time-bound.
  - Ensure technology neutrality, avoid favoring incumbents over new entrants, avoid domestic preference, and target interventions well to avoid government capture and rent seeking.

### Identifying fragile intermediate goods (methodology summary)
- Data and scope:
  - BACI bilateral trade database (UN Comtrade-derived, HS2007), 200 countries, 5,039 products at 6-digit level; analysis focuses on 3,783 intermediate goods (final consumption goods excluded).
- Fragility components and classification:
  - Two components per intermediate product (2017–19):
    1. Presence of central players: uses standard deviation of weighted outdegree centrality; higher standard deviation signals vulnerability from very central exporters.
    2. International substitutability: proxy based on dispersion of human capital levels among exporters; wider dispersion implies more heterogeneous production methods and higher vulnerability when substitutes are not close matches.
  - Components standardized via z-scores; products partitioned into fragility groups using k-median cluster analysis.
  - Result: 650 individual types of goods identified as fragile.
  - Importers of fragile intermediate goods are identified by their share in total imports of a country’s import basket.

### Key takeaways for the EU (concise)
- The EU’s high openness and internal Single Market confer resilience but also exposure to GEF through trade, value chains, FDI, financial links, energy, and innovation channels.
- Fragmentation scenarios produce heterogeneous effects:
  - Extreme autarky induces large losses (5-10 percent) and large EU goods-related losses (~9 percent).
  - Targeted MP or trade restrictions between major powers have limited spillovers to the EU unless the EU participates or industrial subsidies distort global incentives.
  - Behind-the-border industrial policies and subsidies can have larger effects on the EU than cross-border goods trade or MP restrictions.
  - Strengthening intra-EU integration is a robust policy that yields substantial welfare gains (~7 percent of GDP).
- Sectoral vulnerabilities:
  - Energy-intensive manufacturing and fragile intermediate goods expose the EU to higher costs and supply risks.
  - Services trade is concentrated among aligned countries, posing less fragmentation risk.
  - Financial exposure to the “AAA” bloc appears limited in official aggregates but may be understated due to financial center opacity.

*Source: wpiea2023245-print-pdf - Introduction (IMF Working Paper).*

### Introduction ...........................................................................................................

### Introduction

### Major themes and chapter structure
- Introduction (page 4)
- GEF Policies Adopted by the EU and Others (page 7)
- The EU’s Potential GEF Exposure (page 9)
- Possible Implications of Geopolitical Tensions for EU Economies: Key Stylized Facts (page 18)
- GEF in the Context of Innovation and Multinational Production (page 18)
- Impact of AN Energy Price Wedge (page 26)
- Summary of Main Findings and Policy Considerations (page 29)
- Annex I. Select Policy Measures Adopted by the EU, US, and China (page 32)
- Annex II. Identifying Fragile Intermediate Goods (page 34)
  - The Two Components of Product Fragility (page 34)
  - Presence of Central Players (page 34)
  - International Substitutability (page 35)
  - Classifying Overall Product Fragility (page 36)
- References (page 37)

### Figures and visual analysis topics (figure titles)
- Figure 1. Openness
- Figure 2. Trade Restrictions
- Figure 3. Global Slowbalization
- Figure 4. Number of Newly Implemented Trade or FDI Measures
- Figure 5. Restrictions Affecting/Imposed by the EU
- Figure 6. Types of Restrictions and EU State Aid
- Figure 7. Direct Goods Trade Within and Between Blocs
- Figure 8. Value Chain Linkages and Foreign Input and Market Reliance
- Figure 9. Extra-EU Imports of Fragile Intermediate Goods
- Figure 10. EU Commercial Services Trade
- Figure 11. Financial Exposure to Fragmentation Risk
- Figure 12. EU Foreign Direct Investment Linkages
- Figure 13. Fragmentation and Energy Markets
- Figure 14. Economic Importance of Energy Intensive Sectors
- Figure 15. Intellectual Property Trade and Comparative Advantage in Innovation Relative to Manufacturing
- Figure 16. The World Divides into Four Autarkic Blocs
- Figure 17. Spillover Effects from US-China Tensions
- Figure 18. US-China Tensions, with EU as Bystander or Participant
- Figure 19. Lowering Inward MP Costs for Goods Production
- Figure 20. Subsidizing Innovation Activities
- Figure 21. Deepening EU Integration
- Figure 22. EU27: Production of Energy Intensive Industries
- Figure 23. Firm Surveys on Responses to High Energy Prices
- Figure 24. Energy Price Shocks Relative to 2017
- Figure 25. Impact of an Energy Price Wedge

