Global trade war deepens fragmentation which undermines climate solvency

After decades of increasing global economic integration, the world is facing the risk of fragmentation. A shallow and uneven recovery from the global financial crisis (GFC) was followed by Brexit, U.S.–-China trade tensions, and a growing number of military conflicts. The post-GFC era has seen a leveling-off of global flows of goods and capital, and a surge in trade restrictions. The COVID-19 pandemic and Russia’s invasion of Ukraine have further tested international relations and increased skepticism about the benefits of globalization. This Staff Discussion Note explores the potential economic ramifications of a policy-driven reversal of global economic integration, a multidimensional process that the authors refer to as geoeconomic fragmentation (GEF).

The benefits of globalization propagate through multiple channels; the adverse consequences of GEF would be felt in many areas as well. For several decades, trade deepening has helped catalyze catch-up in per capita incomes across countries and a large reduction in global poverty, while in advanced economies, low-income consumers have benefited disproportionately through lower prices. Conversely, the unraveling of trade links would most adversely impact low-income countries and less well-off consumers in advanced economies. Restrictions on cross-border migration would deprive host economies of valuable skills while reducing remittances in migrant-sending economies. Reduced capital flows would hinder financial deepening in destination countries, especially through foreign direct investment which can be an important source of technological diffusion. And a decline in international cooperation would put at risk the provision of vital global public goods.

Estimates of the costs of GEF from economic modeling vary widely. Available studies suggest that the deeper the fragmentation, the deeper the costs; that technological decoupling significantly amplifies losses from trade restrictions; that adjustment costs are likely to be large; and that emerging market economies and low-income countries are likely to be most at risk due to the loss of knowledge spillovers. Depending on modeling assumptions, the cost to global output from trade fragmentation could range from 0.2 percent (in a limited fragmentation / low-cost adjustment scenario) to up to 7 percent of GDP (in a severe fragmentation / high-cost adjustment scenario); with the addition of technological decoupling, the loss in output could reach 8 to 12 percent in some countries. More work is needed to assess and aggregate the costs through multiple channels.

GEF could strain the international monetary system and the global financial safety net (GFSN). Financial globalization could give way to “financial regionalization” and a fragmented global payment system. With less international risk-sharing, GEF could lead to higher macroeconomic volatility, more severe crises, and greater pressures on national buffers. Facing fragmentation risks, countries may look to diversify away from traditional reserve assets —a process that could be accelerated by digitalization— potentially leading to higher financial volatility, at least during transition. By hampering international cooperation, GEF could also weaken the capacity of the GFSN to support crisis countries and complicate the resolution of future sovereign debt crises.

To avert runaway fragmentation, the rules-based multilateral system must adapt to the changing world. This includes the international trade and monetary systems. Given current geopolitical realities, progress through multilateral consensus may not always be possible. Trust may have to be rebuilt gradually through differential engagements depending on the countries’ preferences and willingness to work together. Where preferences are broadly aligned, multilateral cooperation remains the best approach to address global challenges. In areas like climate change and pandemics such cooperation is essential. When multilateral efforts stall, open and non- discriminatory plurilateral initiatives (fewer countries wanting to do more) could be a practical way forward. When countries opt for unilateral actions, credible “guardrails” may be needed to mitigate global spillovers and protect the vulnerable (such as “safe corridors” for food and medicine). Addressing these challenges requires a joint effort of all international organizations, including the IMF. To be effective in a more shock-prone world, the IMF should remain representative of its global membership and at the core of the reinforced GFSN.