Nicholas Mitsakos

While the current trade war commands our immediate attention and thoughts about its impact on the global economy, there are deeper and perhaps more troubling issues regarding globalization and its future.

The international flow of goods, money, ideas and people has been the most important global economic and social factor in the world for the last 30 years, reshaping nations and the relations between states. Globalization has permeated and impacted the world, overwhelmingly for the good.

Recently, the pace of economic integration around the world has slowed by many measures. How severe will it become? How much will the current trade war impact it? What will global commerce look like in the aftermath?

There have been periods of globalization throughout history, but our recent unprecedented era for the last 30 years came from several sources.

World trade rose from 39% of GDP in 1990 to 58% in 2018 and international assets rose from 128% to 401% of GDP (source: The Economist Intelligence Unit). While the world is far more integrated, parts remain mostly outside the global economy. About 1 billion people live in countries where trade is less than a quarter of GDP. While there is great opportunity for continued growth, we seem to be sliding backward.

    • The United States’ sponsorship of a new world order after World War II allowed the cross- border flow of goods and capital to recover after years of war andchaos.
    • China, India and Russia integrated into the global economy, to various degrees, and European countries established the European singlemarket.
    • Containerized freight was perhaps the single greatest development, dramatically reducing shippingcosts.
    • The World Trade Organization was established supporting, among other things, global tariff cuts and a common set of rules for globaltrade.
    • NAFTA, impacting the world’s largest economy more significantly than initially realized, integrating the United States in both regional and global trade.
    • unprecedented international capital flows and foreign direct investment. Capital moved quickly to new markets, and stayed where it was treated well, further accelerating growth and global integration.

Stagnation and the long hangover from the financial crisis

Measures of global integration (as presented by the IMF, Bloomberg, McKinsey and The Economist in the chart below) are mostly stagnating, many unrecovered since the financial crisis in 2008. Trade has stagnated from 61% of world GDP in 2008 to 58% now. The capacity of supply chains that ship half- finished goods across borders has shrunk. Intermediate imports rose fast in the 20 years to 2008, but since then have dropped from 19% of world GDP to 17%. The share of global profits of all listed firms has dropped from 33% in 2008 to 31%. Long-term cross-border investment by all firms has tumbled from 3.5% of world GDP in 2007 to 1.3% in 2018.

Cross-border bank loans have dropped from 60% of GDP in 2006 to about 36% (driven mostly by reductions in European lending). Gross capital flows have fallen from a peak of 7% in early 2007 to 1.5%. When globalization boomed, emerging economies found it easy to catch up with the rich world in terms of output per person. Since 2008 the share of economies converging in this way has fallen from 88% to 50% (using purchasing-power parity).

A few measurements show rising integration. Migration to the rich world has risen (albeit slightly) over the past decade. International parcels and flights are growing fast. The volume of data crossing borders has risen by 64 times (according to McKinsey), perhaps mostly thanks to YouTube’s global popularity.

What’s going on?

There are several underlying causes of the slowdown in globalization.

    • Trade is not getting cheaper. After sharp declines in the 1970s and 1980s, tariffs and transport costs as a share of the value of goods traded is about the same as 10 yearsago.
    • Banks are not financing trade to the same degree as prior to the financial crisis. Also, banking the world has been less profitable than hoped. The rate of return on all multinational investment dropped from an average of 10% in 2005-2007 to 6% in2017.
    • Local competitors were more capable than expected and large investments and takeovers often flopped.
    • Services are becoming a larger share of global economic activity and they are harder to trade than goods. While there are exceptions for software services provided by large technology companies, for example, professionals – accountants, lawyers, doctors, etc. mostly can only serve a localmarket.
    • Emerging economies are getting better at making their own inputs, allowing them to be self- reliant. Factories in China, for example, can now make most parts for an iPhone, except for advanced semiconductors. Made in China used to mean assembling foreign widgets in China; now it really means making thingsthere.
    • Trade and supply chains appear saturated, as the pull of cheap labor and multinational investment in physical assets have become lessimportant.
    • Financial flows, such as bank loans, have not quite picked up as the shock of the financial crisis receded and Asian financial institutions gained more reachabroad.
    • The trade war, with increased tariffs covering a large range of goods, has created uncertainty which far exceeds its direct economic impact. Revenue raised from tariffs, as a share of the value of all imports, is expected to rise to over 3%. The last time it was that high was in 1978, although it is still far below the level of over 50% seen in the 1930s (the wholly disastrous policy that sentenced the world to extended years of economic depression and perhaps WWII). The uncertainty regarding tariffs is causing an outsized fearful reaction – and that reaction may have a longtail.