### Annex II structure on fragile intermediate goods
- The Two Components of Product Fragility
- Presence of Central Players
- International Substitutability
- Classifying Overall Product Fragility

### Glossary (acronyms listed)
- CEESE Central, Eastern, and Southeastern Europe
- EU European Union
- FDI Foreign Direct Investment
- GEF Geoeconomic Fragmentation
- GFC Global Financial Crisis
- GTAP Global Trade Analysis Project
- IP Intellectual Property
- MP Multinational Production

*Source: wpiea2023245-print-pdf - Introduction (IMF Working Paper table of contents and figures list).*

### Introduction

### Introduction

### Geoeconomic fragmentation (GEF): overview and drivers
- GEF is defined as a policy-induced reversal of international economic integration.
- Recent drivers: COVID-19 pandemic; Russia’s invasion of Ukraine; national security concerns; domestic competitiveness; supply chain resilience; climate change.
- Observed effects:
  - Investment and financial flows increasingly driven by geopolitical alignment rather than economic distance.
  - Trade re-routing through third countries and relocation of production due to supply-chain reliability concerns.
  - Important commodities and advanced technologies subjected to restrictions or sanctions (energy, grains, rare earth minerals, vaccines, computer chips, potential dual-use products).

### EU openness, integration, and benefits
- The EU is highly open: measured as the sum of exports and imports of goods and services, the EU is more outwardly-oriented than the US or China (including intra-EU trade, which accounts for over half of trade).
- Trade openness:
  - Continued to rise in the EU while it declined sharply in China since the mid-2000s and edged down in the US over the past decade.
- FDI stock:
  - The EU’s stock of foreign direct investment as a share of GDP—both inward and outward—is high relative to other countries and regions.
- Documented benefits:
  - Openness to imports increased real incomes in the EU by 7¾ percent (€1.2 trillion) compared to a situation without imports.
  - Small and medium-sized enterprises engaging in extra- and intra-EU trade employ over 13 million workers.
  - More than 615,000 (87 percent of total exporting EU companies) sell outside the EU.
  - Over 1 million firms export within the EU (accounting for 35 percent of the total value of intra-EU exports).
  - About half the related jobs are in the service sector.

### Global trends: liberalization, slowbalization, and trade/FDI patterns
- Three-decade deep liberalization began around the 1970s and ended in the early 2000s; WTO established in 1995.
- Global FDI peaked on the eve of the global financial crisis; global trade has undergone “slowbalization” since then.
- Factors cited for stabilizing/moderating global trade:
  - Many trade barriers approached lower bounds (many tariffs fell to zero).
  - Transition economies largely completed market transformations.
  - Moderation of commodity prices (particularly energy).
  - Weaker global growth reduced demand for heavily-traded consumer durables and investment goods.
  - Unit labor costs in developing economies have increased, including China; robotics and other technologies reduced labor intensity of advanced manufacturing.
  - China’s share of global trade has moderated.
- Policy changes affecting FDI:
  - FDI declined sharply from 2017 following the 2017 US Tax Cut and Jobs Act and OECD BEPS initiatives, leading to repatriation of US direct investment and unwinding of related financial holding companies.

