Trade wars and fragmentation: Insights from a new ESCB report

Geopolitical shocks are fracturing global trade, and thus challenging economic integration. Even historically sound trade partnerships are now being strained, threatening decades of cooperation. A new report from the European System of Central Banks argues that EU policy responses in this challenging environment must be data-driven and targeted. This requires enhanced cooperation among EU institutions, central banks, and international organisations and, critically, the improved collection and sharing of granular data. At the same time, central banks must refine their analytical frameworks to better anticipate and respond to more frequent and pervasive price pressures.

The ongoing process of geoeconomic fragmentation signals a fundamental shift in the global economic landscape (Freund et al. 2023, Aiyar et al. 2023). Even long-standing trade partnerships are now under strain, with rising tensions jeopardising decades of cooperation. While global trade integration remains robust in many respects, the emerging patterns of fragmentation pose significant challenges that are not confined to trade flows alone; they extend to production processes, inflation dynamics, and ultimately, to the overall stability of the global economy.

The European System of Central Banks launched a joint collaborative effort to enhance the understanding and monitoring of trade fragmentation (Attinasi et al., 2024). This initiative provides methodological insights and develops new analytical tools, offering valuable guidance for central banks and policymakers navigating this evolving landscape. The recommendations emerging from this effort are grounded in four key findings.

Selective trade decoupling amid lengthening of supply chains

Global trade integration has largely withstood recent shocks, but a selective decoupling is visible in reduced trade flows for certain products between opposing blocs (Figure 1). Thus far, a few key high-tech products have been the main drivers of the selective decoupling between Western economies and China. At the same time, for some products key for the green transition, dependencies on China are on the rise, reflecting its dominant market position in the supply chain and the rising global demand for these products. The decoupling is proceeding at an uneven pace. While the West, and the EU in particular, has almost completely decoupled from Russia, the reconfiguration of trade vis-à-vis China has likely just begun for the EU and is far from concluded for the US. Moreover, data suggest that the selective decoupling from China may mask to a certain extent a lengthening of supply chains in the form of higher imports of Chinese products via third countries.  While the increase in indirect trade with China seems to have started since the beginning of the 2018 trade war for the US, for the EU this is a more recent phenomenon and, so far, much less pronounced compared to the US.

Figure 1 Ongoing reconfiguration of trade flows along geopolitical lines

Source: Conteduca et al. (2025a) with data from Trade Data Monitor (TDM).

Supply chain risks and the impact of supply disruptions

Recent disruptions, including COVID-19 and supply chains bottlenecks, have highlighted the vulnerabilities associated with excessive reliance on key foreign inputs. Survey data indicate that for a substantial portion (17–34%) of manufacturing firms located in Germany, Italy, and Spain, China is a key supplier of critical inputs that would be difficult to replace (Balteanu et al. 2024). Surveys also indicate that, beyond the trade channel, increased uncertainty is another important way in which rising geopolitical tensions impact firms. While small firms are relatively more dependent on China, a stress test based on granular firm-level data for five euro area countries (Belgium, France, Italy, Slovenia, Spain) suggests that supply disruptions affecting large firms could cause significant economic damage. A 50% drop in the supply of critical inputs from high-risk countries, would lead to very heterogeneous losses across firms, regions, and sectors (Figure 2). The electrical equipment industry stands out as the most affected sector, with a median value-added decline across countries of around 7%, more than double the overall median value-added decline of less than 3%. Other industries experiencing above median declines include chemicals, basic metals, electronics, and machinery.

Figure 2 Impact of supply shortages higher in five key industries

Source: Panon et al. (2025), based on the framework from Borin et al (2024).
Notes: The chart reports the value-added change (in percentage) across the most exposed manufacturing sectors coming from a 50% drop in foreign critical inputs (FCI) supply from China-aligned countries.

The high economic cost of escalating trade barriers

A tit-for-tat escalation of trade barriers would not fully eliminate interdependencies while imposing heavy economic costs. Counterfactual simulations reveal that, under scenarios of selective decoupling between a (US-centric) West bloc and a (China-centric) East bloc limited to more strategic products, global GDP losses could hover around 6%. In a more severe scenario affecting all products traded across blocs, losses could climb to 9%. Large, advanced economies are expected to absorb trade fragmentation more easily due to their sizeable internal markets. Depending on the scenario, GDP losses could range from 2% to 6% for the US and 2.4% to 9.5% for the EU, while China would face much higher losses. If the US further restricts trade with other Western and neutral countries, its GDP losses could nearly double, with the EU’s losses increasing only marginally. Moreover, even when trade bans are imposed, targeted products – especially high-tech goods – might still find their way to rival blocs via indirect channels. These dynamics would also fuel inflation, that could spike by as much as 4 percentage points in the most severe scenario the first year following the shock and then gradually converge towards central bank targets only over an extended period.

Figure 3 Output losses across fragmentation scenarios

Sources: Conteduca et al. (2025b), Quintana (2024), and authors’ calculations.

