Geopolitics has cast a long shadow on the gravity model of world trade

This idea has been successfully adapted in the economics of international trade through the gravity model. Countries tend to trade more with those that are close to them in terms of distance. And the size of economies has a big role to play in determining the volume of trade between two countries. As with the laws of physics, bilateral trade strengthens on the basis of economic size while it wanes based on distance.

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This intuitive—but empirically tested—model needs an airing at a time when US President Donald Trump wants to undermine the system of open multilateral trade that has generally served the world well in recent decades. It is thus no surprise that the largest trading partners of the US are either countries such as Canada and Mexico that it shares borders with or large economies such as China and Japan whose sheer size strengthens the case for trade.

All this is in a normal world. But we live in abnormal times, in which the geopolitical factor is growing in importance. Economic relations between countries are increasingly dependent on their strategic alignment. While much of the current discussion is about trade, the first signs of splintering can be found in the patterns of direct foreign investment (FDI). This is an important signal because trade and investment are joined at the hip in this age of global supply chains. Trade moves in sync with investment in specific sectors.

In its April 2023 edition of the World Economic Outlook, the International Monetary Fund (IMF) showed that geopolitics is growing in importance as a driver of FDI, compared to the role of geography (see chart).

Economists at the multilateral lender used voting patterns at the United Nations to measure how well or badly countries are geopolitically aligned. “Over the last decade, the share of FDI flows among geopolitically aligned economies has kept rising, more than the share for countries that are closer geographically, suggesting that geopolitical preferences increasingly drive the geographic footprint of FDI," IMF economists JaeBin Ahn, Ashique Habib, David Malacrino and Andrea F. Presbitero wrote in a blog.

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The role of economic size as well as geographical distance that is predicted by the gravity model of international trade cannot be wished away, but there is a growing body of evidence that geopolitical alignment has also been growing in importance since the pandemic, and well before Trump moved into the White House for a second time.

This is especially true for FDI in strategic sectors such as semiconductors. The result will in all probability be a different form of globalization rather than full-blown de-globalization, though much depends on whether or not the world gets sucked into a vicious spiral of 1930s-style retaliatory tariffs.

India will have to negotiate these troubled waters till a new equilibrium is established in the international trading system. The government is focused on striking bilateral trade deals, though progress has been slow in closing deals with the country’s most important trading partners.

One choice that needs to be made is whether the focus of trade deals will be in the Asian region or with developed countries of the West. Geography strengthens the case for increasing trade with Asia, while geopolitics may drive more trade with the US and Europe.

This choice matters in the context of the Indian development strategy because Asia is where most of the trade in intermediate goods takes place, while areas such as the US and Europe are locations of final demand. The China-plus-one strategy has to be seen against this backdrop.

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Of course, not all decisions have to be binary. A country such as India with growing economic heft can maintain a balance between the regional economic blocs that may emerge in response to US protectionism. Either way, trade diplomacy will grow in importance in the years ahead, at least till a new international framework emerges.

The maxim that trade follows the flag was central to the colonial era built on territorial conquest to get access to raw materials. The multilateral system that emerged at the end of World War II was based on the principle that all countries get the same treatment in trade ties, with the Most Favoured Nation (MFN) as the default status. The tea leaves tell us that strategic alignments will play a bigger role in economic engagements in the years ahead, perhaps with discriminatory tariffs. It is not necessarily the best way to arrange the world economy, but the shift in direction is unmissable.

The author is executive director at Artha India Research Advisors.