Putin’s war is fundamentally changing the make-up of the world. And that is not a good thing. While it is tempting to say the Cold War is back, the changes are more subtle than that: the Cold War was a clash of two ideologies – communism and capitalism – whereas today even Russia has a capitalist system and is deeply integrated into the global economy. But the global economy is being broken into two camps: a US-led bloc made up of largely G7 members and a Sino-Russia led bloc largely composed of emerging markets in Asia, Africa and Latin America.

The two camps will still trade and invest in each other, but there are now extreme government-imposed restrictions that will act as a brake on growth, a reversal of globalisation and result in persistently higher inflation and lower productive amongst other things. Just how this will play out, just how much commerce will remain between the two sides, or indeed if the clash will lead to a global war, remains unclear. But what is already clear is that the change is already doing a lot of damage and the global economy will take years to recover.

“The world economy is fracturing into China- and US-aligned blocs. This will result in shifts in supply chains and reduced technology and investment flows between the two over the coming decade. Geopolitical considerations will play a greater role in economic policy than they have for a generation. If the shifts are gradual, economies and financial markets in much – but not all – of the world will adapt without too much cost. However, antagonism between the blocs means that the risk of a more abrupt decoupling will cast a shadow over the outlook,” Capital Economics said in a paper that looked at the fracturing of the global economy.

The sanctions regime on Russia has accelerated the reversal of decades of increasing globalisation that already started during the coronavirus (COVID-19) pandemic. The most obvious example is the complete remake of the energy system in Europe that has functioned smoothly since the 1970s, and sparked an energy crisis that is likely to get worse.

The world is currently experiencing the “first truly global energy crisis,” according to the director of the International Energy Agency (IEA), Fatih Birol.

Speaking at the opening of the Singapore International Energy Week (SIEW-2022) on October 25, Birol warned that natural gas shortages could worsen significantly in 2023 and higher prices and supply shortages will persist well into 2024. In particular, demand is expected to increase from both China and Europe, which will need additional volumes of liquefied natural gas (LNG) to fill underground storage before next winter, which is not available.

Birol predicts a similar risk in the oil market due to OPEC+’s risky decision to reduce production quotas by 2mn barrels per day announced in October.

Birol warns that this energy crisis could deepen the gap between rich and developing countries, which will catalyse the “geopolitical split” between the developed economies of the world and Emerging markets.

“Since the beginning of 2021, European gas and electricity prices have recorded a rapid increase, which, with a slight delay, has now been affecting households and businesses since summer 2022. We are at a point where the situation is so dramatic that [Western] small and medium-sized enterprises [SMEs] in particular could fall into insolvency without government support. Private households are also dependent on state aid given that electricity and gas costs have been exploding. In this environment, the growth outlook has therefore deteriorated considerably,” Erste Bank said in its recent attempt assess the changes. (chart)

The US has already slapped extreme sanctions on Russia, effectively excluding it from the global financial system and cutting it off from essential technology, but in the second week of October things went up a gear after the US widened its technology war by introducing extremely harsh export controls on China that experts say will “destroy its semiconductor sector” overnight. China is now as cut off from US hi-tech as Russia.

Europe is also closing its markets to Russia, banning the import of raw materials and the exports of high-tech products and basic inputs that Russian industry needs to function.

The breakup is accelerating the deglobalisation trend that was already underway before the war in Ukraine broke out in February. The coronavirus pandemic disrupted long supply chains stretching from Beijing to Berlin and companies were remaking them, looking for suppliers closer to home to buy some immunity from the next pandemic. “Supply security” has become the post-pandemic by-word.

Sanctions have only catalysed this deglobalisation and are being entirely driven by worsening foreign relations. Russian oil ships needed only a few days to sail to German ports, but now already spend weeks at sea to deliver Siberian oil to customers in India. Likewise, factories in the EU heartland have had to abandon Russian coal and buy it from Australia on the other side of the planet, adding to the costs and inconvenience, which eats into prosperity. The Russian induced energy crisis has also led to the closure of large energy-intensive industries in the EU alarmingly fast.

