Dollar remains dominant in global trade, but global tensions are fragmenting the world, says IMF

Dollar remains dominant in global trade, but global tensions are fragmenting the world, says IMF
Geopolitical tensions have not lowered the level of trade, which remains higher than in the Cold War, but the routes have changed dramatically and the use of the dollar is falling slowly. / bne IntelliNews
By Ben Aris in Berlin May 9, 2024

The global economic landscape is undergoing a transformation not seen since the end of the Cold War. Soaring geopolitical tensions have seen the world fragment into large trading blocs based on economic and national security concerns and that has affected the use of the dollar as the currency for trade and foreign direct investment (FDI) flows around the world.

“After years of shocks – including the COVID-19 pandemic and Russia’s invasion of Ukraine – countries are re-evaluating their trading partners based on economic and national security concerns. Foreign direct investment flows are also being re-directed along geopolitical lines. Some countries are re-evaluating their heavy reliance on the dollar in their international transactions and reserve holdings,” First Deputy Managing Director of the IMF Gita Gopinath said in a speech on May 7.

“All of this is not necessarily bad. Given the recent history of events, policymakers are increasingly – and justifiably – focused on building economic resilience. But if the trend continues, we could see a broad retreat from global rules of engagement and, with it, a significant reversal of the gains from economic integration,” Gopinath adds.

The US decision to weaponise the dollar as part of its sanctions regime on Russia has unsettled governments around the world and has pushed them to diversify away from their dependence on the currency.

While the dollar continues to dominate global trade as the foreign exchange of choice, countries with balanced trade relations are already moving to settle this trade in national currencies, led by Russia and China, which have already almost entirely abandoned the dollar in settlements of their mutual trade.

China is ditching the dollar and switching to settling trade in its own currency

More noticeable is the reduction of the share of the dollar in sovereign gross international reserves; the dollar continues to make up the largest share of the reserves of most countries, but its share has already fallen noticeably. China and Russia in particular have been dumping the dollar and rapidly increasing the share of monetary gold in their reserves basket.

The dollar remains dominant in trade and FX reserves

China is dumping the dollar and increasing the share of gold in its reserves basket

“Policymakers are increasingly – and justifiably – focused on building economic resilience,” Gopinath says. However, she warned that if this trend persists, it could lead to a significant reversal in the benefits gained from globalisation in what is becoming an increasingly fractured world.

New trade restrictions have more than tripled since 2019, while financial sanctions have mushroomed. The geopolitical risk index spiked in 2022 following Russia's invasion of Ukraine. And concerns over fragmentation have surged among the private sector, evident in the increased mentions of the issue in corporate earnings calls.

Trade restrictions have increased sharply alongside global political risk

Despite these trends, signs of deglobalisation aren't yet clear at an aggregate level, says Gopinath. Since the end of the hyper-globalisation era of the 1990s and early 2000s, the ratio of goods trade to global GDP has remained relatively stable at around 41-48%. However, fragmentation is evident beneath the surface, as trade and investment flows are redirected based on geopolitical allegiances rather than just profit. The share of international trade has remained roughly the same, but the routes it travels have drastically altered.

Deglobalisation is not yet visible in the overall trade picture

China’s share of US imports dropped by 8 percentage points from 2017 to 2023 amid heightened trade tensions, while the US share of China’s exports decreased by 4 percentage points during the same period. Meanwhile, direct trade between Russia and the West has collapsed following Russia's invasion of Ukraine but Russia’s trade with China has ballooned to more than $200bn a year of trade turnover.

Fragmentation is visible in trade dynamics between the emerging blocs

Three Geopolitical Blocs

Gopinath examines the world through the lens of three geopolitical blocs: the US-leaning bloc, the China-leaning bloc, and a bloc of non-aligned nations, following on from a similar analysis by Capital Economics on the fractured world.

Between the second quarter of 2022 and the third quarter of 2023, trade growth between US-leaning and China-leaning nations was nearly 5 percentage points lower than in the preceding five years, whereas trade growth within each bloc only saw a modest 2-point decline.

Trade and FDI between opposing blocs have fallen by roughly 12% and 20% respectively, since Russia's invasion of Ukraine. This reallocation persists even when removing the US and China from the analysis.

Shadow Trade Networks

Although direct trade between geopolitical rivals has declined, some exchanges are now routed through third-party nations, partially offsetting the impact of US-China decoupling. Countries like Mexico and Vietnam have helped cushion the blow, while the strategic role of "connector" nations remains an open question in terms of supply chain resilience.

New “connector countries” have emerged as waystations between the opposing blocs

Going forward, policymakers face crucial decisions. They can either accept the rerouting of trade and FDI to maintain economic integration or continue raising barriers, further isolating politically distant nations.

Potential Costs of Fragmentation

An IMF study compares current trade fragmentation to the Cold War era, when trade between the Western and Eastern blocs was heavily restricted. Although current fragmentation isn't as severe as during that time, it's still a cause for concern, says Gopinath.

“Today's trade is far more interconnected, with the goods trade-to-GDP ratio at 45% compared to 16% at the start of the Cold War,” says Gopinath.

Fragmentation could stifle productivity gains from specialisation and limit the benefits of global supply chains. The costs of financial fragmentation include weaker risk-sharing and higher macroeconomic volatility. The rise of new payment systems could also hinder interoperability.

“Economic losses from fragmentation could range from 0.2% to 7% of global GDP, depending on the severity of restrictions. FDI losses could trim another 2% off global output,” says Gopinath. “Emerging and developing economies could bear the brunt of these disruptions, particularly those reliant on commodity imports and agricultural trade.”

Call for Cooperation

Gopinath called for a renewed commitment to international cooperation. She urged preserving the multilateral, rules-based trading system and maintaining open lines of communication. Areas of common interest, like climate change, digital trade and cross-border payment systems, should serve as opportunities for collaboration, said Gopinath.

Rebuilding trust is challenging but vital to safeguarding the gains of global economic integration.

“It is well worth it to preserve some of the enormous gains from economic integration that have made the world more prosperous and more secure,” Gopinath concluded.