Fragmentation-driven price shocks and inflation

Trade fragmentation is set to affect the operating environment of central banks in a more direct way, namely, by triggering larger and more frequent supply shocks with far-reaching inflationary consequences. Supply disruptions, such as the surge in energy prices and global supply chain bottlenecks, have been significant drivers of core inflation in the euro area (Banbura et al. 2024). As fragmentation, in the form of weaponisation of critical supply lines, gathers pace over the next few years supply disruptions may become more frequent.  This suggests that trade fragmentation may have first-order effects on inflation, as shown by Russia’s weaponisation of energy supply to the euro area (Alessandri and Gazzani 2023). While price adjustments are costly, firms are more likely to revise prices in response to large supply shocks with more visible implications for aggregate inflation. This, in turn, would pose a challenge to central banks, as they have traditionally relied on their credibility to ‘look through’ temporary supply shocks. Additionally, if as a result of fragmentation production networks become more regionally concentrated, economies will lose the diversification benefits that global trade once provided, increasing their vulnerability to localised shocks. Indeed, simulations indicate that a fragmented global economy is likely to experience greater volatility and sustained inflationary pressures (Figure 4).

Figure 4 Fragmentation could lead to greater volatility and sustained inflationary pressures

Sources: UNIDO, OECD, Haver and ECB staff calculations.
Notes: Estimates are based on a counterfactual analysis from a dynamic multi-country multi-sector model (Boeckelmann et al. 2024) and assume a fragmentation of the world economy along the lines of the severe-decoupling scenario.

Policy implications: A call for targeted, data-driven responses

These findings carry significant implications for both governments and central banks.

For governments:

• Embrace targeted policies responses. Broad-based protectionism tends to be welfare-reducing and can be counterproductive, as key products may simply be rerouted through third countries. Instead, policies responses should be targeted – identifying and mitigating specific vulnerabilities within critical supply chains without sacrificing the benefits of openness. This also applies to the design of any potential countermeasure against other countries’ protectionist trade policies, which should be carefully targeted to maximise impact while minimising unintended consequences.
• Tailor public interventions. The heterogeneity of fragmentation risks means that ‘one size fits all’ policies will likely miss the mark. Instead, public interventions should be tailored, taking into account sector-specific and regional differences. Evaluating the cost–benefit trade-offs carefully is essential, especially given the potential for cross-border spillovers.
• Enhance monitoring of production networks. As de-risking strategies can sometimes lead to more complex and indirect trade linkages, it is crucial to monitor production networks closely. Governments must invest in improved data collection and collaborate with international partners to develop robust monitoring tools.

For central banks:

• Adopt a granular approach to trade monitoring. Traditional aggregate trade data are no longer sufficient. Central banks need to implement disaggregated approaches to track trade flows, particularly those involving products with high weaponisation potential such as semiconductors, raw materials, and upstream inputs. This granular monitoring is essential for assessing the true scope of price pressures stemming from geoeconomic fragmentation.
• Conduct regular business surveys. To gain timely insights into firms’ exposure to fragmentation risks, regular and harmonised business surveys should be conducted. They provide critical data on how firms are adjusting their supply chains and de-risking in response to geopolitical pressures, as well as timely information on price pressures and their passthrough.
• Deepen understanding of sectoral dependencies. Given that production processes are interconnected, understanding how price shocks propagate along supply chains is vital. Central banks should work to develop a detailed picture of sectoral interdependencies both within the euro area and globally. This may require collaboration with international organisations to build updated inter-country input–output tables that can capture these complexities.
• Develop advanced analytical tools. The dynamic nature of trade fragmentation demands a richer set of analytical tools and models. The ESCB analyses based on granular firm-level data and state-of-the-art trade models illustrate the potential of these approaches. Such tools are indispensable for simulating the effects of fragmentation on both economic activity and inflation, enabling more informed policy decisions.

Looking ahead

Amid increasing risks of geoeconomic fragmentation, even among partners with historically strong trade ties, the imperative to design effective policy responses in the EU is clear: strategies need to be targeted and data-driven. At the same time, it is crucial for central banks to refine their analytical frameworks to incorporate the realities of a fragmented global trading system – adopting more granular approaches and investing in new tools to better anticipate and respond to inflationary pressures within the euro area.

Effective policy responses in an era of geoeconomic fragmentation require stronger cooperation among ESCB members, EU institutions, and international organisations. A major obstacle for the EU in assessing the potential economic repercussions of trade barriers implemented by both geopolitical rivals and allies remains its limited knowledge of granular interdependencies within the region and with third countries. Consequently, a comprehensive and timely data collection framework should be established. Expanding access to firm-level data and developing more detailed multi-country input-output datasets would be crucial first steps. Enhanced data collection and sharing among EU member states and collaboration with international partners would not only strengthen analytical capabilities but also enable the design of more informed and effective policy responses, allowing the EU to better navigate the challenges of geoeconomic fragmentation.

Source: cepr.org