The bifurcation is also undermining the multinational institutions. The WTO was already being largely sidelined, but the IMF’s effectiveness could also be in jeopardy if it is seen as being controlled by the US. The BRICS countries have already banded together to set up the BRICS bank, a development bank owned by the leading Emerging Markets without US involvement.

The UN could also be badly affected. During the golden years of globalisation following the collapse of the Soviet Union, the number of Security Council vetoes fell to next to nothing, while the number UN peacekeeping missions expanded vastly as the global community got used to working together. Both those trends are likely to be reversed now as UN returns to something similar to its Cold War polarisation. (chart, chart)

The immediate cost of the fracturing of the world will be a global slowdown. The director of the IMF, Kristalina Georgieva, said at the fund’s annual meeting in October that the cost of the current economic dislocation would be $4 trillion between now and 2026, but the EU alone has already spent nearly €1 trillion on relief and subsidies to deal with the energy and cost-of-living crises before the heating season has got under way. That bill is only expected to grow.

Economists say that Europe has probably already gone into recession and the downturn will probably persist throughout most of next year. The hope is that the recession will be short-lived, but if it lasts, fuelled by persistent inflation and the stubborn energy crisis, then there is a danger of “recession scaring,” according to Oxford Economics. (chart)

“[Worsening inflation and the persistent energy crisis] carry with them a high risk of long-term scarring. An historical analysis by Blanchard et al. looking at 23 advanced economies over 50 years found that around two-thirds of recessions were associated with output being below the extrapolated pre-recession trend 3-7 years later and in a significant share of these cases, the rate of output growth being lower too ('super-hysteresis'). Similar results are visible in research by Cerra and Saxena and for emerging markets in a recent World Bank study. The mechanisms by which these permanent losses may occur are varied, including human capital losses due to unemployment, delays to investments that are not fully recovered, and damage to innovation from lower rates of firm formation,” Oxford Economics in its look at the long-term consequences of the current crisis.

 

Source: Oxford Economics/Haver Analytics/Blanchard, Cerutti & Summers (2015) * for eleven deliberate disinflations. Note pre-recession trend growth is calculated for a four-year period starting two years before the recession begins to try to avoid overestimating trend growth by including boom years.

To avoid the worst-case scenarios Pierre-Olivier Gourinchas, the Economic Counsellor and the Director of Research of the IMF, warned in a recent blog that central banks will have to strike a delicate balance between aggressively hiking rates to curb inflation, but not to overdo it and fall into a deep recession that will be difficult to climb out of, but also difficult to avoid.

“There are risks of both under- and over-tightening. Under-tightening would further entrench inflation, erode the credibility of central banks and de-anchor inflation expectations. As history teaches us, this would only increase the eventual cost of bringing inflation under control,” Gourinchas said. “Over-tightening risks pushing the global economy into an unnecessarily severe recession.”

And all of this assumes the stand-off with Russia does not descend into general or even nuclear war, which now has a non-zero chance of happening.

The world has entered into a polycrisis, as economist Adam Tooze has dubbed it. However, with so many moving parts and so much uncertainty in the progression of the war in Ukraine, it is impossible to say how bad things will get, according to Liam Peach, an emerging market economist with Capital Economics, and Tomas Dvorak, an economist with Oxford Economic in a recent podcast with bne IntelliNews.

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A golden decades-long supercycle of low inflation and large productivity has just come to an end. The gains were driven by the alignment of globalisation of commerce, a revolution in technology, and the end of the socialist experiment. The 3bn people living in the East were united with the 3bn people living in the West and business boomed. All three of those tailwinds have come around the compass and are now headwinds.

There have been three episodes of globalisation so far: 1870 to 1914, 1945-1971 and the most recently following the end of the Cold War in 1990 to 2018, according to Capital Economics. (chart) 

In the last one cross-border trade flows increased five-fold and foreign direct investment (FDI) was up seven-fold. Not only was trade globalised but financial flows were too. That is exactly what is being undone now.

