The world’s economic system is going through some profound and rapid changes Since the start of the war in Ukraine, the energy markets have been totally rebuilt to everyone’s cost. Oil that used to travel a few days from Russia’s port of Primorsk to the EU’s Rotterdam now has to travel half way around the world to refineries in China and India before travelling back to Europe as oil products once it has been whitewashed of its Russian origin.

The globalisation of the last decade was already upended by the coronacrisis as companies looked to shorten supply changes after the pandemic. Globalisation had led to a decade-long period of prosperity, but the sudden acceleration of geopolitical tensions that Russian President Vladimir Putin catalysed with this war of aggression has only made things worse. And those tensions were already rising as the US increasingly clashed with China. In his first speech as Secretary of State in 2021, Antony Blinken made it clear that while Russia was an enemy, China was a rival that needed to be challenged.

As bne IntelliNews detailed in a deep dive into Russia's deepening relations with the global south, the sanctions showdown has only accelerated what the International Monetary Fund (IMF) called Geoeconomic fragmentation (GEF) in a paper in November that looked at the risks for the EU.

“The number of restrictions worldwide with effects on cross-border trade and foreign direct investment (FDI) have risen sharply in recent years,” the IMF said. “Investment and financial flows are increasingly driven by geopolitical alignment, rather than economic distance. Some trade is being re-routed through third countries, and production is beginning to relocate as companies grow increasingly concerned about the reliability of foreign links in their supply chains.” Capital Economics has also done extensive research on this new fractured world, as reported by bne IntelliNews, which in effect reversed globalisation and is becoming the dominant issue for the global economy.

The sanctions against Russia have largely failed and the remaking of the global trade system is now a distortion that is driving up costs everywhere. As bne IntelliNews reported, the subsequent boomerang effect is now hurting the EU more than Russia. This will probably change in the long term, but in the short term the European economies are slowing, while that of Russia is enjoying a military Keynesianism boost.

“Russia’s invasion of Ukraine highlighted the national security implications of concentrated sourcing of key imports. Domestic competitiveness, supply chain resilience and climate change are also driving the global increase in GEF policies,” the IMF said.

Sanctions are inimical to the founding principles of the EU. The idea was to build an open, borderless single market where trade, people and capital could flow freely for the common good. And it has been a spectacular success.

But that open trade regime has also made it easy for Russia to evade sanctions as the flow of goods is so easily switched from one route to another. The sanctions strike at the very heart of what the EU is all about and the latest sanctions are increasingly focused on introducing more restrictions on this trade as the West engages in a game of whack a mole as it tries to prevent banned goods from being delivered to Moscow. Almost 3,000 new harmful restrictions on trade or FDI were implemented worldwide in 2023, nearly three times the number of such restrictions introduced in 2019, and far exceeding the number of liberalising measures.

“The EU economy and its population have prospered as an open economic region, underpinned by liberal frameworks for trade and capital flows. Measured as the sum of exports and imports of goods and services, the EU is more outwardly-oriented than the US or China, despite being of a broadly similar economic size,” the IMF said.

Globalisation represented an effort to extend the EU model to the rest of the world, via the offices of institutions like the WTO. It could be argued that globalisation reached its apex in January 2013, when Russia was finally admitted to the WTO after being kept in the waiting room for 18 years. But Russia’s sojourn in the international trade club came to an end in March 2022 after the G7 stripped it of its WTO trading privileges as part of the extreme sanctions regime imposed immediately after its invasion of Ukraine.

Since then, Russia and China have been working hard to set up a new system of non-aligned economic clubs such as the expanded BRICS+ and the G20, although it remains early days for both and many countries in the global south have already rejected the idea of a “them or us” model of global commerce.

Trade openness in China has declined sharply since the mid-2000s as GDP rose faster than trade, the IMF reports. Trade has also edged down in the US over the past decade as it becomes increasingly protectionist. The introduction of the CHIPS legislation has banned all technology transfers to China as the US seeks to preserve its competitive advantage in advanced technology.

However, trade in the EU continued to rise in the last decade and at the same time its very high stock of FDI also continued to grow – both inward and outward – the IMF reports. That is going to change now.

1223 GLOBAL trade openness, FDI stocks IMF .

The EU liberalised trade restrictions earlier and to a greater extent than did any other region. Free trade is at the heart of Europe’s economic model – much more than it is for the US – and championed by Germany, the Weltexportmeister.

