Werner's Blog — Opinion, Analysis, Commentary
Reglobalization, not deglobalization

Russia's invasion of Ukraine has prompted a concerted response in the form of economic sanctions against Russia. This war has raised many questions about the consequences for the global economy and world trade. The atrocities committed by Russia's army in Ukraine on the orders of a megalomaniacal Vladimir Putin require a triple response: enabling Ukraine to defend its territory; diminishing Russia's ability to produce weapons and materiel used against Ukraine; and inflicting economic consequences that destabilize the Putin regime domestically. Economic sanctions are an immediate response. In the long term, we also need to rethink globalization. One one hand, economic integration creates the ability to inflict economic costs on a war-mongering country. On the other hand, economic integration also imposes costs on the countries imposing sanctions. For sanctions to be effective, they need to be asymmetric—inflicting greater pain on the offender, while dispersing the pain among the countries imposing sanctions—and they need to be adhered to widely.

For the world economy the question looms whether sanctions will reshape international trade permanently. On March 30, 2022, opinion writer Spencer Bokat-Lindell asked the question Will the Ukraine War Spell the End of Globalization? in The New York Times. Is the world economy turning away from globalization towards greater self-sufficiency? Will we see the dawn of deglobalization, a reversal of globalization? Politicians in many western countries have been flirting with protectionism and "repatriating" offshored production. There is a danger that Russia's war is leading to the wrong conclusions: that the answer is disengaging from world trade instead of reshaping world trade.

‘The economic case for international trade remains compelling, but new political realities require new economic responses.’

The economic rationale for globalization is very strong: countries specialize in what they do best, engage in international trade, and reap large economic benefits through comparative advantages. The two downsides of this specialization is concentration and dependency. Economies of scale combined with other local advantages lead to fewer producers, and often dominance by a few producers or producing countries. Dependency comes from the need to import goods from foreign countries, which may not always be reliable or—in the case of Russia—rage war and violate the principles of the UN Charter. Russia and Ukraine together account for about one fifth of global wheat production, and Russia's war against Ukraine has sent food prices up significantly, fueling inflation in many countries. Russia is also a producer of about one tenth of world petroleum supplies, and sanctions impacting this supply have been driving up world oil prices. So while the economic case for international trade remains compelling, the new realities created by Russia's aggression require new responses to adapt our system of international trade to these new realities.

Whether economic sanctions are effective depends on the degree to which they are diminishing the targeted country's overall production through denying critical imports and diminishing the ability to earn foreign currencies through exports. Ineffective sanctions merely reshuffle trade flows, at some cost, but without affecting the overall volume of trade. Reshuffling occurs if Russia's exports to the US and the EU decrease but are offset by increased exports to, for example, China and India. Sanctions against Russia are only effective if reshuffling channels can be diminished. Some goods can be reshuffled more easily than others. Oil on tanker ships can be sent to different ports, but natural gas requires pipeline capacity or liquefaction and regasification capacity by exporter and importer country. Reshuffling still imposes economic costs, because it replaces more profitable export destinations with less profitable export destinations. However, reshuffling imposes economic costs not only on the sanctioned country. The countries imposing the sanctions also need to find alternative supplies, and those will be from higher cost sources. Who wins are third countries that can either import products at a discount from the sanctioned country, or can export products at a premium to sanctioning countries. Closing down reshuffling ultimately requires imposing secondary sanctions on third countries that defy primary sanctions.

China has been taking a position of neutrality in the conflict. Yet, China is unlikely to profit from Russia's war economically. While some Chinese firms may be able to import cheaper Russian oil and gas, China still needs to import fuels from other countries at a much higher cost. China is not energy independent and will suffer the same fate as other economies as fuel prices rise. China will also be wary about the effects of secondary sanctions imposed on Chinese exporters that do not comply with sanctions imposed by western countries. All in all, Russia's war is a disaster for China's commercial interests, and Xi Jinping committed a historic blunder by aligning himself with Vladimir Putin on the basis of perceived "western decline" and a kinship among authoritarian leaders. Today's reawakening of Atlanticism, a strengthening of the North Atlantic defense alliance, is a historic shift. The western world has come to realize its strategic vulnerability in a multipolar world. Rather than Europe drifting away from America in the wake of the anti-Atlanticist Trump administration, the new circumstances have forged together a new sense of purpose. This new-found purpose calls for more strategic resilience. However, in a more uncertain world, economic resilience comes at a premium. Defending liberal democracy necessitates putting resources into military defense, but also strengthening our internal defenses against illiberalism.

