IMF says U.S-China tensions could cost the world about 2% of its output

The International Monetary Fund said in a Wednesday report that global tensions could disrupt overseas investment and eventually lead to a long-term loss of 2% of the world’s gross domestic product.

Companies and policymakers across the globe are exploring ways to make their supply chains more resilient by “moving production home or to trusted countries,” the IMF warned in its report, adding that this will lead to fragmenting foreign direct investment.

The IMF pointed to recent bills adopted against the backdrop of rising tensions between the U.S. and China, such as Washington’s Chips and Science Act. Japan recently imposed its own restrictions on 23 types of semiconductor manufacturing equipment, joining U.S. efforts to curb China’s ability to make advanced chips.

A recent survey conducted by the American Chamber of Commerce in China similarly showed a shift of foreign direct investment away from China. Less than half of its respondents ranked China as a top three investment priority for the first time in 25 years.

IMF economists said that money is now flowing into what are considered “geopolitically close countries.” The rise of “friend-shoring” could hurt less developed markets the most, the organization said.

“Emerging market and developing economies are particularly affected by reduced access to investment from advanced economies, due to reduced capital formation and productivity gains from the transfer of better technologies and know-how,” IMF economists including Jae-bin Ahn wrote in the report.

This comes as tensions increase between China and the United States. After a recent meeting between U.S. House Speaker Kevin McCarthy and Taiwanese President Tsai Ing-wen in California, Beijing made veiled threats, pledging to take “resolute actions” in response to the “provocation.”

The IMF economists added that developing economies are more vulnerable to this shift in foreign direct investment as “they rely more on flows from more geopolitically distant countries.”

Even if more powerful countries reap the benefits they seek through heightened tensions, those gains could be partially offset due to spillover from weaker external demand, IMF warns.

“A fragmented world is likely to be a poorer one,” the IMF economists wrote.

IMF argues that while “reconfigured” supply chains according to geopolitical alliances may benefit a country’s national security interests and secure an upper hand against competitors, there are also consequences.

“Friend-shoring to existing partners will often reduce diversification and make countries more vulnerable to macroeconomic shocks,” IMF economists wrote in a note. The organization argued for more supply diversification in global trade a year ago, saying that a “more diversified global value chains could help lessen the impact of future shocks.

The organization revisited that argument, saying that even for developed economies, overseas firms ramping up competition “spurs domestic enterprises to be more productive.”

It warned that policy uncertainty should be minimized, as it “amplifies losses from fragmentation.”

“In a fragmented world with heightened geopolitical tensions, investors may worry that nonaligned economies will be forced to choose one bloc or the other in the future, and such uncertainty could intensify losses,” IMF wrote.