Undoing globalisation will extract a heavy toll on productivity and so hobble growth going forward, as we are likely entering a new super-cycle of high inflation and low productivity gains. That will have political consequences too.

“Productivity growth in both the G7 and EM slowed sharply after the oil shocks in the 1970s and again after the global financial crisis [in 2008]. A moderate recent recovery is now under threat from the further shocks related to the pandemic, soaring energy prices and Russia's war on Ukraine,” Oxford Economics said in a recent note. (chart)

In the 1970s when globalisation started, the world enjoyed a boost from favourable demographics and rising productivity.

“These factors now constitute headwinds. Most of the world faces a demographic cliff, [and] globalisation is stalling or reversing, resulting in diminishing efficiency and productivity,” says bne IntelliNews columnist Les Nemethy in a column about the polycrisis.

The demographic problem is worst in Europe where the population is falling, and crashing in some countries like Spain and the Baltic States, but populations are in declining in many countries in the world and in all of Russia, China, India and Brazil. The only country with a growing population in the two big blocs is the US and almost all of Africa, which has the fastest growth in the world.

Populations around the world are already facing a cost-of-living crisis induced by the coronavirus pandemic and the stress signs are already visible. Protests appeared in Albania in March and since have broken out in a score of countries including Ghana, Czechia and Germany. So far, these protests remain limited to Europe’s poorest countries or the political fringe groups in the richer ones, but the clash between Russia and the West will increase social tensions as the polycrisis increasingly affects populations in the form of higher bills and rising unemployment.

In one indicator, a new study by the United Nations Children's Fund (UNICEF) finds child poverty has risen by 19% in countries across Southeast and Eastern Europe and Eurasia as a result of the war in Ukraine. Overall, an additional 10.4mn individuals, or around 2.5% of the total population of 22 countries assessed across the region, will fall into poverty due to the economic shock related to the war in Ukraine, including 4mn children. While children make up 25% of the region’s total population, they will account for 40% of the increase in poverty.

The single worst affected country is Russia, according to the research. Russia’s invasion of Ukraine has rebounded on its own population, with the most significant increase in the number of children living in poverty; an additional 2.8mn children now live in households below the poverty line. That is almost three-quarters of the total increase across the region.

At least an additional half million children in Ukraine will also be plunged into poverty. The actual figure is most likely more. The World Bank recently estimated that a quarter of Ukraine’s population is already living in poverty, and that figure will rise to 55% next year.

Capital Economics estimates that expanded trade was responsible for half of the acceleration in productivity growth in emerging economies after 1990 and globalisation also contributed, through trade links and the free movement of low-cost migrant workers, to keeping developed world inflation pressures low. The UK boomed in the noughties, but an army of “Polish plumbers” kept wage inflation and hence cost rises down. The fall of the Soviet Union and the accession of the new Central European countries to the EU, along with more open borders, and the explosion of the Internet and technology in general, all contributed to the globalisation bump to productivity gains.

By 2010, 97% of world goods exports (and 98% of commercial services exports) came from members of the WTO, according to Capital Economics, and the globalisation drive began to run out of steam. Then the system was hit by three shocks: former US president Donald Trump's trade war on China; the coronavirus pandemic; and now Russia’s invasion of Ukraine.

Having said that, the fracturing of the world is not the same as deglobalisation.

“Apart from a few categories of goods deemed politically sensitive or strategically important, most trade between the US and China-aligned blocs will continue as before. And where production does shift away from China, it is likely to move to other EMs within the US-aligned bloc, rather than relocating back to advanced economies,” Capital Economics says.

Russia remains a capitalist society and its businessmen will continue to try to trade with the rest of the world, which in return will continue to want to source Russian commodities and Chinese goods that have not been sanctioned. That will result in significant sanctions leakage as bne IntelliNews has already explored in a series of articles. Fracturing is driven by governments, not companies.