### Rising restrictions and GEF policies
- Number of restrictions worldwide with effects on cross-border trade and FDI has risen sharply in recent years.
- Almost 3000 new harmful restrictions on trade or FDI were implemented worldwide in 2023—nearly three times the number introduced in 2019—and far exceeding liberalizing measures.
- New measures imposed on the EU and its members have trended up since the mid-2010s, mainly concentrated on goods trade.
- The EU’s effective tariff rate has remained stable and low, highlighting the importance of “behind-the-border” restrictions.
- EU actions:
  - Mechanisms for screening inward FDI introduced/expanded by individual EU countries; an EU-wide cooperation mechanism exists since 2020 focusing on critical inputs, infrastructure and technology.
  - Financial support to producers (equity injections, subsidies, tax relief) is the most common form of restriction; for China and EU countries at the national level, financial support accounts for more than 90 percent of all measures.
  - On- and off-budget fiscal cost of state aid in the EU averages 1 percent of countries’ GDP (even prior to COVID and the energy price shock), with wide variation across countries.
  - EU FDI Screening Regulation: by 2022, 18 members had a screening mechanism; 55 percent of requests for FDI authorization in 2022 were formally screened, 9 percent of which were approved subject to conditions, 1 percent blocked.

### EU exposure to fragmentation: trade, value chains, substitutes
- Direct bilateral trade patterns:
  - More than half of EU direct exports are destined for other EU members.
  - An additional quarter of EU direct exports (about 3 percent of EU GDP) is absorbed by non-EU countries that voted in favor of the 2022 UN Resolution on Ukraine.
  - Direct exports to the “AAA” bloc (against/abstained/absent on the UN vote) are modest as a share of GDP.
- Indirect trade and global value chain measures:
  - Backward participation (share of foreign value added embedded in gross domestic exports): EU 16 percent; US ~10 percent of gross exports; China 17 percent.
  - Forward participation (share of domestic value added embedded in gross exports of downstream partners): around 15 percent for the EU; majority used by non-EU “in favor” bloc.
  - Ultimate foreign input reliance (whole economy): rose from around 12 percent of domestic value added in 2004 to 18 percent by 2011, driven mainly by rising reliance on the “AAA” bloc.
  - Manufacturing foreign input reliance: rose from 19 percent of manufacturing GDP in 2004 to 28 percent by 2011, driven by the “AAA” bloc and with dependence on a single country (China) more concentrated.
  - Ultimate foreign market reliance also rose over time, mainly due to greater dependence on the “AAA” bloc.
- Fragile intermediate goods and substitutability:
  - Fragile intermediate goods (defined by limited central providers and low potential to replace suppliers) represent on average about 40 percent of extra-EU imports by value; around half of these are supplied by countries in the “AAA” bloc; mainly consist of transformed goods.
  - Extra-EU fragile imports are more exposed to the “AAA” bloc than US fragile imports.
- EU services trade:
  - Heavily focused on geo-politically aligned countries: ~50 percent with other EU members and ~37 percent with other “in favor” countries; services trade with the AAA bloc is modest.
- Financial exposure:
  - At aggregate level, EU exposure to the “AAA” bloc is relatively small: 3 percent of portfolio investment, 4 percent of FDI, and 2 percent of bank assets in the “AAA” bloc (stocks of foreign liabilities).
  - Caveat: financial centers, multinational holding companies, and resident companies owned by foreign entities may obscure true linkages.

### FDI and geopolitical alignment
- Based on fDi Markets (greenfield FDI projects):
  - About two-thirds of EU outward FDI projects over the past two decades went to countries in the top two quintiles for geopolitical proximity to the EU.
  - EU outward FDI became more responsive to geopolitical distance since 2017, controlling for host-country per capita income and fixed effects.
  - FDI integration with the non-EU “in favor” bloc recovered strongly after the euro debt crisis; EU FDI integration with the “AAA” bloc has remained weak.
  - EU outward FDI to Russia has been halted since the start of the war in Ukraine.

### Energy exposure and consequences
- Pre-war reliance and reorientation:
  - Prior to Russia’s invasion of Ukraine, Russia provided about one-fifth of EU gas in 2020.
  - As piped gas stopped flowing from Russia, EU gas prices (TTF) soared to many multiples of previous levels.
  - EU reliance on Russian piped gas fell to around 5 percent by H1:2023 after diversification.
  - Wholesale prices remain considerably higher in the EU and Asia than previously and than in the US.
- Economic importance of energy-intensive sectors:
  - In 2019, 1.7 percent of the EU’s domestic value added was derived from energy intensive manufacturing (paper and paper products; chemicals and chemical products; other non-metallic mineral products; basic metals).
  - Energy-intensive sectors accounted for 1.2 percent of total employment in 2019, with higher shares in several CESEE countries.
  - Since the onset of the war in Ukraine, output of energy-intensive manufacturing has been considerably weaker than other sectors.

