As US-China tensions worsen, a set of non-aligned ‘connector countries’ have gained importance as a bridge between the cantankerous Western and Chinese trading blocs. There have been significant upsides for them in not picking a side. But those countries — such as Vietnam, Poland, Mexico, Morocco and Indonesia — may not continue to benefit as the rift widens.
Companies and policymakers in both camps are increasingly looking at ways to make supply chains more resilient by ‘friendshoring’ — moving production home, or to trusted countries.
According to the International Monetary Fund, over the last decade, the share of foreign direct investment going to geopolitically aligned countries has kept rising, even more than the share for geographic neighbours. This suggests political preferences increasingly drive the footprint of FDI. So far, FDI to these connector countries has grown from both China and the US.
“If a country is able to stay open to both sides, it can benefit from the diversion of trade and investment flows,” said Andrea Presbitero, deputy division chief of the IMF research department’s multilateral surveillance division. “The benefit, however, perhaps isn’t as big as you’d think for current connector countries. In part this is because global output shrinks, as fragmentation is costly. But uncertainty over future policies would further reduce the potential benefits for non-aligned countries, as investment decisions are generally postponed in a more uncertain world.”
It is easy to assume that as protectionism by the US and China grows — and it might accelerate after the US elections next month — the benefits for current connector countries would increase. But Presbitero said this would be wrong. While there might be winners from investment flow diversion, the detail of the new policies makes this uncertain.
“The realignment of supply chain and trade flows following the 2018-2019 round of tariffs has meant a sharp increase of US imports from emerging Asia connector countries, which partially substituted for the decline of US imports from China,” Presbitero said. “Going forward, it is not a given that the same countries will benefit. This will depend, among other things, on trade policy: stronger enforcement of rules of origin will make it harder for firms strongly integrated with China to take advantage of trade diversion.”
The US Inflation Reduction Act of 2022, for example, gives tax breaks for electric vehicles if they are substantially made or processed in free trade partner countries. But the advantage is withdrawn if any of the components are made in a Foreign Entity of Concern — such as China. That is where two thirds of EV battery components come from.
As the world becomes more fragmented, investors will worry that non-aligned economies might at some point be forced to choose a side.
“It’s going to become harder and harder to remain unaligned,” said William Jackson, chief emerging markets economist at Capital Economics in London. “We’re already seeing that with Mexico, given the pressure the US is putting on it to screen investments and stop the spread of Chinese tech into US supply chains. Exports make up 40% of the GDP of Mexico and almost all of it goes to the US.”
Trade policy is a hot issue in the US election next month. Donald Trump is suggesting sharply higher tariffs across the board, partly to prevent Chinese firms avoiding tariffs by re-routing goods to the US via third countries. Kamala Harris seems keener on selective, targeted tariffs.
Mexico “will face pressure, no matter if Trump or Harris wins,” said Jackson. “Harris will try to limit Chinese investment in Mexico. But it looks like it will be an even bigger challenge under Trump, through tariffs.”
Either policy could prompt retaliation by the countries affected, but Trump’s seem more likely to trigger this. He has outlined plans to impose blanket tariffs of 10% to 20% on all imports, including from Europe, with specific targets like China facing levies potentially over 60%.
“Facing the prospect of much higher tariffs, US firms will think twice before making new investments, building factories for example, in connector countries,” Jackson said. However, the threat is lighter for some countries, such as Poland, he added. “Tariffs from Europe on Chinese goods are less about limiting access for Chinese firms and more about levelling the playing field.”