But global trade is very lopsided. The trade between the US and China-aligned blocs amounts to between a quarter and a third of global trade, which is the share of trade that is vulnerable to fracturing, according to Capital Economics. And two thirds of China’s exports go to the US bloc whereas imports make up only 15%, making China very exposed to sanctions. (chart)

These three things have shifted thinking and introduced the idea of “supply security” that is increasing dislodging “cheap” as the main consideration for where to build your factory. “Reshoring” or even “friendshoring” have become fashionable terms, while other companies simply choose to hold bigger inventories of key inputs. (chart)

The disruption in supplies and the potential for even worse interruptions if China and Russia start to restrict their exports of key commodities have filtered through to governments that are now actively pursuing policies to break their dependencies on key inputs from the Sino-Russian bloc, undoing decades of cross-border investment and the raison d'etre of globalisation. US and EU have both launched strikingly similar action plans that identify the following classes of goods as “strategic”.

USA	EU
semiconductor manufacturing & advanced packaging	Semiconductors
high-capacity batteries	batteries
critical         minerals strategic materials, elements	raw materials (including rare earths and others on a "critical raw materials" list
pharmaceuticals & active pharmaceutical ingredients	active pharmaceutical ingredients
	Hydrogen
	cloud and edge computing
Source: Capital Economics

“The significant overlap between the studies suggests that Western governments have a shared view on the inputs that are either most vulnerable to disruption or most important strategically and for which measures to address supply chain vulnerabilities are most needed,” says Capital Economics.

The Western world’s reliance on China’s rare earth metals is already well known but the coronavirus pandemic revealed that the West is also heavily reliant on China for medicine. According to the US-China Economic and Security Review Commission, around 40% of the generic drugs sold in the US have a single global manufacturer, most of them dependent on active pharmaceutical ingredients sourced from China.

The US review also highlighted its dependency on Taiwan-based Taiwan Semiconductor Manufacturing Company (TSMC) semiconductors, including for weapons manufacture, adding to Taiwan’s strategic importance for Washington. The European Commission identified 137 products in its six focus areas for which the EU is highly dependent on imports from outside the EU. China is the source for more than half of these imports by value.

For its part, China is also actively working to break its dependence on imports from the West. “And it has been at it longer,” Capital Economics comments. China launched its “Made in China 2025” technology roadmap in 2015 that includes explicit targets for self-sufficiency in many areas. Russia has also tried to kick start its high-tech sector and promote innovation, but all these efforts have resulted in abysmal failures. (chart)

Tech wars

Europe is at a disadvantage in the energy war with Russia, which remains a major supplier, but where the West dominates is in its control of technology.

The collapse of the Soviet Union came at a very inopportune time for Russia, as the almost two decades of chaos that followed meant that it missed out on two revolutions in the development of precision tools, as featured by bne IntelliNews a year ago. Experts say that it is simply not possible to Russia to catch up with the West in less than a generation if not longer. Almost half of Russia’s imports over the last three decades have been machinery and equipment, as it has been unable to fill this gap on its own.

Despite being the first country in the world to put a man into space, Russia is even further behind with electronics (although not with software). During the war in Ukraine, the Russian army has been dismantling washing machines to raid their chips to use in replacement missiles, as Russia has no domestic production to speak of. The sanctions on the export of machines and electronics to Russia are by far the most effective and will have devastating long-term consequences, condemning its economy to stagnation in the years to come.

With Russia already effectively cut off from almost all Western tech, the US took things to a new level in October by imposing sanctions on China that have destroyed its semiconductor industry overnight, bring down the same sort of crippling sanctions on Beijing that are already in place on Moscow.

The Biden administration imposed a series of export controls that carry extreme penalties: any US person or company exporting restricted technology to China or just working there for a tech firm will be stripped of their citizenship and could serve long prison sentences at home. There’s also a licence requirement for the export of American tools or components to China-based fabrication plants. Overnight all US executives and companies working in China left the country as the new rules were suddenly put in place.

The controls have caused the “complete collapse” of China’s semiconductor industry, according to one expert. “This is what annihilation looks like: China’s semiconductor manufacturing industry was reduced to zero at a stroke,” an entrepreneur who tweets under the name Lidang wrote in a thread translated by Jordan Schneider, a senior analyst at Rhodium Group.

