Asia and the World Face Growing Risks From Economic Fragmentation

IMF Blog, October 28, 2022

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Geopolitical tensions raise the prospect that strategic competition and national security concerns may trump the shared economic benefits of global trade.
About half of the imports in the United States and a third in Europe come from Asia.
Asian countries account for almost half of global demand for key commodities.
Deep financial ties across countries mean that fragmentation risks extend beyond trade to financial channels.

Trade-policy uncertainty spiked in 2018 amid U.S.–China tensions and increased again around Russia’s invasion of Ukraine as sanctions created uncertainty about future trade relations.
Even without actual restrictions, trade-policy uncertainty can worsen economic activity as firms pause hiring and investment, and new firms may postpone market entry.
A typical shock to trade policy uncertainty, like the 2018 buildup of U.S.–China tensions:
- reduces investment by about 3.5 percent after two years;
- decreases gross domestic product by 0.4 percent;
- raises the unemployment rate by 1 percentage point.
Effects on investment are larger for emerging markets, more open economies, and firms with high debt.
Corporate debt has increased significantly in Asia since the global financial crisis—spiking further in the wake of the pandemic—heightening vulnerability to trade-policy uncertainty.

The modeled fragmentation scenario:
- divides blocs along the lines of the March 2022 United Nations General Assembly vote demanding Russia end its invasion of Ukraine (used for illustrative purposes);
- cuts off trade between trading blocs in sectors that have recently seen an increase in restrictions, like energy and technology;
- raises non-tariff barriers in other sectors to Cold War–era levels.
If only Russia is isolated from countries which voted in favor, output losses for the world economy are small.
Under a more adverse scenario where the world divides into two blocs (trade restricted between countries in favor and those against or abstaining):
- Permanent global annual losses are estimated at 1.5 percent of GDP;
- Losses in Asia and Pacific countries are over 3 percent of GDP, reflecting the key role trade plays in the region.
Losses are larger in countries where trade with the other bloc is significant, due to loss of export markets and splintering of complex production networks.
These output estimates focus on trade effects and represent a lower bound because they do not account for channels such as reduced capital stock from diminished investment or disruption to knowledge flows.

As trade unravels and specialization is unwound, severe implications for labor markets are expected.
- In sectors forced to contract due to higher trade restrictions in the illustrative scenario, average employment losses in Asian countries are estimated to be as high as 7 percent.
Financial fragmentation could cause:
- short-term costs from a rapid unwinding of financial positions;
- long-term costs from lower diversification and slower productivity growth due to reduced foreign direct investment.

Act decisively to avoid adverse effects from greater fragmentation and ensure trade remains an engine of growth.
Priorities include:
- Rolling back damaging trade restrictions;
- Reducing uncertainty via clear communication of policy objectives.
Complement regional agreements with reforms at the multilateral level.
Restore a fully functional World Trade Organization dispute settlement system to mitigate negative impacts of discriminatory policies and help resolve underlying sources of tensions.
Above all, engagement and dialogue between countries are vital to avoid the most harmful fragmentation scenarios.

Diego Cerdeiro, Siddharth Kothari, Chris Redl — October 28, 2022