1. Today’s Situation
2. The first shift
3. The second shift
4. The third shift
The future of Europe is being decided in Ukraine right now. The economic implications of the Russian invasion become a defining factor as far as globalization goes. Europe is forced to react…
The last keynote speech by Christine Lagarde, President of the ECB at the Peterson Institute for International Economics sparked a keen interest. I’ve thoroughly analyzed it and share the most valuable bits with you.
Two factors have appeared in recent years, revealing Europe’s vulnerability to model integration. The commitment to efficiency improvement has resulted in flourishing global value chains along with the growing trade flow. This, in turn, led to the scaling of production across the globe, with Europe particularly benefiting from it.
First and foremost, the improvement of efficiency involves risks. As global supply chains have become more efficient thanks to just-in-time production, they have also become really vulnerable to failures in operation against the backdrop of multi-sectoral global shocks. Supply bottlenecks encouraged half of an upturn in producer price inflation in the euro area.
Second of all, it has become clear how much global output depends on critical raw materials supplied by only several countries. This aspect can quickly become a crack in armour when the geopolitical situation changes and countries with other strategic goals emerge as riskier partners. According to estimates, China will control more than half of the world’s rare earth extraction capacities along with 85% of the rare earth processing capacities.
As discovered by the European Commission, 34 products used in the EU are extremely vulnerable to supply chain disruption given their low potential for diversification and substitution within the European Union. The war between Russia and Ukraine has made this particular vulnerability even more evident.
The euro area is highly dependent on Russian cobalt and vanadium, among other things. These commodities are instrumental to 3D printing, drones, and robotics. In contrast, Ukraine accounts for about a fifth of the European supply of vehicle wiring.
The war has already brought the country’s electrical installation factories to a standstill, forcing some EU car manufacturers to stop production. The export-oriented agricultural sector has also taken a major hit.
Europe does not yet have a full-fledged single market for services. This will significantly impede the growth in the world of remote work. Capital markets in Europe remain segmented, limiting the risk distribution through cross-border debt obligations and stocks. Only about 20% of shocks in the euro area are mitigated this way, while this figure is at least 60% in the United States.
The fact that the war demonstrated Europe’s energy supply vulnerability is possibly the most important thing. In 2020, the EU imported about 60% of its energy. Despite the growing share of renewable energy resources, this dependence has virtually increased since 2000. Only four countries accounted for over 70% of natural gas imports, with more than 40% coming from Russia.
So, what do we have? The early progress of globalization was largely dependent on a golden mean scenario of relative economic and geopolitical stability.
That being said, the economy is prone to huge volatility in cases where the shocks are global and correlated, and when there is an overdependence on particular suppliers.
The next question is, how do we respond to new vulnerabilities? Europe’s response is not to isolate itself or create trade barriers (a retreat from global trade involves significant expenses). Europe needs to make world trade safe, as it relies on signs that three major shifts are happening in response to the new global map.
The first shift involves a transition from dependence to diversification
After having learned the tough lessons of the global pandemic, it is unlikely that the companies will remain dependent on relatively linear global supply chains. That being said, this does not mean that they will strive for deglobalization and wish to reshore their production.
In the early days, Europe will likely focus on diversifying suppliers and creating stocks of basic production resources. Higher diversification may almost halve the negative impact of a supply shock on a country’s GDP, while a higher concentration of supply chains boosts economic volatility.
Diversification will have its limits. The second shift
This consequently leads to the second shift which entails the transition from efficiency to safety.
Europe is witnessing a shift towards a new industrial policy led primarily by China and the United States. In its recent strategy, the U.S. administration specifically established friendly shoring as one of its policy goals.
The war may now become a breaking point for both Europe and other regions, making alliances that include supplying countries more relevant. International companies will still have strong incentives to arrange production in the areas with the lowest costs. However, geopolitical imperatives may restrict the perimeter in which they can do that.
For strategic industries such as semiconductors or pharmaceuticals, very limited reshoring of the supply chain will change as a result of a point strategy. Europe seeks to double its share of the global semiconductor manufacturing market to 20% by 2030. That being said, even those industries that are not seen as strategic will adjust production themselves. 46% of German companies receive significant inputs of products from China, with almost half of these planning to reduce their dependency.
As far as energy resources and critical raw materials go, something else will need to be implemented. Resources are distributed unevenly across the globe and cannot be replaced by domestic alternatives. More often than not, regions will have to source their critical resources from a smaller number of potential suppliers. On top of that, they will have to do it in the context of a green transition that is making certain raw materials, such as copper, cobalt, and nickel, more critical than others. In light of this, a new geopolitical race for access to resources is likely to begin. Achieving greater security will obviously entail great costs.
The third shift is from globalization to regionalization
In the context of a changing geopolitical landscape, global export markets may turn out to be not as open and reliable as they used to be. And so, the possibility of insuring against business cycle risks by “rotating” demand across several trading partners may end up becoming more limited.
Considering the high exposure to global trade, this change may have a significant impact on Europe. Between 2010 and 2014, the external demand as a share of the euro area GDP more than doubled while Europe was recovering from the global financial crisis. However, this emergency valve designed to relieve pressure from shocks may weaken if other regions start turning inward.
On top of that, the transition costs linked to a large-scale reorientation of supply will be quite substantial. For example, creating entirely domestic semiconductor supply chains in the United States may cost up to $1 trillion, which is basically twice the value of the global semiconductor market. Aside from that, a quick shift from the cheaper to higher-cost suppliers may have a significant impact on the price dynamics, at least during the transition period.
In this context, the first best option will be to protect the rules-based multilateral trading system that has stimulated the growth of global trade. Regionalization as a Plan B may offer some of the benefits of globalization on a smaller scale and minimize these costs.