“To put it simply, Biden has forced all Americans working in China to pick between quitting their jobs and losing American citizenship,” Lidang wrote. “Every American executive and engineer working in China’s semiconductor manufacturing industry resigned yesterday, paralysing Chinese manufacturing overnight.”

The decision is an overt and aggressive move to cut the Sino-Russia block off from the latest technology forever and ensure the US maintains a hegemonistic technology lead over the rest of the world. Critically, not only will these rules doom the Sino-Russian block to long-term lower productivity, but it should also ensure the US maintains a large lead in the production of advanced weaponry.

 “I don’t need to tell you that advancements in science and technology are poised to define the geopolitical landscape of the 21^st century,” US National Security advisor Jake Sullivan said in remarks rolling out the new technology strategy on September 16. “They will generate game-changers in health and medicine, food security and clean energy. We’ll see leap-ahead breakthroughs and new industries that drive our prosperity. And, of course, new military and intelligence capabilities that will shape our national security. Preserving our edge in science and technology is not a “domestic issue” or “national security” issue; it’s both.”

The White House has rapidly beefed up its technology drive and recently launched the US CHIPS act that includes $52bn of subsidies for domestic semiconductor manufacturing over the next five years, with a ban on recipients of that money from expanding semiconductor manufacturing in China and other "countries of concern" over the next decade.

It has also been bullying semiconductor global giant TSMC to open factories in the US. TSMC is one of only three companies capable of producing sub-10nm semiconductors. High-end semiconductors are extremely difficult to make and thanks to its expertise a staggering 54% of the world’s chip production has become concentrated in TSMC’s factories in Taiwan. The other two companies are America’s Intel and South Korea’s Samsung. China’s leading chip maker Semiconductor Manufacturing International Corporate (SMIC) has a 6% market share but cannot make the sub-10nm chips the leading three companies can. That puts the world’s entire high-end chip making production capacity inside the US bloc. (chart)

TSMC is planning to invest $40bn in new factories this year, but one of them will be in Arizona, its only plant outside Taiwan. The decision to build in the US was made “at the insistence of the US government,” TSMC founder Morris Chang said in a recent interview.

The US has started a tech war that it intends to win. Sullivan outlined the US plan starting with “recharging the engine of American technological dynamism and innovation.”

“The EO on Biotech and Biomanufacturing ensures that we not only design the next generation of medicines, materials, and fuels here, but also make them here. From lab to fab, as they say,” Sullivan said.

The second pillar is developing, attracting and retaining top talent. But the third pillar is extreme protectionism in technology.

“The third pillar is protecting our technology advantages, and preventing our competitors from stealing America’s intellectual property, and using our technologies against us or their own people,” Sullivan said. “On export controls, we have to revisit the long-standing premise of maintaining “relative” advantages over competitors in certain key technologies. We previously maintained a “sliding scale” approach that said we need to stay only a couple of generations ahead. That is not the strategic environment we are in today.”

Sullivan explicitly outlined a wartime strategy that specifically named Russia as an enemy and cited technology sanctions as weapons.

“If implemented in a way that is robust, durable and comprehensive, they can be a new strategic asset in the US and allied toolkit to impose costs on adversaries, and even over time degrade their battlefield capabilities,” Sullivan said.

Now that weapon has been rolled out and used against China. Chinese Foreign Affairs Ministry spokeswoman Mao Ning has accused the US of “abusing export control measures to wantonly block and hobble Chinese enterprises”.

“Such practice runs counter to the principle of fair competition and international trade rules,” Mao said. “It will not only harm Chinese companies’ legitimate rights and interests, but also hurt the interests of US companies.”

Stagflation

The oil shock in 1973 and an energy crisis in 1979 plunged the world into a decade of miserable stagflation where production collapsed but prices remain stubbornly high, laying the ground work for a string of financial crises that struck in the 1980s. Stagflation is back.