### Innovation, intellectual property (IP), and multinational production (MP)
- IP flows:
  - The EU is the second-largest exporter of ideas (IP), surpassed only by the US.
  - More than half of EU IP receipts originate from countries within the EU, reflecting payments from goods-intensive EU countries (EUG) to more knowledge-intensive EU countries (EUK).
  - The EU relies on IP imports from the US, but much less so from China.
  - Within the EU, Germany and the Nordics are net IP recipients; Ireland is a large net payer/importer.
- Comparative advantage in innovation vs manufacturing:
  - R&D intensity in manufacturing (manufacturing R&D / manufacturing value added) is highest in Korea and the US, then Japan; China has increased manufacturing R&D but retains a manufacturing advantage.
  - The EU includes countries across the spectrum, forming an innovation-production ecosystem distinct from the US (more innovation-specialized) and China (more manufacturing-focused).
- Role of multinational production (MP):
  - Firms can produce in home country (i), country of final demand (l), and/or third production-platform country (n).
  - MP allows production-location choice and generates cross-border profit flows (royalties); innovative countries tend to export ideas and receive profit inflows; manufacturing-intensive countries send net profits abroad.
  - GEF policies can target both goods and knowledge flows.

### Model simulations: scenarios and key quantitative outcomes
- Literature findings referenced:
  - If the world splinters into US- and China-centered blocs while other large countries remain nonaligned, long-term global output would decrease by 2 percent (IMF 2023a).
  - Increased geopolitical distance (divergent UN voting) associated with a 15 percent reduction in cross-border portfolio flows and bank claims (IMF 2023b).
  - Fragmenting world supply/demand for key mined commodities into “China/Russia+” and “US/EU+” blocs would lower world GDP by ¼ percent, with larger output loss for the “China/Russia+” bloc and sizable inflation effects in “US/Europe+” (IMF 2023c).
  - Segmenting markets for minerals critical to the green transition lowers global investment in renewables and EVs by 30 percent.
  - Trade decoupling reduces EU output and trade and raises prices; welfare losses are up to five times larger in the short term when prices and inputs are rigid (Attinasi and others 2023).
- Global innovation & MP model scenarios (calibrated to OECD behavior):
  - Scenario: world segmented into four autarkic blocs (deep fragmentation): output losses between 5-10 percent across regions.
    - For the EU, goods-related losses around 9 percent of GDP dominate; profit loss is small.
    - Expanding the EU-centered bloc to include Türkiye and the UK reduces welfare loss under strict autarky.
  - Bilateral US-China tensions:
    - Scenario 2a (rising bilateral goods trade costs US-China): modest welfare costs; MP channel remains and China remains an MP hub.
    - Scenario 2b (increased outward MP costs for US multinationals producing in China): lowers US royalties and raises manufacturing costs in China; EU impact limited due to Single Market home bias in MP.
    - Scenario 2c (raise cost of importing each other’s goods + raise outward MP costs): similar but larger effects than 2b; EU little affected.
    - Scenario 3 (EU replicates US trade and MP measures on China and China reciprocates): EU welfare losses around ¼ - ½ percent of GDP relative to remaining on the sidelines.
  - Industrial policies and subsidies:
    - Scenario 4a (US subsidizes inward MP to encourage domestic manufacturing): US real income declines by around 1¾ percent (mostly from falling profits); EU gains around ¾ – 1 percent of GDP due to greater innovation opportunities.
    - Scenario 4b (EU also subsidizes inward MP): EU would lose via forgone royalties and higher cost/fewer varieties; losses larger for more innovative EU countries.
    - Scenario 5a (US subsidizes R&D): US and all other countries generally benefit through increased blueprints and varieties; other innovative countries (including EU knowledge producers) could experience welfare loss.
    - Scenario 5b (EU also subsidizes innovation): EU gains from higher royalties but loses from diverting resources from manufacturing; net effect mixed.
  - Deepening intra-EU integration (scenario 6): reducing remaining bilateral MP and goods trade costs among EU members by 10 percent yields large welfare gains—on the order of 7 percent of GDP—accruing to both EU innovating and manufacturing countries; limited spillovers to other regions.

