The United Nations estimates that there are 54 nations globally suffering from debt distress. In the face of multiple crises, including the Russia-Ukraine war and a global economic downturn, this is leading some countries to engage in trade protectionism.
But protectionism would lead to a world that is less resilient and more conflict prone. It is not the solution to debt distress and may further exacerbate the problems.
The International Monetary Fund projects that a deep fracture of the global trading system could reduce global output by 7%. The cumulative stock of import restrictions up to late 2022 impacted over 9% of the total merchandise imports amounting to more than $2tn, according to World Trade Organization economists.
Figure 1. Turbulent era: signs of trade fragmentation are increasing
Trade uncertainty contribution to World Uncertainty Index, %
As trade barriers on imports are increased, this results in higher prices due to a shortfall on the supply side. To tame inflation, central banks increase policy rates, which leads to higher borrowing costs and lower profits for businesses.
Domestic producers can sell products at a higher price with lower quality due to the reduction in foreign competitors in the market. Fiscal expenditure of the government increases as the need for social security grows. As mortgage rates rise, the disposable income of consumers decreases, resulting in less consumption and leading to lower corporate taxes, which affects fiscal revenue.
Higher trade barriers result in higher costs for the importation of capital and intermediate goods needed by the export-focused manufacturing industries. This makes locally produced exports less competitive, resulting in reduced output. This causes a reduction in fiscal revenue from export-based manufacturing and also decreases foreign exchange, especially for developing markets that need hard currency to import. This has been one of the key reasons for many developing countries to borrow foreign exchange, which puts further strains on fiscal policy.
As domestic companies are protected from imports through trade barriers and subsidies, local companies tend to have fewer incentives to innovate. This results in lower spending on research and development. Consumers receive inferior products as many businesses become comfortable within a protected economy. Local firms tend to focus inwards and, even if the economy is opened a few years later, they cannot build products that can be exported in a competitive global market. Eventually, exports are affected and fiscal revenue from exports decreases.
There is a correlation between innovation and economic growth. As economic growth slows, it also results in fiscal imbalance. Geopolitical tensions over the last few years have resulted in limited technology transfer and restrictions in investments between nations, which reduces the ability to innovate in a fragmented world with less collaboration. This will make it more difficult to develop technology and find solutions for key issues such as climate change. Without this, climate change will cause economic damage and result in drastically higher fiscal expenditure and rising public debt levels.
Depressed economic growth
Trade protectionist policies usually result in a backlash from other countries, resulting in fragmented markets. This means reduced economies of scale for many companies and lower profits as efficiency falters. Fiscal revenue is affected with lower profits from the private sector. As profits drop, many companies may lay-off employees, resulting in a further dip in consumption.
As trade barriers increase, local industries are expected to match the needs of the population. Subsidies, tax breaks and, in certain cases, government financing are provided, which increases fiscal expenditure. This means governments will have to cut down expenditure in other important areas or increase taxes, which further dampens the economy.
The global economy is in a weak position with high inflation, high policy rates, geopolitical tensions, rising public debt and the looming threat of climate change. Trade protectionism leads to higher prices, less innovation, slower economic growth and larger fiscal deficits. But there is an alternative solution.
Trade liberalisation will lead to greater efficiency in production as each country produces goods that have a comparative advantage over others. Free flow of goods and services with increased competition also results in increased innovation, which is essential to driving global economic growth.
Talal Rafi is an Economist at the Deloitte Economics Institute and an Expert Member of the World Economic Forum. He is a regular columnist for the International Monetary Fund and a Visiting Lecturer at the Centre for Banking Studies, Central Bank of Sri Lanka.