RegStream

Navigating a fragmenting global trading system: insights for central banks

AFA Panel: Geopolitical Fragmentation

2025 ASSA Annual Meeting, San Francisco

3 January 2025

1

Philip R. Lane Member of the Executive Board

www. ecb. europa. eu ©

Outline

Based on “Navigating a fragmenting global trading system: insights for central banks”, Occasional Paper Series, No 365, ECB.

Explores major re-alignments of global trade due to non-tariff barriers

Not a conjunctural analysis of tariff policies

2

Defining geo-economic trade fragmentation

Policy-driven reversal of global trade integration motivated by domestic economic policy objectives and geopolitical as well as strategic considerations

Basic setup: three geopolitical blocs

West (42% world GDP PPP)

Neutral (31%)

East (27%)

Notes: The allocation of countries to blocs is based on the geopolitical index developed by den Besten et al. (2023). This index is based on the voting patterns of countries at the United Nations General Assembly (UNGA) and includes additional measures of political alignment and economic ties between countries.

3

Ongoing selective decoupling along geopolitical lines

Western bloc’s import shares (percentage points; percentage points change)

Share of imports from China by product category

(percentage)

Intra bloc Neutral Opposite bloc

4

2

0

-2

-4

-6

2017-19

2021-23

4

2

0

-2

-4

-6

Others

Russia to EU

China to United States

United States - Advanced technology products EU - Advanced technology products United States - Products needed for the green transition EU - Products needed for the green transition

35

30

25

20

15

10

5 2017

2019

2021

2023

Sources: Conteduca et al. (2024) and Trade Data Monitor (TDM).

Sources: Conteduca et al. (2024) and Trade Data Monitor (TDM).

4

Firms are de-risking from China, mainly via EU-shoring

Actions taken to reduce exposure to China

(percentage of firms relying on critical Chinese inputs)

De-risking action Considering de- risking action No de-risking on the way

100

90

80

70

60

50

40

30

20

10

0

Italy

Spain

Germany

Sources: Banca d’Italia, Deutsche Bundesbank and Banco de España. Manufacturing firms only.

5

De- risking strategies implemented

(percentage of firms taking de- risking actions)

Replacing Chinese critical inputs with domestic inputs

Replacing Chinese critical inputs with others from non-EU countries

Replacing Chinese critical inputs with others from EU countries

Other strategies

100

90

80

70

60

50

40

30

20

10

0

Italy

Spain

Germany

Sources: Banca d’Italia, Deutsche Bundesbank and Banco de España. Manufacturing firms only.

Halving the supply of critical inputs from high-risk countries

EU imports of key inputs from non-EU countries, by partner alignment

Sources: Author elaborations based on CEPII BACI 2022 data.

Note: The size of the circles represents the relative share of each non-EU country’s exports of foreign critical inputs (FCI) in EU imports of FCI from all non-EU countries.

6

Shortages of critical inputs have widely diverging effects

Change in manufacturing value-added

Change in value-added, by sector

(percentage change)

Top 25%

Bottom 75%

(percentage change)

0. 0

-0. 5

-1. 0

-1. 5

-2. 0

-2. 5

-3. 0

-3. 5

Italy

Slovenia

Spain

France

Belgium

Sources: Author elaborations based on Panon et al. (2024).

Notes: The bars show value-added change for a 50% drop in foreign critical input supply from China-aligned countries. Firm size measured as value-added of exposed manufacturing firms.

7

Sources: Author elaborations based on Panon et al. (2024).

Trade fragmentation scenarios

Assumptions underlying scenarios of trade fragmentation

Scenario

Sectors affected

Type of shock

Mild decoupling

All sectors

Partial trade restrictions

Selective decoupling

Products whose supply is more prone to being weaponised

Full trade ban for affected products

Severe decoupling

All sectors

Full trade ban

8

Trade fragmentation entails sizeable output losses

Global real GDP

(percentage deviation from steady state)

Baseline effects

Capital accumulation channel

Real GDP by region

(percentage deviation from steady state)

Mild decoupling Selective decoupling Severe decoupling

0

-2

-4

-6

-8

-10

Mild

decoupling

Selective decoupling

Severe

decoupling

Sources: Conteduca et al. , (2024b), OECD TiVA, EORA, and authors’ calculations.

