As geopolitical tensions rise, companies and policymakers are increasinglylooking at strategies to make supply chains more resilient by movingproduction home or to trusted countries.
The US Treasury Secretaryargued in April 2022 that firms should move towards the friend-shoring of supplychains. More recently, the European Commissionproposed the Net Zero Industry Act to counter the subsidies in the US InflationReduction Act. And Chinaaims to replace imported technology with local alternatives to depend less ongeopolitical rivals.
These examples highlight the rising trend of geoeconomic fragmentation, aswe show in an analytical chapter of the latest World Economic Outlook. Ouranalysis of the impact on foreign direct investment shows that such flowshave been characterized by divergent patterns across host countries,particularly in strategic sectors, like semiconductors. The flow ofstrategic FDI to Asian countries started to decline in 2019 and hasrecovered only mildly in recent quarters, except for flows to China thathave not yet recovered.
Over the last decade, the share of FDI flows among geopolitically alignedeconomies has kept rising, more than the share for countries that arecloser geographically, suggesting that geopolitical preferencesincreasingly drive the geographic footprint of FDI.
These trends also indicate that if geopolitical tensions continue tointensify and countries further diverge along geopolitical fault lines, FDImay become even more concentrated within blocs of aligned countries.
Along with shifts in new flows, we also explore whether increasing fragmentation could lead to existing direct investments being relocated bybuilding an index of countries’ exposure to such developments. Emergingmarket and developing economies are more vulnerable to FDI relocation thanadvanced economies, in part because they rely more on flows from moregeopolitically distant countries.
Several large emerging economies are vulnerable to the relocation of FDI,indicating that fragmentation risk isn’t just concentrated in a fewcountries. Nor are advanced economies immune, particularly those withsignificant FDI stocks in strategic sectors. As vulnerabilities can alsoextend to non-FDI flows, which is detailed in an accompanying analytical chapter of the April 2023 Global Financial Stability Report, a rise inpolitical tensions could trigger a large reallocation of capital flows atthe global level.
While reconfigured supply chains could potentially strengthen nationalsecurity and help maintain a technological advantage over geopoliticalrivals, reshoring or friend-shoring to existing partners will oftenreduce diversification and make countries more vulnerable to macroeconomic shocks. In addition,our new analysis suggests that relocating FDI closer to source countriescould hurt host economies through reduced access to capital andtechnological advances.
Our analysis finds that the entry of multinational corporations in foreigncountries often directly benefits domestic firms. In advanced economies,increased competition from foreign firms spurs domestic enterprises to bemore productive. In emerging market and developing economies, domesticsuppliers benefit from technology transfers and increased local demand forcomponents that end up being used in downstream industries.
These benefits are more likely when foreign companies enter a country toproduce inputs that will be supplied to affiliated firms—think of theSamsung Electronics semiconductor factory in Vietnam that, makes productssold mainly to other units of the Korean conglomerate around the world.This is because this type of vertical FDI is concentrated amongintermediate-goods producers that deploy more sophisticated andskill-intensive technology.
Poorer world
Finally, we use hypothetical scenarios to illustrate the possible impact oflong-term fragmentation of investment flows. In general, a fragmented worldis likely to be a poorer one. We estimate that long-term global outputlosses are close to 2 percent of world gross domestic product. These lossesare likely to be unevenly distributed. Emerging market and developingeconomies are particularly affected by reduced access to investment fromadvanced economies, due to reduced capital formation and productivity gainsfrom the transfer of better technologies and know-how.
While there may be winners from investment flow diversion, such gains aresubject to substantial uncertainty. Some economies, such as those thatremain open to different geopolitical blocs, could enjoy gains fromredirected investment. Such benefits, however, are likely to be at leastpartly offset by spillovers from weaker external demand. In addition, in afragmented world with heightened geopolitical tensions, investors may worrythat nonaligned economies will be forced to choose one bloc or the other inthe future, and such uncertainty could intensify losses.
The widespread economic costs from FDI fragmentation suggest thatpolicymakers should carefully balance the strategic motivations behindreshoring and friend-shoring against economic costs to their own economiesand the spillovers to others.
The estimated large and widespread long-term output losses show whyit’s crucial to foster global integration—especially as major economiesendorse inward-looking policies. At the same time, the current rules-based multilateral system mustadapt to the changing world economy and should be complemented by credible mechanisms to mitigate spilloversfrom unilateral policy actions.
As policy uncertainty amplifies losses from fragmentation, multilateralactions should be taken to minimize such uncertainty, including byimproving information sharing through multilateral dialogue. Thedevelopment of a framework for international consultations on, forinstance, the use of subsidies to provide incentives for reshoring orfriend-shoring of FDI could help governments identify unintendedconsequences. It could also mitigate cross-border spillovers by reducinguncertainty and promoting transparency on policy options.
—This blog is based on Chapter 4 of the April 2023 World Economic Outlook:“Geoeconomic Fragmentation and Foreign Direct Investment.”