### Key takeaways for the EU
- The EU’s high openness and internal Single Market confer resilience but also exposure to GEF through trade, value chains, FDI, financial links, energy, and innovation channels.
- Fragmentation scenarios produce heterogeneous effects:
  - Extreme autarky induces large losses (5-10 percent) and large EU goods-related losses (~9 percent).
  - Targeted MP or trade restrictions between major powers have limited spillovers to the EU unless the EU participates or industrial subsidies distort global innovation/manufacturing incentives.
  - Behind-the-border industrial policies and subsidies can have larger effects on the EU than cross-border goods trade or MP restrictions.
  - Strengthening intra-EU integration is a robust policy that yields substantial welfare gains (~7 percent of GDP).
- Sectoral vulnerabilities:
  - Energy-intensive manufacturing and fragile intermediate goods expose the EU to higher costs and supply risks.
  - Services trade is concentrated among aligned countries, posing less fragmentation risk.
  - Financial exposure to the “AAA” bloc appears limited in official aggregates but may be understated due to financial center opacity.

*Source: wpiea2023245-print-pdf - Introduction*

### 6. Impact of Reducing Cost of Trade and Multinational

### 6. Impact of Reducing Cost of Trade and Multinational Productionwithin the EU by 10 Percent (Percent of GDP)

### Impact of an Energy Price Wedge on the EU
- EU firms could face persistently higher fossil fuel prices relative to pre-Russia-invasion levels, creating a positive price wedge versus some peer regions with implications for economic activity.
- Energy-intensive production in the EU declined sharply in 2022 even as other industrial sectors continued to grow.
- Wholesale gas prices have moderated since 2022, but energy-intensive production remains weaker than other industries.
- Firm responses to high gas prices (survey evidence):
  - Around 60 percent of EU firms viewed energy costs as a long-term barrier to investment (European Investment Bank’s 2022 Investment Survey).
  - 30 percent of firms in the US viewed energy costs as a long-term barrier to investment.
  - In Germany, 12.5 percent of manufacturers were planning to—or had taken action to—relocate production.
  - Common firm responses: pass-through of higher costs to customers, investment in energy efficiency, switching energy sources, and adapting production methods.

### Modeling Approach (GTAP-E CGE model)
- A global multi-sector computational general equilibrium (CGE) model (GTAP-E, calibrated to 2017) is used to analyze a permanent increase in EU energy prices in a fragmented world market.
- Key model features:
  - Interactions between the energy sector and the macroeconomy via derived demand for energy as a factor of production.
  - Multiple global energy types and substitution between different forms of energy.
  - Perfect competition, constant returns to scale, Armington assumption, inclusion of intermediate goods, and nontradable primary factors (labor, physical capital, land).
  - Calibration based on input-output tables covering 141 countries and 65 sectors.
- Scenario assumptions:
  - (i) Permanent reduction in Russian energy exports to world markets, raising average world fossil-fuel prices.
  - (ii) A region-specific price wedge in world gas markets keeping EU gas prices above US prices; gas wedges modeled as region-specific iceberg tariffs with any revenue discarded.
  - Resulting regional gas prices are consistent with prevailing levels.

### Quantitative Scenario Results
- Persistent—and in the case of gas, differentiated—increases in fossil fuel prices are found to permanently reduce EU value-added by about 4 percent per year.
- Distributional effects:
  - Global energy exporters gain; energy importers lose.
  - Russia benefits from higher energy prices that more than offset the fall in its energy exports.
  - Effects in the US are modest, consistent with more closed energy markets.
  - Largest EU declines in value added occur in energy-intensive manufacturing and services (services decline reflects sizable services-input into manufacturing and reduced spending on services from lower income).
  - Non-energy-intensive manufacturing increases modestly on average due to a fall in the real exchange rate.
  - Mining and extraction respond positively to higher fossil fuel prices.
  - Variation within the EU is sizable: more fossil-fuel intensive countries (including in CEE) are generally more affected; services in Greece heavily affected, likely reflecting commodity shipping’s importance in GDP.

