The cross-border flow of goods, services, capital and data gives rise to a variety of economic vulnerabilities and risks. Vulnerabilities afford other countries to exert geo-economic leverage by threatening to impose significant costs. Risks hold the prospect of systemic disruption and significant economic costs in the event of a broad-based disruption of international economic relations.
Economic security is also closely tied to national security in terms of a government’s ability to maintain control over its critical infrastructure (in case it is foreign-owned), prevent the leakage of key technologies and retain the ability to maintain access to, or produce goods and services critical to the overall economy, national defense and other critical sectors, such as health.
Mitigating economic risk is costly and not all risks need to be maximally minimized. It is therefore important to identify the most critical systemic risks and prioritize their mitigation in the context of a broader economic security strategy. Broadly speaking, critical vulnerabilities should be reduced to the maximally acceptable level, while non-critical vulnerabilities can be managed through less costly deterrence policies.
The government has an important role to play in ensuring national economic security. To paraphrase Georges Clemenceau: economic security is too important to be left to the market (alone). In cooperation with the private sector, the government should establish a risk review process to identify and assess systemically relevant risks and coordinate, guide or lead respective risk mitigation policies, particularly in areas where the private sector does not have the ability or willingness to mitigate national level risk sufficiently. Managing firm-level risks does not always translate into low risk at the systemic level. The government is tasked to ensure national-level systemic economic and financial stability.
Aside from national security and technology leakage risks related to the foreign ownership, forced technology transfer related to overseas direct investment and risks related to cyberespionage as well as cyberattacks against critical infrastructure, import-related vulnerabilities bear the greatest potential for systemic economic disruption at the national level.
Risks related to cross-border financial claims translating into losses can be managed through the implementation of a rigorous country risk management process at the firm level. If need be, it can be backstopped by the government to avoid broader disruption in cases where a firm is deemed systemically relevant. The risk arising from foreign import restrictions is also manageable, as few countries will want to risk a full-blown trade war with the EU. The risks related to German companies owning foreign subsidiaries only represent a systemic problem if they are a critical part of the German economy’s international supply chain (and there are no or few substitutes available). This risk be addressed with the help of supply chain reengineering and diversification.
The greatest systemic source of economic risk is related to critical imports that are essential to the proper functioning of the German economy or critical economic sectors, like defense or health. Import-related risk would cause maximum damage in case of major systemic economic disruption to international, such as an international war (e.g. Taiwan). Import-related risks can be mitigated in a variety of ways.
Cross-Border Trade and Finance Related Economic Risks
| Vulnerability | Geo-Economic Deterrence | Short-Term Defense | Medium-Term Defense |
Import-related vulnerabilities | Export controls => loss of access to critical imports cascades through national economy or negatively affects the production of essential goods (e.g. defense, health) | Leverage coercer’s own critical vulnerabilities (esp. “cost-effective” import-related vulnerabilities) | Stockpiling of critical goods | Diversification Innovative substitution Reshoring |
Export-related vulnerabilities | Import restrictions => reduced exports and economic efficiency and growth losses | Germany/ EU have significant deterrent/ retaliatory powers vis-à-vis third parties, given their importance as an export market to third parties | Create fiscal space to buffer short-term demand impact | Negotiate and deepen free-trade agreements |
Vulnerabilities related to cross-border financial claims and flows | Seizure, expropriation etc. => financial losses due to impairment of the value of foreign claims Reduced ability to engage in international trade and finance in case of currency sanctions | Germany/ EU hold financial “collateral’ in the form of foreign investment in EU (esp. government debt) | Rebalancing foreign financial claims | Strengthen country risk management at individual firm level Strengthen Economic and Monetary to provide safe assets Advance capital markets union to make euro more attractive |
Foreign direct investment related vulnerabilities | Financial losses Supply chain- and import-related risks Technology leakage National security risks related to foreign ownership of critical infrastructure | Germany/ EU hold financial “collateral’ in the form of foreign investment in EU | Tighten regulation and supervision of critical companies and sectors Tighten restrictions on foreign investment in critical sectors Force foreign owners to divest critical companies | Diversification Tighten restrictions in technology/ national security relevant sectors, broadly Tighten regulation and supervision of critical sectors Strengthen counter-espionage and cyber-defense capabilities of critical companies and sectors |
Mitigating import-related vulnerabilitiesGovernment policy should prioritize the mitigation of import-related dependencies. Among all the various economic vulnerabilities, import-related dependencies are not only economically the most disruptive, but they are also more likely to be exploited by geo-economic adversaries. Mitigation policies include:
Stockpiling. Stockpiling critical inputs helps buffer the impact of supply shocks and it reduces the ability of geo-economic adversaries to exploit import-related dependencies by buying time to take other mitigating actions. The government can provide financial incentives to the private sector to stockpile critical goods, or the government can set mandatory targets. In the case of extremely important commodities, such as energy, the government might want to get more directly involved in the purchase and storage of critical goods. It could also consider entering into swap and insurance agreements with other government engaged in stockpiling critical commodities. Lastly, the government could consider setting up an international buyers’ cartel. This should help reduce the risk of “panic buying” and of bidding up prices unnecessarily in the event of international supply bottlenecks.
Diversification. Import diversification reduces the risk of economic disruption and curtails the ability of a geo-economic adversary to exploit import-related dependencies. Diversification should be primarily led by private sector. But the government can actively support diversification by providing financial incentives (e.g. subsidies, tax credits) and by negotiating enhanced market and investment agreements with other countries. More intrusively, it can pursue government-to-government supply deals and even, if necessary, impose minimum mandatory diversification thresholds in critical economic sectors.
Reshoring. Reshoring seeks to reduce risks to a disruption of imports by producing critical goods domestically. This will tend to require moving the entire upstream supply chain onshore. This is generally very costly. While it lowers the risk in terms international disruption, concentrating production onshore may increase the risk of other types of domestic disruption. This needs to be taken into consideration when devising reshoring policies. Reshoring is worth considering, however, particularly in critical sectors, such as defense or health.
Innovative substitution. Innovative substitution seeks to find substitutes for critical imports over the medium term through the development of new, alternative goods. Government can provide incentives to subsidize to the private sector to engage in research and development. War economies have often proven adept at finding, even relatively quickly, substitutes to sustain critical production, even if they often proved of lower quality and higher cost. Alternatively, reusing and recycling critical commodities can also help reduce import dependence.
Deterrence. Deterrence seeks to dissuade politically motivated attempts to disrupt imports rather than mitigate the impact of global systemic disruptions. Deterrence policies should be well-calibrated in terms of the potential geo-economic coercer’s politically most salient economic vulnerabilities (including its import-related vulnerabilities). Targeting import-related vulnerabilities is generally most cost-effective than opting for broader retaliatory measures. However, deterrence can and does fail, and this is particularly true with respect import-related dependencies, which often provide for cost-effective coercion (e.g. Arab state oil embargo).