Sources: Baqaee and Farhi (2024), Conteduca et al. (2025), OECD TiVA, EORA, Quintana (2024) and authors’ calculations.

Notes: Non-linear impact simulated through 25 iterations of the log-linearised model.

The impact from capital accumulation is based on Quintana (2024).

0

-5

-10

-15

-20

-25

EU

United States

China

Sources: Baqaee and Farhi (2024), Conteduca et al. (2025), OECD TiVA, EORA, Quintana (2024) and authors’ calculations.

Notes: Non-linear impact simulated through 25 iterations of the log-linearised model.

Values include the additional impact from capital accumulation channel. The EU aggregate includes results for EFTA countries due to model-based aggregation.

9

Inflationary effects of trade fragmentation subside gradually

Global inflation

(annual percentage changes, percentage deviation from no

fragmentation)

Mild decoupling (dyn. BF)

Severe decoupling (dyn. BF)

Mild decoupling (DSGE)

Severe decoupling (DSGE)

5

4

3

2

1

0

Euro area year-on-year core inflation

(left: p. p. deviations from baseline; right: p. p. deviations from baseline and p. p. contributions to historical decomposition)

Range of impacts from severe decoupling High wage adjustment

Low wage adjustment

Range of contributions to historical decomposition from gas shortages

Low wage adjustment

5

4

3

2

1

0

5

4

3

2

1

0

1

2

3

4

5

Number of years after fragmentation shock

Sources: Quintana (2024), Lechthaler and Mileva (2024), OECD TiVA, EORA, and author calculations.

Note: “Dyn. BF” refers to the dynamic extension of the Baqaee-Farhi model by Quintana (2024a) and “DSGE” refers to the Dynamic Stochastic General Equilibrium model by Lechthaler and Mileva (2024).

10

1

2

3

4

1

2

3

4

5

6

Years after the shock

Quarters after the shock

Sources: Left panel: Quintana (2024a), right panel: Quintana (2024), Barbura et. al. (2023) (lower bound), Alessandri and Gazzani (2023) (upper bound).

Note: For the empirical estimated (right panel) the period covered is Q3 2022 – Q4 2023.

Recent inflation surge and sectoral supply shocks

Euro Area HICP core inflation

(annual percent changes, deviations from the mean implied by the model)

Other Supply Energy

5

4

3

2

1

0

Geopolitical shocks as supply shocks

(output: trough response, percentage; prices: peak response,

percentage)

Import prices

Import volumes

0. 2

0. 0

-0. 2

-0. 4

-0. 6

-1

2021

Source: Bańbura et al. (2023).

Latest observation: 2024 Q1

2022

2023

2024

US

EA

Source: Khalil et al. (2024) Notes: The chart reports effects for the US and the euro area from increasing a trading-partner’s GPR index by 50% on imports and import prices from this country.

11 Four policy implications Avoid broad-based protectionism Adopt targeted policies Strengthen supply chain monitoring Fragmentation matters for monetary policy …because while resilience is a legitimate concern, tit- for-tat trade war is welfare- reducing and does not fully eliminate interdependencies …to account for heterogeneity across sector, firms, regions …by monitoring production networks to understand direct and indirect foreign dependencies and risks …during the transition: larger, more frequent supply shocks; in the long run: reduced diversification through trade increases volatility and inflation 12 Four insights for central banks Look beyond aggregate trade data Conduct regular business surveys Enhance understanding of EU interdependencies Richer set of analytical tools …by using granular trade data and a disaggregated approach to monitor fragmentation …for a timely understanding of firm’s exposure to fragmentation risks …as the full extent of detailed interdependencies is still unknown; enhanced cooperation among NCBs and other EU institutions is desirable …is necessary to assess impact of fragmentation shocks on activity and prices 13 Conclusions Geopolitical fragmentation a major topic for central banks Model analysis: many choices in selecting and calibrating scenarios ECB Governing Council: uncertain impact of trade frictions on inflation; downside risk to output 14