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Arguably the world has never been more uncertain today than it has been in decades and geopolitical and geo-economic impacts will be varied and often paradoxical. There are wars, quasi-wars and the threat of war in key parts of the globe and there are no immediate signs that tensions will abate.
In the Middle East, Israel and Iran might have stopped short of a direct war, but the situation remains highly volatile. As of April 26, Israel and Iran’s proxy, the Hezbollah, continued to exchange fire, beyond levels seen before the October 7 attack on Israel by Hamas. The Hezbollah maintained a high level of rocket fire on the Israel-Lebanon border and Israel’s air force bombed Hezbollah targets across the border. Another Iranian proxy group in Yemen, the Houthis, continued its efforts to destabilise the Red Sea with attacks on shipping, expressing solidarity with Hamas. On April 25, a Houthi military spokesman, Yahya Sarea, said yet another ship, the MSC Darwin, had been targeted by the group in the Gulf of Aden. US President Joe Biden signed legislation on wartime assistance of $26 billion for Israel on April 23. The trade and economic consequences for the world from a prolonged conflict or a deeper war in the Middle East could be severe.
In Europe, the war between Russia and Ukraine continued unabated. Biden signed off on a $61 billion military aid package for Ukraine, and Russia’s nearly incessant bombardment of Ukrainian military and civilian sites continued, with retaliation by Ukraine. France’s President Emmanuel Macron said that there might be a need to get European feet on the ground in Ukraine but found no real support from his colleagues in the European Union. Germany’s Chancellor Olaf Scholz was adamant that he would not provide Ukraine with the German Taurus missiles. Meanwhile, the IMF said that the Eurozone economy would rise by a tepid 0.8% in 2024 and a slightly better 1.5% in 2025, but warned that these numbers could be dampened by risks arising from the tensions in the Middle East and the Russia-Ukraine war. However, the IMF expected the Russian economy to grow 3.2% in 2024, while projections from the Russian economy ministry put the growth figure at a rather more conservative 2.8%.
Across the Indo-Pacific, the China-Taiwan and China-Philippines tensions continued to simmer. In response to China’s belligerence in the South China Sea, particularly targeting the Philippines and the waters around the country, the US’ and the Philippines’ militaries staged a major joint exercise, dubbed Balikatan or “shoulder-to-shoulder”. The joint exercise focused on the northern and western parts of the Philippines near potential flashpoints in the South China sea, bordering Taiwan’s maritime economic zone. For the first time ever, the exercise went beyond the Philippines maritime zone. On April 25, a Chinese military aircraft was seen just 76 km from Keelung City in Taiwan at the country’s northern tip. China’s air force and navy have been routinely sending aircraft into Taiwan’s Air Defense Identification zone to assert its sovereignty over that country. China accused the US of “stoking a military confrontation” over the deployment of a missile launcher that could fire weapons with a range of 1600 km and India sold its powerful BrahMos missile to the Philippines. The threat of a war or even a quasi-war in a region so vital to global supply chains stoked fears of dire economic consequences for the global economy.
But even amidst the uncertainty there were some clear signals about how geopolitics and geo-economics could shape up over the next, say, five years. One, the US-China hegemonic rivalry is now real, and here to stay. Strategic realism and economic nationalism are on the rise everywhere, whether it’s in the US or across the EU or in India with calls for atmanirbharta, or even across fast growing economies like Saudi Arabia with its quest to drive its economy beyond oil.
Two, China’s capacities and the trend of its global investment indicated that its centrality to global supply chains would remain for quite some time to come. Major, conclusively defining breaks in world trade, with tightly drawn blocs, are not as likely as the news headlines would claim.
Over the long-term, however, the US and China will no longer be quite as entwined in trade and supply chain terms as they were less than a decade ago. The US, certainly, no longer wants to be quite as entwined as it was. But realistically, no hard, final decoupling may be possible and the world will have to live with loose, complexly layered, multi-faceted alliances, with layers drawn by economics, politics and military needs.