Uncertainty regarding the sustainability of international relationships and economic integration seem to be the greatest overall factor. Global reaction to this uncertainty is causing increased fragmentation, more localized protection, and less integration – thus, lower economic growth overall.

The Almighty Dollar

America’s control of the dollar-based payments system (over 60% of all trade is denominated in US dollars, and 90% of all global trade is ultimately settled in US dollars, including the global trading in commodities), the backbone of global commerce, gives the U.S. an overwhelmingly powerful weapon. A weaponized dollar is a Sword of Damocles over any particular country’s head and perhaps the global economy in general – if it threatens to use that power irresponsibly.

Examples of the impact from flexing the dollar’s muscle come from the experience of two Chinese companies. One is ZTE, which was temporarily banned from doing business with American firms. The practical consequence was to make it hard for it to use the global financial system, with devastating results. Another is Huawei. It is ostensibly being investigated for violating financial sanctions. But national security concerns and other issues have also been raised. Fundamentally, it is a devastating dollar-based sanction. Punishment could be a ban on doing business in America, which in effect means a ban on using dollars globally.

Another dollar risk is that U.S. Federal Reserve may not act as a lender of last resort for foreign banks and central banks that need dollars, as it did during the financial crisis. Other central banks are preparing for a post-American era. But this seems unrealistically optimistic, given the dominance of the dollar, and the likelihood that it can be replaced anytime soon is questionable at best. The dollar’s nearest competitor in global trade is the Euro, which accounts for slightly less than 15% of trade value. In spite of attempts to make it more integrated and important, has leveled off here, and is unlikely to increase its share substantially. The Chinese yuan is not freely exchangeable and controlled by the Chinese central government, making it almost impossible to play an important role, much less a dominant role, in globaltrade.

Trading partners are becoming more acrimonious. China is raising tariffs and used its antitrust apparatus to block the acquisition of NXP by Qualcomm. China is also pursuing an antitrust investigation against a trio of foreign tech firms—Samsung, Micron and SK Hynix—which its domestic manufacturers complain charge too much. State interference is not limited to China. In Europe, governments are becoming much more active in using their minority ownership or “golden share” to be influential. An example is France taking an overt role in the dispute between Renault and Nissan, having been inactive for years. States will continue to be more active to serve local interests despite global ownership and markets. Expect more state interference, even in previous “free” markets.

War, what war?

Most multinational firms continue to insist to investors that the current trade war does not matter. The impact of tariffs to total profits in 2018 is about $6 billion or 3%. Most firms said they could pass on the costs to customers. Many claimed their supply chains were less extended than believed, with each region a self-contained silo. This seems a bit fanciful.

This attitude is changing as executives factor in not just the mechanical impact of tariffs but the broader consequences of the trade war on investment and confidence, not least in China. Federal Express said that business was slowing, Apple said that trade tensions were hurting its business in China, and Samsung gave a similar message, among many other large companies with significant business interests in China and other markets.

America has had fleeting moments of protectionism policy before. But, is this time different? The U.S. had a protectionist action against Japan in the 1980s, but the U.S. share of global GDP was roughly 33% in 1985 and the U.S. used that leverage to resolve issues favorably for the United States. Today, the U.S. share of global GDP is roughly 25%, and the U.S. may not have the same kind of leverage in negotiations with trading partners, especially China. Fear of trade and anger about China is bipartisan and will not subside easily. Globalization, as seen between 1990 and 2010, is no longer underwritten by America and no longer commands popular consent in the West. The outcome may be suboptimal for all parties, especially the U.S.

Where do we go from here?

Supply chains are not easy to adjust. Multinationals are looking at how to shift production from China, but it is not as simple as changing a physical location. Logistics, network systems and processes are complex and integrated. An exodus cannot happen overnight, if at all. For example, Apple is committed to paying its Chinese vendors $42 billion in 2019 and the contracts cannot be cancelled. It relies on a long tail of over 30 (barely profitable) suppliers and assemblers of components. If these firms were asked to shift their factories from China, they might struggle to do so quickly – the cost could be anywhere between $25bn and $90bn, making this tactic nearly impossible.