The IMF warned in April that a repeat of the 1970s experience is a major threat and again in its October outlook said central banks urgently need to do something about inflation, but they must tread careful. Failing to curb price rises will make taming inflation more painful later, whereas overdoing the rate hikes will plunge the world into a deep recession that will also permanently slow growth. There is not a lot of wiggle room between these two extremes.

So how are regulators doing? The key to rate hikes is to set the prime rate above the rate of inflation – to make sure banks are offering real positive interest rates, which will encourage people to save their money rather than spend it. However, despite the increasingly aggressive hikes put in place this year, real interest rates are mostly negative (red in the heat map). Most central banks across Europe have fallen behind the curve.

CPI inflation, monetary policy interest rates and real interest rates. Enter the names of countries in the box to see individual or groups of countries’ data.

As the heat map shows, real interest rates are in the red across much of Europe, with the Baltics and Moldova in particularly bad shape, where inflation is well over 20% in all four states. In Poland, Hungary and Czechia inflation is 17.2%, 20.1% and 18% respectively, whereas the prime rates are half that at 6.75%, 11.75% and 7% respectively, leaving all three countries with deeply negative rates, even after a series of emergency rate hikes in Hungary in recent weeks. Capital Economics says that rates are set to stay high for a while longer.

Russia’s emergency rate hike to 20% days after the invasion of Ukraine in February stands out as a blue box in the middle of the chart, but the Central Bank of Russia (CBR) has been cutting rates fast since then. Russia currently the only country in Europe where inflation is falling and the regulator has gone back to easing monetary policy. (chart) But the CBR lockdown of the financial system days after the invasion of Ukraine means its macroeconomic results are seen as largely artificial.

There is some room to manoeuvre in the rate setting, as much of the inflation is driven by things that central banks can’t control: 70% of the current inflation is driven by rising food and energy prices, which only make up about a third of the basket. (chart)

“The eurozone inflation final estimate for September was revised to 9% year on year, marginally down from 10% in the preliminary estimate. The revision is mostly cosmetic and does not alter the picture of strong inflation pressures, which are not yet diminishing. To make it worse for the ECB, there is also a historically high dispersion within eurozone countries, with inflation rates varying from 20% among Baltics countries and around 6% in France,” Oxford Economics said in a recent note. The ECB recently was forced to put in a 75bp rate hike for the first time ever and economists say more large rate hikes are on the way.

Against the extraordinary inflation pressures, the coming global recession will be disinflationary in its own right, so the CBR can afford to cut rates faster than inflation is falling. CBR Governor Elvira Nabiullina is currently more worried about soft landing the contracting Russian economy and allowing negative real rates to encourage spending and growth, otherwise the contraction will overshoot, and the recession becomes unnecessarily deep. Monetary policy meetings have become like driving a car in a slide on an icy road as everyone pumps the brakes carefully, trying to avoid losing control.

The Russians have a legend that when God was making the world he was flying over Siberia when the tarpaulin on his sled came loose and rained down riches – oil, coal, diamonds, gold and every kind of mineral – onto the land below. So, he froze it to prevent anyone from stealing this treasure.

As the world coalesces into two blocs the distribution of mineral and energy resources is very unevenly distributed, as are the trade relations.

China exported $521bn worth of goods to the US in 2021, while Chinese exports to Russia stood at $59bn, down from around $140bn the year before. Similarly, India’s top trade partner is the United States, which accounted for 18.1% of the total 2021, worth $71bn, whereas Russia is not even among India’s top 25 trade partners.

The breakup will not have a major impact on the US-aligned bloc, other than to make problems in sourcing some raw materials, but it will have a much bigger impact on China-led bloc. China’s own current economic slowdown will also be a problem for both the bloc and the global economy. (chart)

“One consequence is that even if not much appears to change for advanced economies, the shape of the world in 2050 could be very different from what many currently suppose. The share of global output accounted for by the China-bloc has increased sharply over the past three decades, from 10% in 1990 to 25% today. But this surge will peter out over the next few years, in large part due to the productivity sapping effects of fracturing. The China-aligned bloc's weight in the global economy won't increase substantially from here,” says Capital Economics.

