The Cost of Decoupling: What US-China Economic Fragmentation Really Costs the World

Economists analysing decoupling generally invoke two related but distinct frameworks: trade diversion versus trade creation, and the reversal of what trade economist Richard Baldwin termed the ‘second unbundling’ — the geographic splitting of production stages across borders that defined globalisation from the 1990s onward. Standard trade theory predicts that tariffs and barriers between two large economies redirect commerce toward third countries (trade diversion) rather than eliminating it outright, which is consistent with the Vietnam-Mexico-India reallocation observed since 2018. The efficiency loss comes from abandoning the lowest-cost global supply configuration in favour of a second-best, politically constrained one.

Quantifying this loss requires computable general equilibrium (CGE) modelling, the methodology behind most of the headline figures now circulating. These models simulate an economy (or the whole world) as a system of interlinked markets and estimate how tariffs, non-tariff barriers, and investment restrictions ripple through wages, prices, and output. The World Economic Forum's $6.9 trillion full-decoupling estimate and the IMF's more conservative $213-307 billion current-fragmentation figure both derive from variants of this approach, differing mainly in their assumptions about how completely trade blocs separate and how quickly firms can substitute alternative suppliers. The wide range between these numbers is itself informative: CGE models are highly sensitive to elasticity assumptions (how easily buyers switch suppliers) and to whether technology transfer effects are included, since restricting Chinese access to advanced semiconductors carries growth costs beyond simple trade-volume effects.

Sectoral analysis sharpens the picture considerably. Semiconductors sit at the centre of the conflict: the US CHIPS and Science Act subsidises domestic and allied fabrication capacity while export controls restrict China's access to sub-14nm lithography equipment, aiming to constrain Chinese progress in AI and military applications. China's countermove — restricting exports of gallium, germanium, and rare earth elements critical to chip manufacturing, EV batteries, and defence hardware — demonstrates that supply chain leverage runs in both directions. Roughly 70% of global rare earth processing capacity remains concentrated in China, meaning Western ‘de-risking’ in this sector requires years of mine development and refining capacity that does not yet exist at scale elsewhere.

The electric vehicle and battery supply chain illustrates a parallel dynamic. Chinese firms dominate lithium-ion battery production and lithium/cobalt/graphite refining; US and EU policy has responded with local-content requirements that effectively exclude Chinese-linked supply chains from full subsidy benefits. The result is duplicated capital investment — batteries and refining capacity built twice, once for each bloc — which is precisely the kind of redundant, cost-raising investment that CGE models attempt to capture as decoupling's dead-weight loss.

A financial and monetary dimension compounds the trade story. Export controls and tariffs have been paired with an expanding US sanctions regime, prompting some countries — chiefly China and Russia — to accelerate efforts to reduce dependence on the dollar-denominated financial system for trade settlement, a theme covered in EconoLens's earlier de-dollarisation analysis. Reduced dollar centrality is not yet a first-order macro effect, but it represents a slow-moving structural response to the same underlying fragmentation pressure, with implications for US Treasury demand and global liquidity over a longer horizon than the trade effects discussed above.

There is genuine debate among economists over whether ‘decoupling’ is the right description of what is actually happening, or whether ‘de-risking’ — the term favoured by the European Union and, more recently, by US Treasury officials — better captures a more selective, sector-specific separation that leaves the bulk of US-China commerce intact while ring-fencing strategically sensitive technologies. Aggregate bilateral trade data support a nuanced reading: direct US-China trade has fallen from its 2018 peak as a share of each country's total trade, yet China's global export share has continued rising, increasingly channelled through Vietnam, Mexico, and other intermediary economies whose imports from China and exports to the US have both grown in tandem — a pattern consistent with transshipment and final-assembly relocation rather than a genuine reduction in Chinese manufacturing's role in US-bound goods.

From a growth-theory perspective, the long-run cost of fragmentation operates primarily through the total factor productivity channel rather than through capital accumulation or labour supply. Trade openness has historically been associated with productivity gains from specialisation, economies of scale, and technology diffusion; reversing that openness, even partially, works against these channels. This is why the WEF's severe scenario shows growth effects (up to -6.4 percentage points) that dwarf what a simple tariff-revenue or trade-volume calculation would suggest — the model is capturing lost productivity growth compounding over multiple years, not merely a one-off price shock.

The events of 2026 add a further complication that most pre-existing decoupling models did not anticipate: the Iran conflict and the effective closure of the Strait of Hormuz from March 2026 onward, disrupting roughly a fifth of global oil flows and forcing the IMF to cut China's growth forecast to 4.4% in its April World Economic Outlook. This illustrates a broader point applicable well beyond the US-China relationship: in a fragmenting world with less spare capacity and fewer redundant supply routes — precisely the outcome decoupling is producing — external shocks of any kind propagate faster and hit harder, because the shock-absorbing flexibility of a more integrated system has been deliberately dismantled in the name of resilience. Whether this trade-off between geopolitical security and macroeconomic shock resilience is worth its measured cost remains the central, unresolved question for policymakers navigating the rest of the decade.