The global economic architecture built from the ruins of World War II is under threat, with profound implications for investment.

There is a widespread belief China will challenge the world economic rule book

The global economic architecture built from the ruins of World War II is under threat, with US efforts to export its version of liberal democracy and free-market economics around the world on hold. What happens next is likely to have profound implications for the investment landscape, argues Michael Grady, senior economist and macro strategist at Aviva Investors.

In July 1944, delegates from 44 countries gathered in the Mount Washington Hotel in Bretton Woods, New Hampshire, to establish a new international economic order. The aim was to prevent a repeat of the breakdown of the international financial system of the 1930s, which led to the Great Depression and was one of the causes of World War II.

With protectionism, or so-called beggar-thy-neighbour policies, widely blamed for much of the economic mayhem witnessed during the inter-war years – in the five years to 1934 global trade plunged 66 per cent – signatories to the agreement promised their central banks would refrain from devaluing their currencies.1

We are moving on with other nations to build an even stronger structure of international order and justice. We are ready to undertake new projects to strengthen a free world. 
US President Harry Truman at his inaugural address, January 1949.

US hegemony

To support the drive for a new international economic order, Bretton Woods led to the creation of three multinational institutions that were to form the backbone of a new global economic architecture. They were the International Bank for Reconstruction and Development, later to become The World Bank, the International Monetary Fund (IMF), and the General Agreement on Tariffs and Trade (GATT), the precursor to the World Trade Organisation (WTO). Their purpose was to ensure an orderly financial system and encourage trade and overall economic activity.

The World Bank was established to loan money to war-ravaged countries in western Europe, while the main objective of the IMF was to offer financial assistance to nations experiencing balance of payments difficulties, thereby helping ensure the stability of exchange-rate pegs. As for the GATT, its purpose was to promote international trade by reducing or eliminating trade barriers such as tariffs and quotas.

From the outset, the US, thanks to its economic might, and aided by the dollar becoming the world’s de facto reserve currency, played a dominant role in all three multilateral institutions. As such, Bretton Woods helped establish US hegemony over world economic affairs. In doing so, it became a key vehicle for the US, alongside its military prowess, to export its version of liberal democracy and free-market economics around the globe. The subsequent creation of other supervisory bodies, such as the G7 and Organisation for Economic Cooperation and Development, served to reinforce this rules-based world order.

This economic system helped to foster increasingly international markets for goods, services, capital and labour – a process that became known as ‘globalisation’. In doing so, it arguably served the world well. Today’s global economy is largely a product of the free markets that the US – and Bretton Woods institutions – promoted.

Cracks in the architecture?

In reality, the architecture as originally conceived began to be undermined as long ago as 1971. That was when US President Richard Nixon severed the link between the dollar and gold to stop foreigners, who were flush with dollars since the US had been running sizeable balance of payments deficits in the preceding years, from sapping US gold reserves.

With currencies suddenly freely floating, one of the IMF’s main objectives – to maintain the fixed exchange-rate system by transferring capital from surplus to debtor countries – was redundant.

The World Bank’s role has also changed radically since its inception in 1944. With the Marshall Plan going into effect three years later, the institution soon shifted its focus to loaning money to poorer nations for infrastructure projects, such as ports and power plants, as a means of promoting economic development and social progress.

During the 1980s, under pressure from Washington, the bank emphasized lending to service developing nations’ debt that was often tied to demands for economic reform. Then, following harsh criticism from environmental groups among others, the bank in 1989 began including environmental factors when deciding to lend money.

Globalisation under threat

Despite these setbacks, the establishment of agreed-upon structures and rules of international economic interaction, meant conflicts over economic issues were minimized and the overall architecture was rarely called into question. However, with nationalism suddenly on the rise across much of the rest of the world as countries struggle to shake off the effects of the financial crisis, and with rising inequality and unprecedented migration flows further fuelling the angst, it is now under severe strain. Many are pondering whether the rules and institutions established at Bretton Woods can survive. And, if not, what will replace them. The answer is likely to have profound implications for the world and the investment landscape.