### Stylized Facts from Simulations
- Protectionist policies evaluated on economic grounds (irrespective of security benefits) bring economic losses for the EU.
- Deep fragmentation into a handful of strict autarkic blocs is very costly for the EU and other regions by cutting off cross-bloc exchanges of goods and knowledge and precluding multinational production.
- Refraining from taking action as others restrict trade or subsidize domestic manufacturing is less costly for the EU than replicating those measures.
- Persistently higher fossil fuel prices cause a sizable drop in EU GDP, with energy-intensive activities most impacted.
- Deepening the EU’s Single Market by lowering costs of cross-border trade and multinational production could yield a large increase in GDP benefiting EU innovators and manufacturers.

### Policy Considerations and Recommendations
- Support an open, rules-based trading system and address concerns within that framework:
  - Ensure climate-related policies, including the Carbon Border Adjustment Mechanism, are compliant with World Trade Organization rules.
- Use narrowly targeted restrictions on FDI where fragmentation has already set in; avoid broad protectionism which would increase exposure to localized shocks and reduce foreign market size for EU products.
- Adopt “targeted de-risking” rather than “outright decoupling”:
  - Underpin targeted de-risking with detailed economic security risk assessments.
  - Work with private sector to identify critical dependencies not fully internalized by individual firms.
  - Possible responses: diversify suppliers, hold inventories, improve recycling, and where feasible homeshore essential products.
  - Set a high bar for intervention; interventions should meet criteria such as low technical substitutability, lack of suppliers from less-risky regions, and socially harmful disruptions (e.g., certain medical products).
  - Broaden trade and development partnerships with less-risky countries (including via comprehensive trade agreements and the EU’s Global Gateway Initiative).
- Protecting and deepening the Single Market to strengthen resilience:
  - Remove remaining internal barriers to increase mobility of capital, labor, and services.
  - Complete the capital markets union to mobilize funding for climate and digital investments.
  - Conclude the banking union to raise competition and more efficient use of bank capital.
  - Harmonize taxes and subsidies across countries to boost investment in cross-border infrastructure and discourage “state aid shopping.”
  - Ease cross-border supply of services and reciprocal recognition of qualifications to enhance competition, lower prices, and reduce adaptation costs to shocks.
- Industrial policy constraints to preserve a level playing field:
  - Restrict industrial policies to addressing externalities and market distortions and make them time-bound.
  - Ensure technology neutrality, avoid favoring incumbents over new entrants, avoid domestic preference, and target interventions well to avoid government capture and rent seeking.

### Context: Policy Measures and Comparative Examples (select figures from annex)
- Recovery and Resilience Facility: EUR 672.5 billion (announced on 2/18/2021); sectoral support including climate; financial grant; state loan.
- Inflation Reduction Act (US): $369 billion for energy security and climate change (8/16/2022, and phased provisions on 1/1/2023, 1/1/2024, 1/1/2025); mix of tax relief, local content incentives, state aid, financial grants, state loans.
- CHIPS and Science Act of 2022 (US): 8/9/2022 – 9/30/2026; state loan, loan guarantee, tax relief, state aid; sectoral support.
- EU Carbon Border Adjustment: 10/1/2023; import tariffs; stated purpose: level playing field for environmental purposes.

### Identifying Fragile Intermediate Goods (methodology summary)
- Data: BACI bilateral trade database (UN Comtrade-derived, HS2007), 200 countries, 5,039 products at 6-digit level; analysis focuses on 3,783 intermediate goods (final consumption goods excluded).
- Fragility classification uses two components for each intermediate product (2017–19):
  1. Presence of central players:
     - Uses standard deviation of weighted outdegree centrality (weighted outdegree centrality defined per Barrat and others (2004) formulation); higher standard deviation signals vulnerability from very central exporters.
  2. International substitutability:
     - Proxy based on dispersion of human capital levels among exporters (inspired by Revealed Factor Intensity); wider dispersion implies more heterogeneous production methods and higher vulnerability when substitutes are not close matches.
- Components are standardized via z-scores and products are partitioned into fragility groups using k-median cluster analysis; 650 individual types of goods are identified as fragile.
- Importers of fragile intermediate goods are identified by their share in total imports of a country’s import basket.