What remains unclear is how sever the fracturing will be. So far China, while supporting Russia, has kept enough distance to avoid becoming the target of sanctions itself. Currently China’s trade turnover with the West is around $1 trillion a year and it has another $1 trillion invested in US T-bills. Beijing has invested heavily in developing its technology sector but is not self-sufficient. As the tensions rise, and they will continue to do so, smaller poorer countries will it increasingly difficult to stay out of the fray. (chart)

 

A full break is not possible, as the global economy is now too deeply intertwined. The West’s biggest vulnerability is many of the exotic materials needed in modern manufacturing are produced or refined in Emerging Markets and not Developed Markets. China has limited supplies of some rare earth metals, but it dominates the refining of most of them. In Europe, Ukraine happens to be the only producer of the noble gas neon that is essential in the production of lasers. And Russia is famously home to large deposits of most of the elements on the periodic table as well as food and oil products. (chart, chart)

The majority (57%) of global supplies of coal come from the China-led bloc, with China alone accounting for over half of the world's production and Russia making up another 6% of global supply. As coal is bulky, proximity makes a difference and the EU imported 46.7% of its coal from Russia – the highest share of any of the fuels imported to the EU from Russia.

Coal imports from Russia was banned in April as part of the fifth package of sanctions that came into effect on August 10, but since then the EU has been forced to ease these sanctions again as it has been unable to source enough coal from elsewhere.

Europe’s oil and gas dependency is much more significant as bne IntelliNews reported in a deep dive into oil and gas and the sanctions leakage that has already begun. But the production of oil and gas globally is much more balanced between the US- and Chinese-led blocs.

The two blocs are also fairly well balanced on food security, producing enough for their own consumption. Russia’s power in agriculture is its large share in the narrow traded-grain business and that specifically affects Africa and the Middle East, which import large amounts of Russian grain.

But these are all well-established commodities with decades of investment behind them and multiple producers. Where the scales are heavily tipped in the Sino-Russia bloc’s favour is in the new commodities which have risen in importance recently thanks to technological advances. Lithium and cobalt in particular are the new kids on the block due to the electric vehicle (EV) revolution and their production is heavily concentrated in just a few countries.

China plays a particularly important role here, as although it doesn’t have a wide range of deposits, it has invested heavily in the refining of these more exotic materials and typically has a 50% market share or more from the sale of the refined metals.

“To conclude, the US-led bloc looks in a fairly good position to secure supplies of food and energy, but China holds the cards on supply of metals, notably those needed to transition to a green economy,” says Capital Economics.

Fractured financial flows

One of the most crushing sanctions imposed on Russia was the SWIFT sanctions only days after Russia’s invasion of Ukraine. The US has in effect weaponised the dollar and ejected Russia from the global financial system.

Russia was already actively de-dollarising before the war in Ukraine started, but it has redoubled its efforts since. It set up its own equivalent of SWIFT in 2014, the System for Transfer of Financial Messages, to reduce the risk of sanctions imposed on Russian businesses and banks. Despite Russian declarations on the effectiveness of this system, SPFS has suffered from a number of shortcomings, including high transaction costs, system availability and security requirements, which have undermined its reliability and usefulness.

China is due to join the SPFS system in 2022 and India said in 2019 that it was also interested in joining, but neither country has followed through yet. Iran is another candidate to join after it was banned from SWIFT in 2012.

At the same time, Russia set up a card settlement system in 2017, the MIR payment system that is meant to serve as an alternative to the US-based Visa and MasterCard system. MIR has already been accepted in 11 other countries, although US pressure recently forced Turkey’s leading banks to abandon the system, followed by Egypt’s banks a few days later.

China too is concerned with the dominance of the dollar and there is a general trend to settle trading bills in national currencies. From almost zero, Russia and China settled 41.5% of their trade in national currencies in 2020. The use of the rupee-ruble in bilateral transactions has quintupled recently.

Since new extreme sanctions were imposed this year, Russia is rapidly going through a process of yuanisation its financial system as much as it can; Russia already has the largest share of yuan in its reserves basket of any country in the world and the number of banks offering yuan-denominated deposit accounts in Moscow has gone from one to 20 since the war started.

