Will the Russian war stimulate trade diversification?

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Building resilience has become something of a mantra in recent years, especially during the Covid-19 pandemic. But measures to strengthen economic security and advance diversification have been slow. However, after Russia invaded Ukraine, that might be about to change.


In the decades following the Second World War, economic actors around the world placed considerable – and growing – confidence in a broad-based international commitment to a relatively open global economy. Unlike in earlier times when countries routinely went to war to protect their economic interests, policymakers cared little about arbitrary or politically motivated denials of access to critical resources or markets. They might limit their concerns to issues such as the economy’s exposure to changing supply and demand conditions, and sometimes violent price movements.

But the tensions, frictions and blockages in global supply chains during the pandemic have begun to erode that faith. Prices and markets were not the main determinant of vaccine distribution. Additionally, China, the United States and others have erected high barriers to market access for foreign tech companies (especially those of their rivals), citing national security concerns.

More broadly, economic and financial sanctions have become a foreign policy weapon of choice, particularly in the United States. It is therefore not surprising that sanctions have formed the bulk of the West’s response to the Ukraine crisis, especially given the likelihood that Russia will view any direct NATO military intervention in Ukraine as a declaration of war. The United States and the European Union moved quickly to cut off major Russian banks from international transactions by excluding them from the SWIFT financial messaging system and have now frozen the assets of the Russian central bank.

With Russia’s economy already faltering, it is now abundantly clear that a country’s economic security depends on its broader relationship with its trading partners, which must be reasonably reliable and predictable. This raises serious short-term challenges, especially for the EU, which finds itself in the unenviable position of being heavily dependent on Russian energy imports.


Illustration: Binay Sinha


Currently, Russia supplies nearly 40% of Europe’s natural gas. Fear of losing this supply severely limited the West’s economic response to the invasion of Ukraine. For example, there was initial resistance from major EU countries to exclude Russia from SWIFT, and when the decision was made, only “selected” banks were affected.

At the same time, Russia depends on the EU to continue buying its gas. Thus, perhaps the most potent economic weapon in the Western arsenal is one that the EU cannot use without inflicting serious damage on itself. The result is akin to the “mutually assured destruction” the world has long relied on to deter nuclear attacks.

As Italian Prime Minister Mario Draghi acknowledged last week, “the events of these days show that it was unwise not to have further diversified our energy sources and suppliers over the past decades.” Indeed, Europe seems to have found itself stuck in an energy wedge, although the non-energy related sanctions are undoubtedly severe and could still be tightened. In any case, the cost of any sanctions – including Russia’s isolation from world markets and loss of access to products and technologies – largely depends on the extent to which China decides to support Russia. .

For now, European leaders will simply have to face what comes. But, to build their long-term security in an increasingly turbulent world, countries must also build economic resilience – achieved through diversification – into their foreign policy strategies.

In energy, Europe could imitate Japan, which is also entirely dependent on imported fossil fuels. Japan acquires oil from several countries in the Middle East and natural gas in the form of liquefied natural gas (LNG) from Australia, Malaysia, Qatar, Russia, the United States and others, Australia holding the largest market share (27%). If Europe’s energy supply were more like Japan’s, the payoff structure of the current Russia-West game would be very different, with Europe having the power to impose asymmetric costs on Russia through penalties related to energy.

The value of diversification increases with the magnitude of the relatively uncorrelated risks one faces. Some would argue that such diversification is costly, partly because it reduces efficiency. But while the costs may not be worth it in a stable, low-risk environment, we don’t live in such an environment. In today’s world, the costs of diversification are dwarfed by the potential — and likely — costs of disruption. In the presence of significant partially uncorrelated risks, diversification is the best strategy.

This is not true only for imports. Since market access can be interrupted – China has learned this first hand during the administration of US President Donald Trump – countries should also strive to diversify their export markets. Although it is difficult to diversify outside of economies as large as the United States or China, countries can move in this direction.

Of course, the most pressing imperative is to diversify away from unpredictable trading partners. Partners with whom the rules of engagement are clearly agreed and likely to remain stable are far less risky, reducing the benefits of diversification. Nevertheless, countries should avoid over-reliance on a partner, however stable, especially in view of the growing risks of disruptions linked to climate change.

It is important to note that the necessary level of diversification—that is, a level that strengthens a country’s economic security and negotiating position in the event of a crisis—is unlikely to emerge as a result. purely commercial, as the economic and strategic benefits are not fully captured by market players. Although market players recognize the risks and are not reluctant to fully diversify markets and sources of supply, they are unlikely to go far enough.

Given this, public policy and international coordination must play an important role in moving this process forward. Fortunately, for now, policy makers have strong incentives to take the necessary action. But it remains to be seen whether their sense of urgency will persist or fade as perceived threat levels decline.



The writer, winner of the Nobel Prize in economics, is professor emeritus of economics and former dean of the Graduate School of Business at Stanford University.


©2022Project Syndicate





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