Over time, however, firms will apply a higher cost of capital to long-term investments in industries that are politically sensitive, such as tech, and in countries that have fraught trade relations. This will slow down cross-border investment, as well as domestic investment intended for production to serve overseas markets. This impact is understated by current policymakers. The legal certainty created

by NAFTA in 1994 and China’s entry into the WTO in 2001 boosted multinational investment flows. The removal of certainty will have the opposite effect.

Already, activity in the most politically sensitive channels is falling. Investment by Chinese multinationals into America and Europe sank by 73% in 2018. Overall global foreign direct investment, including cross- border M&A activity, fell by 20% in 2018. This trend seems to be continuing in 2019, and it is expected that foreign direct investment will be another 20% lower in 2019. This trend has a substantial long-term impact beyond 2019 since foreign direct investment leads to years of potential return in that local market. Such a significant drop will have a meaningful negative effect for many years in those countries.

Back to that war

These trends can be used as a crude indicator of the long-run effect of a continuing trade war. Assume that foreign direct investment does not pick up, and that the recent historical relationship between foreign direct investment and international trade can be extrapolated. On this basis, exports would fall from 28% of world GDP to 23% over a decade. That would be equivalent to a third of the proportionate drop seen between 1929 and 1946, the previous crisis in globalization.

Perhaps firms can adapt, shifting away from physical goods to intangible ones. Trade in the 20th century morphed three times, from boats laden with metals, meat and wool, to ships full of cars and transistor radios, to containers of components that feed into supply chains. Now the big opportunity is services.

The flow of ideas can pack an economic punch; over 40% of the productivity growth in emerging economies in 2004-2014 came from knowledge flows (according to the IMF).

Overall, exports of services for the last 10 years have stagnated at about 6-7% of world GDP. But new technologies do enable more effective remote workers and the provision of higher value-added global services. Indian outsourcing firms are shifting from running functions, such as Western payroll systems, to more creative projects, such as configuring new Walmart supermarkets. Cross-border e-commerce is growing. Alibaba expects its Chinese customers to spend at least $40 billion abroad in 2023. Netflix and Facebook together have over a billion cross-border customers.

Reality check

It is a seductive story, but the scale can be overstated. Typical American Facebook users have 70% of their friends living within 200 miles and only 4% abroad. The cross-border revenue pool is relatively small. In total the top 1,000 American digital, software and e-commerce firms, including Amazon, Microsoft, Facebook and Google, had international sales equivalent to 1% of all global exports in 2017. Facebook may have a billion foreign users but in 2017 it had similar sales abroad to Mondelez (all due respect to Oreo cookies).

Technology services are especially vulnerable to politics and protectionism, reflecting concerns about fake news, tax-dodging, job losses, privacy and espionage. Here, the dominant market shares of the companies involved are a disadvantage, making them easier to target and control. America discourages Chinese tech firms from operating at scale within its borders and American companies like Facebook, Google and Twitter are not welcome in China.

This behavior is spreading. Consider India, which Silicon Valley had hoped was an open market where it could build the same monopolistic positions it has in the West. India passed rules that clobber Amazon and Walmart, which dominate e-commerce there, preventing them from owning inventory. The objective is to protect local digital and traditional retailers. Draft rules would require internet firms to store data exclusively in India. A third set of rules requires financial firms to store data locally, too.

Significant restrictions favoring local companies, such as those in India, are a more likely model for other countries to emulate. Substantial value can be created in these local markets, as seen in both China and India. Politically, the value created will be kept within borders among local companies much more than large international companies had anticipated. Global markets, especially for technology services and other new services and technologies, will be much more fragmented and may not be as available for consolidation and centralized systems as large, mostly American-based, technology companies believed.

Furthermore, trade in services might bring the kind of job losses that led manufacturing trade to become unpopular. Imagine, for example, if India’s IT services firms, experts at marshalling skilled workers, doubled in size. Assuming each Indian worker replaced a foreign one, then 1.5 million jobs would be lost in the West. Even the flow of raw ideas across borders can be slowed. New restrictions on Chinese scientists’ access to research programs are being considered in the U.S. America’s new investment-vetting regime could hamper venture-capital activity. Technology services will not evade the backlash against globalization and is very likely to make itworse.