Whereas the first two episodes of globalisation were driven by the improvement of shipping and especially the advent of steam-powered ships, the last episode was driven by the improvement in the speed of communications and the transfer of large amounts of data that allowed for financial integration. The daily turnover on FX markets soared from $500bn a day in 1989 to $6.5 trillion in 2019.

“A key pillar of the so-called "Washington Consensus", which shaped global economic policy in the 1990s and 2000s, was a belief in floating exchange rates and open capital accounts. This loosened restrictions on central banks' ability to create money (subject to them meeting their inflation targets), and then allowed that money to cross borders more freely,” says Capital Economics.

During the third wave of globalisation countries steadily dismantled controls that had previously restricted the movement of capital. In emerging economies, this liberalisation often formed part of IMF programmes. This is why the SWIFT sanctions will be particularly crippling for Russia, as integration into the global financial system is a crucial element in driving its growth.

This financial integration has been most intense in the US-aligned bloc. By 2020 claims of China-aligned countries on US-aligned countries were $3.6 trillion and US-aligned claims on China-aligned were $3.1 trillion; however, claims amongst US-aligned countries between themselves was $65 trillion by 2020. The “global financial system” remains very much a developed market phenomenon. (chart)

The US has been by far the biggest beneficiary of globalisation and the changes wrought to the global financial system. It has only enhanced the power of the US in the global financial system as an estimated 50% of all this trade that is sent by SWIFT in dollars and 60% of central bank reserves are denominated in dollars, according to Capital Economics. Russia and China’s efforts to switch to using their own currencies to settle trade deals is very much at the margin of the global financial system.

“The dominant use of the dollar in cross-border transactions has increased the centrality of the US within the global financial system. In effect, the US now provides the financial plumbing for the world economy,” says Capital Economics.

Nevertheless, the global financial crisis in 2008 and the technology sanctions being imposed now have already slowed the expansion of cross-border bank transfers.

“The reduced growth of financial flows may also reflect the fact that many of the gains from the IT revolution in finance have already been reaped,” says Capital Economics, adding that tougher banking regulation that followed the Great Financial Crisis, such as the Basel III and IV rules, have also made it more difficult to make international transfers.

Going forward, trade is likely to grow in line with GDP growth, rather than in the boom years of the last globalisation episode, where trade grew much faster than GDPs. And as firms become more cautious and shorten their supply chains or re-shore factories, trade may start to grow more slowly than GDPs. Europe has already seen its trade plunge into the biggest deficit on record this year as a result of the dislocations caused by the war in Ukraine.

That said, a number of international brands will remain in Russia despite the sanctions, highlighting the fact that the global economy is not in a Cold War with an impenetrable curtain, but only fractured, making this trade more difficult. French yoghurt-maker Danone is not pulling out of Russia but transferring the ownership to a Russian entity. Spanish fashion chain Zara has also transferred the ownership of its Russian business to a “friendly” domicile. And Swedish furniture maker IKEA has already said that it will return to Russia in two years' time. More than 1,000 foreign firms have said they will pull out of Russia, but in reality only about two or three dozen have actually followed through, according to one study by Kyiv School of Economics (KSE), and others continue to supply Russia via the parallel import schemes.

The dollar is likely to retain its dominant position in global trade despite the fact it only accounts for 10% of global GDP. Any replacement has to serve three functions: act as a unit of account; a medium of exchange; and be a store of value. Any currency can be a unit of account, but to be a medium of exchange the currency must have deep pools of liquidity. The euro could possibly challenge the dollar and is widely used inside the EU, but neither the ruble nor the renminbi meet all these conditions.

“The global economy and financial system may be stuck in an awkward half-way house. Financial links will remain large relative to GDP but integration will stagnate. Global finance will increasingly split into two unequal but rivalling camps that are still co-dependent. And, for better or worse, the dollar will remain the dominant global currency, giving US policymakers significant sway over core financial markets and infrastructure,” Capital Economics says.