This analysis explores the contours of current events and attempts to look into the why, the how and the what that drive the world today and their possible outcomes. Section I talks about geo-economics and how the world will not fragment easily, while Section II discusses geopolitics and the emerging multi-layered, multi-faceted alliances. They can be read as standalone pieces but the reader will find that each section is inexorably tied into the other.
SECTION 1: GEO-ECONOMICS - THE WORLD WILL NOT FRAGMENT EASILY
The US-China tension is changing the shape of supply chains. But China will continue to be at the core
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The big questions at the firm level and the industry level today are whether definitive decoupling of supply chains from China is about to happen and whether this will lead to hard trade blocs like there were during the Cold War. It’s hard to say what could happen in the long-term. However, over the next 5-7 years, there are several paradoxes at work, which imply that neither hard trade blocs nor a truly geo-economically fragmented world along geopolitical lines will be in play.
China’s Control Through the Backdoor
The first paradox is that China’s exports to the US have declined. But overall Chinese control over supply chains has not.
A recent IMF paper authored by Gita Gopinath, Pierre-Olivier Gourinchas, Andrea Presibtero and Petia Topalova argues that based on its models “fragmentation in trade and investment flows is becoming a reality”. The paper also argues that “there is by now robust evidence that the trade tensions between the US and China since 2018 have triggered a reallocation of the supply chains that have intertwined the world’s two largest economies over the past decades.”
Yet, as the paper also points out, “there is little evidence on whether the looming “great reallocation” extends beyond US efforts to de-risk, friendshore and onshore and whether there is broader fragmentation of the international trade and investment landscape along geopolitical lines”. This, the IMF authors argue, leads to a “conundrum”.
The authors point out that “the more cross-border countries are rerouted via ‘connector’ countries, the less effective the policies driving fragmentation may be in achieving their stated objectives… the reshuffling that is taking place seems to be lengthening supply chains, as connector countries are stepping in to bridge the gap between rival blocs. The study also points out that “even if direct links to less politically aligned partners are severed, exposure may not change substantively if imports and FDI from China underpin the exports by more politically aligned trading partners”.
The ‘connector’ countries, and their own supply chain links to China are a critical paradox that prevents the emergence of a truly geo-economically fragmented world based on geopolitical lines
These ‘connector’ countries, and their own supply chain links to China are a critical paradox that prevents the emergence of a truly geo-economically fragmented world based on geopolitical lines. There are two complex, intertwined layers at play where these connector countries are concerned. One, US and EU strategies like tariffs, onshoring, and friend-shoring are leading to more sourcing from countries like Vietnam and Mexico. Two, there’s the inherent problem of over-capacities within China, especially in the context of a global economy that’s operating with several growth constraints and emerging policy barriers.
A paper from the Centre for Economic Policy Research (CEPR) last September highlighted that while China’s share in US imports was falling, in line with the IMF findings, countries like Vietnam and Mexico were seeing a rise in their exports to the US. The study also indicated how China’s FDI into Vietnam and Mexico was rising, especially over the last three years.
Intermediate and late-stage manufacturing is shifting to those countries while the core component manufacture remained in China. In Africa, China is building capacities for refining products like cobalt—and thus controlling the supply chain on the commodity, while moving away from building new capacities back home.
Critical Connectors
The connector countries strategy is critical for China, and they remain equally critical to global growth. If the US, and eventually the countries of the EU, followed by Japan and South Korea, begin pushing nationalism-driven economic strategies into place alongside friend-shoring or even near-shoring, China, with its capacities, could face problems with deteriorating terms of trade.
China must ‘export’ its capacities across sectors to other countries which lie within the spectrum of friend-shoring and near-shoring for the US and its allies
China already has trillions of yuan invested in sectors ranging from basic steel, to products that drive the globe’s renewable energy industry, and EVs. Further, the solution for China’s economic problems today, and future growth, arguably lies in higher levels of investment across manufacturing and services and moving away from real estate and infrastructure. At some point, as China’s domestic demand growth slows, its economy will reach its absorption limits and, indeed, it may be close to those limits today. Insufficient domestic downstream demand will create massive problems for the Chinese economy.