As globalization fades, cross-border commerce will become more regional. This matches the trend of shorter supply chains and fits the direction of geopolitics. The picture is clearest in trade. The share of foreign inputs that cross-border supply chains source from within their own region – measured using value added – has risen since 2012 in Asia, Europe and North America, (according to the OECD).

Global becomes regional

The global interconnected world is fragmenting.

    • Multinational activity is becoming more regional. A decade ago, a third of foreign direct investment flowing into Asian countries came from elsewhere in Asia. Now it is half. Asian firms made more money selling things to the other parts of Asia than to America in 2018. In Europe around 60% of foreign direct investment has come from within the region over the past decade. Outside their home region, European multinationals have leaned towards emerging markets and away from America. American firms’ exposure to foreign markets of any kind has stagnated for a decade.
    • The legal and diplomatic framework for trade and investment flows is also becoming more regional. A new version of NAFTA (USMCA) in North America, the European Union has a new regime for screening foreign investment, and China is backing several regional initiatives, including the Asian Infrastructure InvestmentBank.
    • Tech governance is becoming more regional, and this is adding increased trade tension (and especially acrimonious tax issues). Large U.S.-based tech firms have become global targets. Europe now has its own rules for the tech industry on data, privacy, antitrust and tax. China’s techfirmshaverisinginfluenceinAsia.NoemergingAsiancountryhasbannedHuawei,despite Western firms’ security concerns. The likes of Alibaba and Tencent are investing heavily across South-EastAsia.
    • Both Europe and China are trying to make their financial system more powerful. European countries plan to bring more derivatives activity from London and Chicago into the euro area after Brexit and are encouraging a wave of consolidation among banks. China is opening its bond market, which over time will make it the center of gravity for other Asian markets. As China’s asset-management industry gets bigger it will have more cloutabroad.

Yet the shift to a regional system comes with three big risks.

    • First, two of the three zones lack political legitimacy. The EU is unpopular among some in Europe. Far worse is China, which few countries in Asia trust entirely. Traditionally, economic hegemons are consumer-centric economies which create demand in other places by buying lots of goods from abroad, and which often run trade deficits as a result. Yet both China and Germany are mercantilist powers that run trade surpluses. As a result, there could be lots of tensions over sovereignty and one-sidedtrade.
    • Second is finance, which remains global for now. Money management firms are global. The dollar is the world’s dominant currency, and the decisions of the Fed and gyrations of Wall Street influence interest rates and the price of equities around the world. When America was ascendant the patterns of commerce and the financial system were complementary. During a boom healthy American demand lifted exports everywhere even as American interest rates pushed up the cost of capital. But now the economic and financial cycles may work against each other. Over time this will lead other countries to try to switch away from the dominance of dollar and Fed policy. But this is still unlikely, and it creates a higher risk of financial crises.
    • The final danger is that some countries and firms will be caught in the middle or left behind. Taiwan makes semiconductors for both America and China, Apple relies on selling its devices in China. Africa and South America are not part of any of the big trading blocks and lack a center of gravity, among many other countries and firms outside of the mainstream.

Many emerging economies now face four headwinds:

    • Fading globalization
    • Automation
    • Weak educational systems that make it hard to exploit digitalizationfully
    • Climate-change-induced stress in farming industries, and thus local foodsupplies.

Far from making it easier to mitigate the downsides of globalization, a regional world would struggle to solve worldwide problems such as climate change, cybercrime or tax avoidance. Every economy, local market, regional trading group in the global interdependence would be weaker and less valuable.

Globalization is inevitable, barring an unforeseen catastrophe. Technology advances, lowering the cost of trade in every corner of the world, while the human impulse to learn, copy and profit from strangers is irrepressible. Yet, there now seems to be a period of slow global economic growth because of the fragmentation of globalized systems. Integration is stagnating or declining in many areas. Globalization created huge benefits but also costs and a political backlash. The new pattern of commerce that is emerging is no less fraught with opportunity and danger.

Opportunities may be regional, and integrated global players will not be as prosperous. Innovation in technology (ranging from AI-based robotics to web-based services) will continue to find opportunities globally, but these may be more selective, and scale creates local political backlash.

The global economy will slow due to the factors outlined here. Through this fragmentation and stagnation will come improved systems and the potential for increased prosperity. But there will be challenges and difficulty in reaching a newly refined and stable global structure.

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