Leading G20 finance ministers in March tasked an independent group of experts with “delineating the challenges and opportunities of a new era” of global governance. The group will report in October.

World leaders have already begun to put forward their visions for the future. French President Emmanuel Macron told US lawmakers in April: "We can build the 21st century world order based on a new breed of multilateralism, based on a more effective, accountable, and results-oriented multilateralism."2

At the same time, he implicitly acknowledged that would be impossible without the US, which having both created and been responsible for safeguarding multilateralism, was needed “more than ever” to build a new world order for the 21st century.

Unfortunately for Macron, in Donald Trump the US electorate in November 2016 voted in a president who scorns multilateral institutions such as the United Nations, appears to dislike dealing with other transnational bodies like the European Union, accuses US allies of not pulling their weight in NATO and walked away from the Paris climate accord.

What to do about the WTO

The WTO is bearing the brunt of the attacks from critics of globalisation, such as Trump, who called the organisation a “catastrophe”.3 With Trump threatening to tear up international trade deals and undermine the WTO in other ways, whether or not the institution can be reformed in such a way as to retain its relevance will likely hold the key to globalisation’s fate.

The WTO, and its forerunner the GATT, have played a central role in advancing the cause of trade liberalisation, in turn helping lift billions out of poverty. Beyond being the guardian for global rules, the WTO provides the forum for trade liberalisation, the writing of new rules and the settling of disputes.

Part of the WTO’s problem is that it has made little progress since it was born out of a meeting of 124 ministers in Marrakesh, Morocco, in April 1994, marking the culmination of the so-called Uruguay Round of negotiations that lasted eight years. The subsequent Doha round, which began almost 17 years ago, largely stalled due to the refusal of the United States and European Union to lower agricultural subsidies. The WTO’s rulebook is now hopelessly out of date having preceded the advent of the internet and electronic commerce. That means adjudicators in the organisation’s appellate court often have to apply evolutionary reasoning to outdated rules, attempting to compensate for the gaps in them.

Adding to concerns, Trump is blocking the appointment of judges to the court. That means the body’s dispute-settlement mechanism could grind to a complete halt next year. The court, which is supposed to have seven judges, is set to be down to three later this year, the legal minimum it needs to pass judgements.

This prompted the WTO’s director general, Robert Azevêdo, to warn recently the dispute system was a fundamental pillar of the organisation. Without it, members would very quickly start taking matters into their own hands, leading to a dangerous cycle of retaliation.

“The current situation is of grave concern. We need to find a solution quickly,” he told Politico.4

Since Washington has not publicly explained its decision to block the appointment of judges, and has reportedly not linked it to any specific demands for reform, it is impossible to tell what Trump’s ultimate objective is. However, given he is simultaneously threatening to spark a trade war with China, some fear his ultimate goal is to not only rip up the WTO’s rule book but to kill the organisation off altogether.

According to one line of reasoning, Trump, who has said he is a fan of bilateral trade agreements, could be making a cynical calculation the US, with the world’s biggest economy, can outmuscle any opponent in a trade dispute without the need for international arbitration.

Spaghetti junction

While much of the liberalisation of international trade during the 20th century happened under GATT’S aegis, countries have in recent years turned to free trade agreements (FTAs) to access new markets.

Today, the governance of multilateral trade is a far more complex affair than in the past; partly because of the emergence of these FTAs, but also because increasingly trade is not just about goods crossing borders but factories crossing them too.

However, according to a report published by the World Economic Forum in August 2015, even though rules governing the more complex cross-border flows involved in these so-called global value chains (GVCs) have been written outside the WTO, this offers little comfort.

The authors of the report, Richard Baldwin and Michitaka Nakatomi, argued the uncoordinated development of rules, by undermining the global rule of law, would hinder the development of GVCs too.5 In any case, Trump is not a fan of the FTAs that govern these value chains either. Having pulled the US out of the Trans-Pacific Partnership, he is currently renegotiating the North American Free Trade Agreement with Canada and Mexico.