This implies that China must ‘export’ its capacities across sectors to other countries which lie within the spectrum of friend-shoring and near-shoring for the US and its allies—ergo, another reason, beyond policy constraints, for China’s connector countries in ASEAN, Latin America or Africa.
Two, it also means that China’s substantive links to industry across the US and its allies is not completely cut-off since these connectors employ both Chinese capital and technology. China could and would play an arbiter in global, and indeed US value chains, leading to economic advantages that these connector countries would hate to give up.
Three, it means that the connector countries need to carefully balance their relationships with both the US and China. This highlights the multi-faceted complexity that is building up in geo-economics. If indeed these countries, especially those in the ASEAN region like Vietnam and Indonesia or those in Africa, are somehow cut off from trade with the US and its allies for geopolitical reasons, there would be severe global economic repercussions.
These connector countries will lengthen supply chains—which will raise costs and the time taken to manufacture. But given that their core remains Chinese, they draw upon the benefits of the subsidised, cost-effective and comprehensively networked, backward-integrated, manufacturing ecosystem that China has created for itself.
China clearly has several advantages including a first mover advantage. For the US or its allies like the EU, any attempt to re-create this ecosystem would be both time-consuming and capital intensive, and certainly financially tough in a constrained global economy.
If existing geopolitical conditions continue to have an overhang for any length of time in the near-term, the constraints on global growth would continue and attempts by the US and its allies to build new capacities could lead to a major global imbalance, with terms-of-trade deteriorating across global markets. The economic effects on the weaker economies of Africa and Asia could be quite deleterious.
Nevertheless, supply chains in frontier technologies like semiconductor are moving away from a dependence on China with the US allying with Japan and South Korea to build capacities domestically and in countries like India. The US Department of Commerce has given Samsung $6.4 billion in subsidies for its investment in Texas. But developments such as these will take another 2-3 years to fructify.
Yet, China remains critical to many companies from other regions like the EU.
German chemical companies are reluctant to move out of China given both their massive investments in that country and the tepid economies of their home region, the EU. With the currently high cost of capital prevailing across the globe, such a move is also financially difficult, despite any emotional cries back home in the EU calling for a complete decoupling from China.
An indication of how China, as a consumer economy, also remains vital to global markets came on April 17 when the Dutch giant, ASML, whose lithography technology lies at the core of the mass production of semiconductors, announced its results. China accounted for 49% of ASML’s sales in Q1 2024. Significantly, new US and EU rules to prevent the sale of some deep ultraviolet lithography machines to China kicked in this January and it will not be easy for ASML to find new markets with the levels that China offers.
China’s massive capacities will keep it at the centre of global manufacturing for at least half a decade
China’s massive capacities—across even commodities like steel to the refining of lithium and the production of magnets or some classes of semiconductors or even intermediate goods across the engineering product markets, EVs, batteries, etc.—will keep the country at the centre of much of global manufacturing for at least half a decade.
Take for instance rare earths. The International Energy Agency (IEA) says that China controls nearly 90% of the global refining, and more than 60% of global supply. New capacities and new mines are not easy to build or come by. China has nearly perfected the technology of refining rare earths. Downstream industries cannot do without China, which will necessarily remain at the centre of global manufacturing for some time to come. China has also signalled that it’s willing to weaponize its technologies, much like the West has sought to, when it banned the export of the technology to extract and refine rare earth elements in November last year.
How Does India Fit In?
India could find itself in a bit of a geo-economic quandary. On the one hand, it remains a rival to the ‘connector’ countries for global investment, though New Delhi will baulk at investment from China. Although there are now more than a few indicators that FDI is being directed towards India in some commodity segments of the semiconductor market, aircraft manufacturing, turbines, auto components, EVs, etc, in many key frontier technology sectors it’s not just countries like Vietnam, even countries like Saudi Arabia are potential competitors for FDI today.
