Europe in a Fragmented World
IMF News, November 30, 2023
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- Published: November 30, 2023
Geoeconomic fragmentation: evidence and trends
- Geoeconomic fragmentation is "increasingly a reality."
- Since the start of the war in Ukraine, trade within a politically aligned bloc of countries has grown nearly 1½ percentage points faster than trade across blocs.
- The share of global trade in world GDP has been relatively stable, but underlying bilateral trading relations have shifted meaningfully.
- EU gas sourcing shifted from "over 20 percent of total gas imports in 2020" from Russia to "around 5 percent by the first half of 2023," with increased imports from the US and Norway.
- EU wholesale gas prices are now about twice as high as before Russia’s invasion and are considerably higher than those in the US.
- Trade within a politically aligned bloc has about halved from "3 percent pre-war." Trade between blocs that are not politically aligned declined from "4 percent pre-war to around 0%."
- Net effect: "1.5 percentage point faster growth in trade within blocs as opposed to between blocs."
- Supply chains are lengthening via re-routing through neighboring countries without changing ultimate origin or destination (examples below).
- Exports to Russia: sharp drops from neighboring EU countries—"75 percent for Finland and 100 percent for Ukraine"—while exports to Russia from other neighbors "have more than doubled" and "risen five-fold in the case of Armenia."
- Similar supply-chain lengthening also apparent for countries neighboring China and the US.
- Global FDI is segmenting along geopolitical lines; destination for global FDI increasingly driven by geopolitical closeness versus geographic closeness, especially in strategic sectors and for emerging market recipients.
- Outward FDI by EU countries has become more responsive to geopolitical distance since 2017; fragmentation of outward FDI flows by the EU began soon after the euro area debt crisis.
- Cross-border restrictions have increased substantially: "750 liberalizing measures" announced so far this year versus "almost 2,900 harmful measures" (including subsidies, tariffs)—"close to triple the number of harmful measures announced in 2019."
- Harmful measures include fiscal and financial support to specific sectors and local content requirements.
EU exposure and capabilities
- The EU is highly open to trade and therefore particularly vulnerable to disruptions: extra-EU foreign trade to EU GDP at "over 40 percent in 2021," exceeding the US and even China.
- The EU is also more open in FDI: stock of non-EU FDI "stood at more than 90 percent of GDP in 2021."
- Direct dependence on countries not politically aligned with the EU is high: "About 40 percent of imports from outside the EU are sourced from countries not aligned with the EU" and "around half of such imports would be difficult to access through alternative suppliers." This includes some natural resources and manufactured intermediates (advanced semiconductors).
- Indirect dependence on China has risen: for the EU-based auto sector, "China provides 10 percent of the final value added and is the final market for 7 percent of EU-made cars," both "more than double" where they were a decade earlier.
- The EU’s mix of innovation and manufacturing creates an ecosystem distinct from the US and China:
- Some EU countries channel "the equivalent of 7-9 percent of manufacturing value added" back into research and development (examples include the Nordics, Benelux, Germany, and France).
- Other EU countries undertake considerably more manufacturing but less manufacturing R&D.
- The Single Market gives scope for specialization across member countries and potential to re-shore production to cost-efficient locations with lower adjustment costs—conditional on reforms.
Policy recommendations and priorities
- Principal recommendation: EU policymakers should "deepen the single market" while advocating for a rules-based global trading system.
- External policy:
- Continue to be a strong advocate for openness and for the proper functioning of the WTO to support emerging and developing countries’ access to the global trading system.
- Ensure climate-related policies are compatible with WTO rules. Implement the Carbon Border Adjustment Mechanism (CBAM) to encourage greener imports and "be based on actual emissions embedded in imports rather relying on EU industry benchmarks," to signal protection of the planet rather than EU industry.
- Pursue "targeted de-risking" rather than outright "decoupling"—diversifying suppliers, holding inventories, improving recycling, and possibly homeshoring for activities critical to economic security. Set a high bar for such measures.
- Deepen economic partnerships with lower-geoeconomic-risk countries; recognize difficulties (e.g., pending agreements with the US on metals tariffs and workarounds to the US Inflation Reduction Act; slow progress with Indonesia and the Mercosur region).
- Develop long-term infrastructure partnerships (e.g., "Global Gateway") that are mutually beneficial and financially sustainable.
- Internal EU policy:
- Protect and deepen the Single Market; better harmonize taxes and subsidies to increase cross-border investment and discourage "state aid" shopping.
- Complete the capital markets union and banking union to mobilize funding for climate and digital investment needs.
- Reduce internal frictions: model estimates show lowering internal barriers within the EU would generate large welfare effects—"on the order of 7 percent of GDP"—benefiting both EU innovating and manufacturing countries, with small net spillovers to non-EU countries.
- Coordinate centrally to protect the level playing field and avoid competitive advantages from national fiscal support measures.
- Set decarbonization targets at the EU level to concentrate efforts where marginal abatement costs are lowest and ensure largest emissions reductions per green investment.
- Restrict industrial policies to addressing market distortions; ensure they are targeted, time bound, technology-neutral, and avoid favoring incumbents or domestic over foreign firms.
- Consider an EU-wide central fiscal capacity "of a meaningful size" to finance interventions and ensure resources flow to highest-benefit uses rather than to governments better able to provide state aid.
- Resist subsidizing fossil fuel prices during the green transition; fossil fuel prices are "not expected to return to the low levels of before the war in Ukraine over the next several years, at least." Subsidies risk locking in fossil fuel use and blunting price signals for renewables.
- Use targeted government intervention to de-risk energy supply and support renewables, smart grids, and EV charging infrastructure where appropriate.
Risks, scenarios, and quantitative impacts
- Extreme geoeconomic fragmentation scenario: an extreme form of fragmentation in trade "could wipe out 7 percent of global GDP over the medium run."
- The recent surge in national measures (including energy-price related fiscal support) risks damaging the Single Market and giving subsidizing countries a competitive edge.
- Positive scenario: a deeper Single Market combined with targeted de-risking and adherence to a rules-based global trading system could allow the EU to leverage its innovation-manufacturing ecosystem, produce large welfare gains (on the order of "7 percent of GDP"), and avoid substantial negative spillovers to non-EU countries.
First Deputy Managing Director Remarks for the Bernhard Harms Prize, November 30, 2023.
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