‘Reglobalization must promote resilience, retractability, and responsibility.’

So where does world trade go from here? That's the billion dollar question that trade experts are contemplating. Are we really headed towards deglobalization? I find the term deglobalization rather misleading because it suggests a turn-around, a turn away from globalization towards autarky. Such a reversal is both unlikely and unnecessary. The question is not about diminishing international trade, but to reorganize it in such a way that it provides greater resilience in case of disruptions, greater retractability in response to bad actors such as Russia, and greater responsibility in terms of environmental sustainability and human rights. Call it the three "Rs" of reglobalization, a concept that I would like to introduce as a distinct alternative and to distinguish it specifically from naïve deglobalization. Reglobalization is characterized by a significant degree of reshuffling of international trade along the lines of trading with reliable trade partners who act responsibly.

‘Resilience combines diversification with investments into pre-disruption redundancy and post-disruption recovery.’

What does reglobalization look like in practice? How is reglobalization compatible with market forces and international trade law? The answers to this are complex. Companies will ordinarily converge on least-cost solutions that pursue comparative advantages regardless of other societal objectives. Such objectives can only be imposed by influencing markets, by creating incentives or imposing regulatory constraints for resilience, retractability, and responsibility. In some instances market forces are already at work to reward responsibility through certification of sustainability or fair trading practices. A combination of green/ethical consumerism and green taxes on negative externalities can go a long way to make international trade more sustainable environmentally and promote responsible production methods and labor standards. However, resilience and retractability are not easily achieved through such channels. Resilience is both a macroeconomic and microeconomic outcome. Individual firms can become more resilient through greater pre-disruption redundancy investments and post-disruption recovery investments. Retractability means being able to abandon foreign operations without lasting harm to the firm overall. Macroeconomically, resilience means import and export diversification, and retractability means ability to abandon foreign markets without harm to the economy overall. There is clearly no free lunch here. The three Rs of reglobalization inflict significant economic costs, and require government investments and regulation to support these goals. This ultimately raises the question: what price are we willing to pay for maintaining high standards? It means that we can no longer avert our eyes from seeing where and how our consumer goods are produced. We need greater transparency, visible to all of us, about which products meet which standards.

There is one area where reglobalization has a clear perspective: energy. Moving away from fossil fuels will lessen the dependence on energy imports because renewable energy sources tend to be domestic: hydro power, geothermal power, wind power, and solar power can all be harvested locally. Nuclear power depends on uranium, but uranium is available from reliable sources. The electrification of mobility will go a long way to lessen our dependence on fossil fuels and thus has taken on even greater urgency.

Our economy's dependence on minerals and metals remains a source of vulnerability because their availability has a strong geographic element. To the extent that we rely on imports of these from problematic sources, we need to look either at diversifying sources or finding substitute materials. In some cases this involves investing in exploration in locations that are deemed dependable, even if it involves higher production cost. Nevertheless, the problem will remain that such higher costs will increase the price of many goods. Call it the "freedom premium". Some exposure to political risks will always remain, but through diversification of these risks their economic impact can be mitigated significantly.

‘Firms must prepare for worst-case scenarios of leaving foreign markets and prepare exit strategies that minimize pain.’

The notion of retractability pertains to investments more than to exports and imports. Retractability is the ability to walk away from foreign investments without threatening the economic viability of a firm. The risk of expropriation always looms over foreign investments in unfriendly foreign countries. Thus smart investments have a safety valve: financing the foreign investment with a foreign loan in that country's currency. In the case of sanctions, an investor can walk away without jeopardizing equity as the investment position is "net zero", as assets (a foreign plant) are balanced by liabilities (a foreign loan). Retractability may also involve having a plan to turn over assets to a trusted foreign partner instead of risking outright expropriation. Retractability may seem like a sleight of hand, but it is not. Once retracted, the stream of knowledge and technology that comes from a company's home will cease, and the foreign plant will also lose critical intermediate goods supplies. Of course, retraction is a costly endeavour. But no firm should enter a foreign market without having a clear plan for departure—and exit strategy that minimizes pain.