“The global economy underwent around 30 years of deep and substantive liberalisation, beginning around the 1970s and ending in the early 2000s, during which advanced and emerging market economies – including China – lowered barriers and the former Soviet bloc was integrated into the global economic system,” the IMF said.

For the EU, this period included several waves of enlargement, where accession required new members to liberalise their economic relations with countries outside the bloc while adopting the EU’s internal single market for goods, services, capital and labour. The EU has been a strong supporter of the multilateral trading system, with the WTO at its centre, although it has also advocated for some reforms, including in the areas of health, energy, ecommerce, facilitating investments, and industrial subsidies.

This heady period of trade-driven prosperity has now come to an end. The Washington Post described the WTO as “worse than useless” in an article in January as the game shifted to a rules-based trading club to the raw geopolitics of banning trade as a geopolitical weapon to punish Russia for its military aggression. The US’ CHIPS legislation and Donald Trump's trade restrictions on China are the first salvos in a similar looming trade war between Washington and Beijing.

That is going to come with a cost. The IMF calculates that the EU’s openness increased real incomes by 7.75% as of 2020, putting an additional €1.2 trillion into the EU’s collective pocket, and 87% of the EU’s exporting companies sell outside the EU.

EU trade exposure to GEF

Just how severe these costs are going to be remains the object of study and the estimated impacts on global and European GDP vary widely, depending on the channels and the fragmentation scenarios considered, the IMF reports.

In one of its own studies in 2023, the IMF found that if the world were to splinter into US- and China-centred blocs, but with other large countries and regions remaining non-aligned (and hence able to trade with both blocs), long-term global output would decrease by 2%, with China suffering more than the West because it is more dependent on foreign investment.

At first glance the EU does not appear very exposed to trade problems caused by the new restrictions. Half of EU members' exports go to other EU members. Another quarter of EU exports (3% of EU GDP) go to non-EU members that voted in favour of the 2022 UN resolution condemning the invasion of Ukraine. However, these figures only represent direct trade between two countries. What Russia has done, and China is increasingly doing, is create long “daisy chains” of intermediaries to hide the ultimate location of a trade deal.

1223 EURO trade vs Russia invasion Ukraine UN votes import export IMF

As has been widely reported, trade between the EU and countries such as Kyrgyzstan or Estonia have soared by hundreds of percent as sanctioned goods are rerouted via Russia-friendly countries.

The IMF points out that the trade fragmentation dangers to the EU is largely concentrated in goods and especially in strategic inputs like energy and minerals. The EU’s service trade is heavily concentrated in trade with other EU members and so is not at risk. The story is the same with the EU’s reliance on the financial sector.

The EU’s exposure to FDI fragmentation was already falling after the 2017 debt crisis and here too the EU has low exposure. Moreover, the EU’s outward FDI to Russia has been halted since the start of the war in Ukraine.

Energy is more difficult and where the EU is most exposed to fragmentation. Prior to the invasion Russia provided about one-fifth of EU gas in 2020; however, after a difficult 2022, the EU has successfully diversified its energy imports, albeit at a very high cost that has already caused the start of deindustrialisation in countries such as Germany. Somewhere between a tenth and a quarter of energy-intensive companies in Germany are now planning to move operations to other countries with lower energy costs.

The IMF paper runs through many scenarios. One of the worst cases would be if the major blocks adopt autarky and cut the West off completely from their minerals, energy and food. In this case the damage to the resource-deficient EU would be large, whereas the US, which is largely self-sufficient in all the most important inputs, would not be badly affected.

A more likely scenario is if the higher energy costs in Europe become permanent, where the EU is also a big loser.

“These persistent – and in the case of gas – differentiated increases in fossil fuel prices are found to permanently reduce EU value-added by about 4% per year,” says the IMF. “Global energy exporters gain, while energy importers lose from the energy shock. Russia, in particular, benefits from the increase in energy prices that more than offsets the fall in its energy exports.”

“The EU suffers the largest decline in value added on drops in energy-intensive manufacturing, but also services, reflecting both the sizable services-input into manufacturing and less spending on services (the largest sector in the economy) induced by the fall in income,” the IMF says. “Non-energy-intensive manufacturing increases modestly on average on the fall in the real exchange rate, while mining and extraction respond positively to higher prices. Variation within the EU is sizable, with more fossil-fuel intensive countries (including in CEE) generally among the most affected. Services in Greece are found to be heavily affected, likely reflecting the importance of commodity shipping in its GDP.”