As a result, Baldwin and Nakatomi warn the collapse of the WTO would likely result in a “spaghetti bowl” of rules and a re-emergence of raw power politics in trade relationships, with the rich and powerful discriminating against the weak. In a world that returns to the law of the jungle, it could be that Trump reckons he wins.

Sino-US relations

Somewhat ironically – given at the time it was widely seen as its crowning achievement – many of the threats to the WTO can be traced back to the admission of China in December 2001. While that decision has helped promote further increases in world trade, in the eyes of Trump and others it has enabled the country to gain access to foreign markets without opening up its own.

Washington and Beijing have in recent months exchanged a series of tit-for-tat restrictions on each other’s goods.6 The concern is that a trade war between the world’s two biggest economies could quickly escalate, dragging in other nations and spelling the end for the WTO.

For now, the betting appears to be that the two sides will see sense and manage to avoid an all-out trade conflict. Despite Trump’s protestations to the contrary, there are huge advantages to the US of having an open trading system, with US consumers having massively benefitted from the decline in traded goods prices. The US also arguably receives sizeable benefits from the dollar’s status as the world’s reserve currency, since it lowers interest rates by making it easier to attract capital from abroad.

US officials have even started to strike a conciliatory tone. For instance, Treasury Secretary Steven Mnuchin said the trade war with China was “on hold” after the two sides agreed to drop their tariff threat while they work on a wider trade agreement.7 Perhaps such voices of concern will grow louder as the White House starts consultations with different industries on its trade policies.

Interestingly, on May 11 Trump tweeted he had ordered Commerce Secretary Wilbur Ross to save Chinese telecoms group ZTE from collapse since it would cost too many jobs in China. Days earlier, the Chinese company said it would cease trading after the US announced punitive measures for its failure to comply with a settlement of charges for violating sanctions on Iran and North Korea. China demanded the Commerce Department ease restrictions.8

A challenge to the Bretton Woods system

Pressure on the global economic architecture is not only coming from richer nations such as the US. While ironically Trump has enabled Beijing to position itself as a champion of the liberal economic order, at the same time China’s emergence as a global economic superpower has encouraged it to challenge the Bretton Woods institutions that underpin that order. For instance, in January 2016, China launched the Asian Infrastructure Investment Bank (AIIB), widely seen as a rival to the World Bank, as a means of projecting its soft power. That China should be doing this is hardly surprising since it does not share the same commitment to the principles underlying these institutions, which it sees as extensions of US foreign policy.

Beijing has been aided in its task by a feeling that, despite the expansion of the G7 into the G20 in 2008, representation for emerging nations has not kept pace with their growing contribution to world economic output. For instance, although China accounted for nearly 15 per cent of world economic output in 2016, it held less than five per cent of voting shares in the World Bank. And while the OECD sets global standards in some areas, its membership comprises just 35 countries, most of them rich.

There is a widespread belief China will inevitably start to challenge this world economic rule book with greater force, and with it US hegemony.

“It is my personal view and shared by many people that they (China) are carrying out a well-orchestrated, well-executed, very patient, long-term strategy to replace the United States as the most powerful and influential nation on earth,” senator Marco Rubio told a Congressional hearing in February.9

Chinese President Xi Jinping appeared to have admitted as much in 2017 when he revealed China planned to become the world's biggest superpower within 30 years.10 How the US responds to this challenge remains to be seen.

Thucydides Trap

In his 2017 book Destined for War, Harvard professor of government Graham Allison coined the phrase “Thucydides Trap” – a reference to the ancient Greek historian’s observations about the war between Sparta and Athens in the fifth century BC – to describe the dangers of a period in which an established great power is challenged by a rising power.11

“China and the United States are currently on a collision course for war – unless both parties take difficult and painful actions to avert it,” he argued.