*Source: IMF staff calculations and text from "6. Impact of Reducing Cost of Trade and Multinational Productionwithin the EU by 10 Percent (Percent of GDP)" (wpiea2023245-print-pdf).*

### References

### wpiea2023245-print-pdf - References

### Geoeconomic fragmentation and multilateralism
- Aiyar, S.,   A. Ilyina, and others, 2023, “Geoeconomic Fragmentation and the Future of Multilateralism,”  Staff Discussion Note SDN/2023/001 (Washington: International Monetary Fund).
- Aiyar, S.,    A. Habib, D. Malacrino, and A. Presbitero, 2023, “Investing in Friends: Geopolitical Alignment and Vulnerability to FDI Relocation,”  IMF Working Paper, forthcoming.
- Aiyar, S.,  A. Presbitero and M. Ruta (eds), 2023, “Geoeconomic Fragmentation: The Economic Risks from a Fractured World Economy,” (Paris and London: CEPR Press).
- Bekkers, E. and C. Góes, 2022, “The Impact of Geopolitical Conflicts on Trade, Growth, and Innovation,” Staff Working Paper ERSD-2022-09, World Trade Organization.
- Bolhuis, M.  A., J. Chen, and B. R. Kett, 2023, “Fragmentation in Global Trade Accounting for Commodities,”  IMF Working Paper 23/73 (Washington: International Monetary Fund).
- International Monetary Fund, 2023a, “Geoeconomic Fragmentation and Foreign Direct Investment,”  April 2023 World Economic Outlook, Chapter 4, (Washington: International Monetary Fund).
- International Monetary Fund, 2023b, “Geopolitical and Financial Fragmentation: Implications for Macro-Financial Stability,”  April 2023 Global Financial Stability Report, Chapter 3, (Washington: International Monetary Fund).
- International Monetary Fund, 2023c, “Fragmentation and Commodity Markets: Vulnerabilities and Risks,”  October 2023 World Economic Outlook, Chapter 3, (Washington: International Monetary Fund).
- Gopinath, G., 2023, “Europe in a Fragmented World,” Bernhard Harms Lecture, Berlin, Germany, 30 November 2023, Speech.

### Foreign direct investment (FDI) and firm-level evidence
- Blank, S., A. Lipponer, C. J. Schild, and D. Scholz, 2020, “ Microdatabase Direct Investment (MiDi)–A Full Survey of German Inward and Outward Investment,”  German Economic Review, Vol. 21, No. 3, pp. 273–311.
- Buch, C.M., J  . Kleinert, A. Lipponer, and F. Toubal, 2005, “Determinants and Effects of Foreign Direct Investment: Evidence from German Firm-Level Data,” Economic Policy, Volume 20, Issue 41, 1 January, pp. 52–110, https://doi.org/10.1111/j.1468-0327.2005.00133.
- Buch, C.M. and A. Lipponer, 2007, “FDI versus Exports: Evidence from German Banks,” Journal of Banking & Finance, Volume 31, Issue 3, pp. 805–826, https://doi.org/10.1016/j.jbankfin.2006.07.004.
- Fletcher, K., V. Grimm, T. Kroeger, A. Mineshima, C. Ochsner, A. F. Presbitero, P. Schmidt-Engelbertz, and J. Zhou, 2023, “Germany’s Foreign Direct Investment—in Times of Geopolitical Fragmentation,” IMF Working Paper, Forthcoming.
- Kleinert, J., and F. Toubal, 2010, “Gravity for FDI,” Review of International Economics, Vol. 18, No. 1.
- Kleinert, J., and F. Toubal, 2013, “Production versus Distribution-Oriented FDI,” Review of World Economics 149, pp. 423–442.

