Critically Important: The Heterogeneous Effect of Diplomatic Tensions on Trade

Abstract

With global value chains interlocking today's economies, what is the impact of diplomatic tensions on international trade? We exploit variation in monthly data on imports, a measure of imported input use in the domestic economy, and the incidence of bilateral diplomatic tensions to show that their impact on trade is heterogeneous across countries and industries. Trade in industries that are crucial for domestic production is more sensitive to political tensions. We expose the underlying mechanism in a simple framework before testing it in reduced form. Keywords Diplomatic tensions • Political relations • Trade "Multinationals are very nervous now, and they should be. [...] In the past, only some sectors-mining, oil and gas, commodity companies-had to worry about geopolitics. Now companies that make fizzy drinks or handbags or chocolate are finding their supply chains, their markets, their operations completely blown apart by geopolitical risks and unfavorable treatment."-Mark Leonard, co-founder of the European Council on Foreign Relations. 1 Formerly circulated under the title "Politics of Global Value Chains".

The Impact of the 2018 Tariffs on Prices and Welfare

“…Although we will focus on tariffs as by far the most important protectionist trade policy, these same techniques can be used to examine the effects of quantitative restrictions on imports, such as quotas and voluntary export restraints. 2 Under perfect competition, a quota that restricts imports to the same amount as under a tariff has exactly the same effects on prices, quantities, government revenue, and welfare as the tariff, as long as the home government auctions the licenses to import under the quota competitively. In Figure 1, home consumers lose region A + B, and the home government gains region A + C from sales of the quota licenses, leaving a net effect on home welfare of area C -B.…”

“…Therefore, if quota licenses are auctioned competitively, the net effect of the quota on home welfare (like the net effect of the tariff on home welfare) depends on the extent to which there is an improvement in the terms of trade (area C). In contrast, if the home government gives these import licenses to foreign firms for free, or if foreign firms voluntarily restrict their exports under a voluntary export restraint, the home government receives no 2 Governments influence international trade through eight main policy instruments: import taxes (tariffs), export taxes, export subsidies, import subsidies, antidumping actions, quantitative restrictions (in the form of import quotas or export restraints), and standards protection. Of these instruments, export taxes are explicitly prohibited by the US Constitution and import subsidies are rare; the majority of interventions come in the form of tariffs, quantitative restraints, antidumping actions, and standards protection.…”

Analysis of the global trade network using exponential random graph models

“…One surprising result was the negative effect of diplomatic relations on trade exchanges, while we expected a positive impact of diplomatic relations on edge formations. The negative impact can be explained by the heterogeneous effect of diplomatic relations on trade, that according to Hinz and Leromain (2020), can vary within pairs of countries.…”