Allison’s conclusions have been attacked by Arthur Waldron, a noted scholar of Chinese history and military affairs, who says the Chinese are “intelligent enough to realize that war — not to mention nuclear war — with the United States would be an insane action”.12

Nevertheless, with two such pugnacious leaders as Trump and Xi at the helm, tensions between the two nations are unlikely to be defused quickly. Even when Trump’s presidency comes to an end, demands for protectionism are unlikely to abate so long as large trade imbalances between the two nations persist.

Although a trade war makes little sense for Trump or Xi, the threat of one breaking out cannot be ruled out entirely given the fraught backdrop. That will keep the survival of the WTO, and with it the global economic architecture established at Bretton Woods, in doubt.

The finacial implications of a new world order

If the US were to retreat from global institutions and raise trade barriers, the near-term implications for financial markets would likely be considerable.

The complex inter-connected supply chains that have been erected in recent decades would likely be disrupted. That would impact a wide range of companies’ earnings and probably trigger sharp reductions in future investment. Costs to final consumers would also likely rise, both from the direct imposition of tariffs, as well as the second-round effects as companies incurred significant costs to restructure their businesses.

While rising protectionism would be bad for equities in general, the biggest losers would likely be emerging markets. Here, living standards have been steadily converging towards those in advanced countries in recent years thanks to the liberalisation of trade. That convergence could slow or even stop altogether, which would be negative for the price of other assets in these countries as well. Euro zone and Japanese equities would likely be badly affected, given many companies’ in these regions are heavily reliant on exports.

The US dollar may also be a casualty. Having enjoyed the ‘exorbitant privilege’ of being the world’s reserve currency since World War II, a material change in the global monetary architecture could see it lose that status and become more vulnerable to the massive funding requirements resulting from the US’s fiscal and current account deficits.

The impact on government bond yields would be less obvious. Rising protectionism could lead to stagflation, which would be challenging for central banks to respond to. The likelihood is that monetary policy would be eased if central banks were prepared to overlook a short-term boost to inflation. For the US, where monetary policy is expected to continue to ‘normalise’ over the coming years, there would be more scope for yields to fall. On the other hand, increased uncertainty and volatility could also see ‘term premia’ rise sharply, offsetting any reappraisal in the monetary policy outlook.

At the start of this year, share prices fell sharply as tensions between the US and China ratcheted up. They have since recovered strongly as markets began to bet an all-out war would be avoided. However, with hostile exchanges likely to continue, markets could be in for a bumpy ride for some time yet.

References

1 World Trade Organization World Trade Report: Trends in international trade, 201

2 ‘Macron calls on US to embrace “strong multilateralism” to build a “21st Century world order”’, Washington Examiner, April 201

3 ‘Trump calls WTO a “catastrophe” amid criticism of trade deals’, The Telegraph, February 201

4 ‘Europe fears Trump is out to kill the World Trade Organization’, Politico, March 201

5 Restoring WTO centrality to a multi-tiered global trading system, World Economic Forum, August 201

6 ‘Trump proposes $100 billion in additional tariffs on Chinese products’, CNBC, April 201

7 ‘US, China putting trade war on hold, Treasury’s Mnuchin says’, Reuters, May 201

8 ‘Trump vows to help sanctioned Chinese tech company, citing job losses’, Daily Intelligencer, May 201

9 ‘China carrying out “patient, long-term strategy” to replace US as top global power, say American lawmakers’, Firstpost, February 2018

10 ‘China reveals plan to become world’s biggest superpower within 30 years’, The Independent, October 2017

11 Destined for War by Graham Allison (2017)

12 ‘There is no Thucydides Trap’, SupChina, June 2017

Important information

This document is for professional clients and advisers only. Not to be viewed by or used with retail clients.

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). As at 19 June 2018. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.

In the UK & Europe this material has been prepared and issued by AIGSL, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27- 13 South Tower, Singapore 048583. In Australia, this material is being circulated by way of an arrangement with for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd (AIPPL) does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.

RA18/0651/01062019

Related views