### Trade, global value chains, and production networks
- Arkolakis, C., N. Ramondo, A. Rodríguez-Clare, and S.  Yeaple. 2018, “Innovation and Production in the Global Economy,”  American Economic Review Vol. 108, No. 8, August 2018, pp. 2128–73.
- Attinasi, M., L. Boeckelmann, and B. Meunier, 2023, “Friend-Shoring Global Value Chains: A Model-based Assessment,” ECB Economic Bulletin, Issue 2/2023.
- Baier, S. and J. Bergstrand, 2001, “The Growth of World Trade: Tariffs, Transport Costs, and Income Similarity,”  Journal of International Economics, 2001, Vol. 53, Issue 1, pp. 1–27.
- Baldwin, R., R. Freeman, and A. Theodorakopoulos, 2023a, “Deconstructing Deglobalization: The Future of Trade Is in Intermediate Services,”  Asian Economic Policy Review(2023) 9999, pp. 1–20.
- Baldwin, R., 2023b, “Horses for Courses: Measuring Foreign Supply Chain Exposure,” NBER Working Paper No. 30525.
- Baqaaee, D.R. and E. Farhi, 2023, “Networks, Barriers, and Trade,” Econometrica. forthcoming.
- Bekkers, E. and C. Góes, 2022, “The Impact of Geopolitical Conflicts on Trade, Growth, and Innovation,” Staff Working Paper ERSD-2022-09, World Trade Organization.
- Korniyenko, Y., M. Pinat, and B. Dew, 2017, “Assessing the Fragility of Global Trade: The Impact of Localized Supply Shocks Using Network Analysis,”  IMF Working Paper 17/30, (Washington: International Monetary Fund).
- Wang, Z., S. J. Wei, X. Yu, and K. Zhu, 2017, Measures of Participation in Global Value Chains and Global Business Cycles, NBER Working Paper No. 23222.
- Bolhuis, M.  A., J. Chen, and B. R. Kett, 2023, “Fragmentation in Global Trade Accounting for Commodities,”  IMF Working Paper 23/73 (Washington: International Monetary Fund).

### Capital flows, finance, and macro-financial stability
- Coppola, A., M. Maggior, B. Neiman, and J. Schreger, 2021, “Redrawing the Map of Global Capital Flows: The Role of Cross-Border Financing and Tax Havens,”  The Quarterly Journal of Economics, Volume 136, Issue 3, pp. 1499–1556.
- Lane, P. R. and G. M. Milesi-Ferretti, 2018, “International Financial Integration in the Aftermath of the Global Financial Crisis,”  IMF Working Paper 17/115, (Washington: International Monetary Fund).
- International Monetary Fund, 2023b, “Geopolitical and Financial Fragmentation: Implications for Macro-Financial Stability,”  April 2023 Global Financial Stability Report, Chapter 3, (Washington: International Monetary Fund).

### Methodology, models, and environmental/economic assessment tools
- van der Mensbrugghe, D., 2019, “The Environmental Impact and Sustainability Applied General Equilibrium (ENVISAGE) Model,” The Center for Global Trade Analysis, Purdue University.
- Cerdeiro, D. A., J. Eugster, R. C. Mano, D. Muir, and S.  J. Peiris, 2021, “  Sizing Up the Effects of Technological Decoupling,” IMF Working Paper 21/69 (Washington: International Monetary Fund).
- Korniyenko, Y., M. Pinat, and B. Dew, 2017, “Assessing the Fragility of Global Trade: The Impact of Localized Supply Shocks Using Network Analysis,”  IMF Working Paper 17/30, (Washington: International Monetary Fund).

### Deglobalization, policy reflections, and regional perspectives
- Dadush, U., 2022, “Deglobalization and Protectionism,”  Working Paper 18/2022, Bruegel.
- Darvas, Z., 2020, “Resisting Deglobalization: The Case of Europe,” Working Paper 01/2020, Bruegel.
- European Commission, 2006, “Global Europe: Competing in the World, A Contribution to the EU’s Growth and Jobs Strategy,” COM(2006) 567.
- European Commission, 2020, “Trade Policy Reflections Beyond the COVID-19 Outbreak,”  Chief Economist Notes Series, DG TRADE, Issue 2, June 2020.

*References list from wpiea2023245-print-pdf - References*

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_Source: https://www.imf.org/-/media/files/publications/wp/2023/english/wpiea2023245-print-pdf.pdf_