Reglobalization must also be seen through the lens of world trade law. The two most fundamental principles of world trade law involve non-discrimination: treating trading partners alike (the most-favored nation principle) and treating domestic and foreign companies alike (the national treatment principle). Reglobalization distorts trade flows and thus impedes these two World Trade Organization (WTO) principles. Yet, there are important exceptions to these two principles. In order to balance trade distortions from differential carbon pricing around the world, and thus prevent carbon leakage, the European Union has introduced a carbon border adjustment mechanism (CBAM) that will become fully operational in 2026. The CBAM conflicts with both WTO principles, but will likely remain compatible with trade law through exceptions in article XX that allow for the protection of the environment. It is yet difficult to see how a similar mechanisms can be designed that extends into other areas of responsible behaviour. We can measure carbon content of goods, but how do you measure adherence to democratic principles and human rights? What other tools are at hand that remain WTO-compliant?

‘Any new Free Trade Agreements need to align with promoting greater resilience, retractability, and responsibility.’

The most obvious way to increase retractability is to realign free trade areas in such a way that they promote peace and democracy. Free trade must be conditional on meeting human rights obligations, including the right to free speech and free assembly. Free trade must be a privilege that is earned through demonstrated commitment to protecting fundamental human rights. The long-held notion that economic engagement opens up autocratic countries was proven wrong by Russia. Instead, economic engagement has enabled recklessness. Any new free trade agreements must promote greater resilience, retractability, and responsibility. This means they need to be more comprehensive agreements and go beyond trade. For resilience, FTAs need to pass the test of enhancing diversification of supplies. This they typically do For retractability, they need to have a mechanism through which they can be suspended if a trade partner violates key obligations. And for responsibility, FTAs need to explicitly acknowledge working conditions and human right, as well as environmental sustainability.

Fortunately, countries are already moving in this direction. Canada's Comprehensive Economic and Trade Agreement (CETA) with the European Union, and the new Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) include elements that go beyond trade. Widening the scope of the partnership should include elements that further the three Rs of reglobalization.

‘Will China choose diplomacy over bellicosity? ’

The country that could be most affected by reglobalization is China. Whether China's position in world trade will become the target of a major re-evaluation depends crucially on which path the country takes: will China choose diplomacy over bellicosity? The leaders of China's Communist Party, most notably president Xi Jinping, have made it rather clear that they have the ambition to reunify Taiwan with the mainland, and by force should Taiwan declare independence. If China is presenting itself as a future country at war, this posture jeopardizes integration into the world economy as investors in China, exporters to China, and importers from China, all are at risk of huge economic disruptions should a war break out across the Taiwan Strait. Clearly, such a conflict could never be in China's commercial interests, just like Russia's war today is not in Russia's economic interest either. For the Taiwan Strait to remain peaceful, mainland China needs to commit to using only diplomatic means to resolve the issue of Taiwan's status, and ultimately accept if Taiwan wants to reunify with the mainland or pursue an independent path. Sadly, China's current leadership is fueling nationalist sentiment and is repeating Russia's lies about its war in Ukraine. China's political choice today casts a dark shadow over China's trade relations with the West. The world economy has benefited hugely from China's integration, and China has been able to realize unprecedented economic growth in a short period of time. Yet, the specter of conflict across the Taiwan Strait should make all liberal democracies wary of their exposure to China's economic heft. Which countries and industries meet the criterion for retractability from China? The truth is that China's economy is seven-to-eight times larger than Russia's, and economic turmoil involving China would be hugely more disruptive. The burden is on China to choose diplomacy over bellicosity, and develop structures that ensure and guarantee durable peace in the region. But the Western world needs to be prepared for events to take a turn for the worse. In Russia's case, too long wishful thinking about the true aspirations of the Putin regime prevailed. Western countries need to learn from this colossal mistake.

World trade has arrived at a crossroads. Some things need to change to realize most of the benefits from free trade while maintaining resilience, retractability, and responsibility in trade relationships. It's doable, albeit not for free. How much reglobalization we need remains to be explored vigorously. The answer is clearly not zero if we value liberty and democracy, and also if we value a sustainable future for our fragile planet. But importantly, the world does not need deglobalization. We need to look towards maintaining as much open trade as possible while remaining cognizant of the political aspirations of our trade partners. The world cannot afford to deglobalize. Instead, careful reglobalization needs to strengthen global institutions and multilateralism.

Further readings and information sources:

Posted on Thursday, April 21, 2022 at 17:00 — #Trade
© 2024  Prof. Werner Antweiler, University of British Columbia.
[Sauder School of Business] [The University of British Columbia]