On the other hand, India’s problems arise from its economic structure. Take for instance the low manufacturing to GDP ratio—around 17% currently. India now targets 25%, but it will need to go upwards of 30% to truly drive power as a manufacturing powerhouse. This will call for FDI and the concurrent technology investment and that will require the government to do some deft balancing on the geopolitical front, with closer ties to the US, Japan, South Korea and other like-minded nations.
Oil and Gas Remain Critical
Beyond the issue of connector economies there’s the paradox arising from commodities like oil and gas which, despite the drive for renewables, will remain the key to global growth for a long time and will influence any system of global alliances. These markets are complexly intertwined. It’s not just their use across energy but their use in downstream petrochemicals which form the bedrock of so much of industry today.
The US, Russia and the Middle East will remain the key drivers of oil and gas economics. The rise of US power in the oil markets is palpable. Last year, US crude oil production was a record-breaking average of 12.9 million barrels per day with a new monthly high of 13.3 million barrels per day in December alone. Production is expected to decline to around 11 million barrels per day, as rig counts fall, in 2024, but the US remains the largest player in the market alongside Saudi Arabia.
Russia’s now opportunistically in the OPEC+ camp, willing to cut production to keep oil prices high. Last November Russian President Vladimir Putin and the Saudi Crown Prince, Mohammed Bin Salman met and a Kremlin statement after the meeting said: "In the field of energy, the two sides commended the close cooperation between them and the successful efforts of the OPEC+ countries in enhancing the stability of global oil markets… They stressed the importance of continuing this cooperation, and the need for all participating countries to join to the OPEC+ agreement, in a way that serves the interests of producers and consumers and supports the growth of the global economy.”
Qatar is now the world’s largest producer of natural gas, and arguably the most vital player in the global gas trade, and accounts for nearly a quarter of EU’s gas. It’s also intricately entangled with China which, in 2023, has signed some of the biggest gas deals ever, making it a significant swing player in the global natural gas stakes.
The US, Europe and a wider Asia will collectively draw far greater volumes of crude oil and natural gas than China. In 2022, the Biden administration sold about 180 million barrels of oil from its Strategic Petroleum Reserve (SPR) in about six months to keep oil prices down after the Russian invasion of Ukraine. The administration has not yet given any indications of when it will replenish the SPR, and this will become a factor in any analysis of oil prices in the near term.
But China has strategically bought about 90% of Iran’s oil over the past two years or so, playing a big role in keeping that country’s economy on a somewhat even keel. India and China are the biggest buyers of Russian oil since February 2022.
Indeed, as India’s foreign minister, S. Jaishankar, has pointed out, India’s oil purchases and its refining capacities have done much to keep global crude and refined petroleum product prices at manageable levels. Both the US and the EU are among the largest buyers of downstream petrochemical products from India, irrespective of the origin of the oil.
If India does move away from Russian oil, it would be more because it sees Moscow’s ability to provide it crucial geopolitical support dwindling as a result of China’s economic entanglement
India also maintains a stance that its buying of Russian oil is strategically driven by its own social, political and national security concerns, with the country reserving the right to move towards traditional sources like Iraq and Oman as needed. If India does move away from Russian oil, it would be less because of high prices and more because it sees Moscow’s ability to provide it crucial geopolitical support dwindling as a result of China’s economic entanglement.
A hard decoupling from China, in effect a world fragmenting into hard trade blocs, is clearly neither on the anvil anytime over a 5-7 year timeframe, nor is it at all desirable.
Coming on Wednesday, May 8, 2024: In Part 2 of this 3-part series, Vivek Kelkar dives into the web of alliances that are shaping geopolitics. And why the emergence of the two clear blocs— led by the US and China—does not imply another Cold War
