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The Misguided War on Global Value Chains

The COVID-19 pandemic has brought economies around the world to an abrupt halt and highlighted the fragility of existing global value chains. But demolishing these key drivers of international trade and investment would only make a bad situation worse.

WASHINGTON, DC – Most international trade and investment occurs in networks which divide production into discrete steps that can be carried out in different countries. Firms exchange inputs and outputs in cross-border value chains, some of great complexity. These value chains – whether intra-firm or inter-firm, regional or global – accounted for more than two-thirds of world trade in 2017 and an astonishing 80% in some manufacturing industries.

But, as a result of COVID-19, global merchandise trade is set to plummet by an estimated 13-32% in 2020. Worse yet, the pandemic has paralyzed manufacturing networks and supply chains – especially in China, which accounts for 28% of global manufacturing output. That has delayed the delivery of essential services and food, pharmaceuticals, basic medical products (including surgical gowns and masks), electronics and automotive components, metals, and other manufactured goods.

In the aftermath of the damage and economic disruption wrought by COVID-19, business leaders are reassessing the extent of their firms’ dependency on single foreign suppliers and examining how to mitigate strategic vulnerabilities. And there are growing calls from rich-country political leaders for radical shifts in production structures and trade policy.

Some Western governments have announced plans to encourage more domestic production of basic necessities. But these countries’ high average wage and productivity levels will make labor-intensive goods, basic manufacturing, and some services expensive to produce, while protective measures such as tariffs will hurt domestic consumers.

Some advanced economies are also increasing their scrutiny of foreign investments related to the supply of critical goods and services. Such policies, which are intentionally left vague, apply to almost all products and are largely intended to discourage takeovers of domestic firms by Chinese investors during the pandemic. And some developing countries, such as India, have started to impose similar curbs.

But dismantling global value chains (GVCs) and erecting barriers to foreign direct investment (FDI) are bad ideas. Implementing them would augur the return of the worst forms of protectionism and economic micro-nationalism, with potentially devastating consequences for global prosperity, stability, and peace.

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Such policies could amount to a death sentence for many low-income economies and would worsen inequalities between countries, thus exacerbating the current weakness of global aggregate demand. After all, global growth has benefited enormously from the emergence of large new markets in once-poor countries such as Japan, China, or South Korea, all of which have become reliable sources of consumer demand and investment financing.

By and large, rich countries benefit from GVCs. Lower transport costs and innovations in packaging mean that many goods can now be produced far away from their eventual markets. As a result, high-value goods are often manufactured in low-cost regions of the world. And by adopting a global sourcing model based on cross-border supply chains, many firms in advanced economies can take advantage of these reduced costs.

Companies that participate in GVCs thus become more efficient and productive. As they move into higher-value (often capital-intensive) industries, that are able to pay their employees higher wages and upgrade their activities toward the technological frontier. GVCs also create opportunities to subcontract the production of goods with increasingly sophisticated components, manage manufacturing processes requiring several layers of expertise, and tailor production to demand.

Developing countries, whose share in global value-added trade has increased from 20% in 1990 to 30% in 2000 to over 40% today, also benefit from GVCs, with even the poorest increasingly participating in them. This has resulted in positive spillovers for the domestic economy, especially in countries that upgrade their industries in a manner consistent with their comparative advantages.

Participation in GVCs also tends to be correlated with optimal sources of external financing – primarily FDI. Unlike portfolio investment, FDI reflects foreigners’ commitment to long-term business relationships in industries that capitalize on comparative advantage. Besides providing developing countries with much-needed stable non-debt finance, FDI inflows are associated with higher employment, transfers of technology and managerial know-how, and learning opportunities for workers within and across firms.

In the unfavorable business environments typical of many developing countries, GVCs can stimulate the emergence of well-functioning clusters of private firms in competitive industries. They also provide small and medium-size domestic firms opportunities to join strong international networks of partners, suppliers, and clients, which can bring access to finance, higher standards, and expanded markets.

Crippling GVCs in response to the pandemic will therefore be self-defeating. To be sure, rich economies may have legitimate concerns about relying too heavily or solely on China or any other single country for key parts and materials. But the answer is not to dismantle GVCs or roll back global trade, but rather to revamp supply, identify the vulnerabilities, and mitigate the risks.

For starters, multi-sourcing, or having suppliers in different regions of the world, would build in redundancy in case of disruptions. Second, we must ensure that governments’ COVID-19 rescue packages account for long-term effects on climate change, promote economic sustainability, and strengthen supplier codes of conduct regarding labor and environmental practices. New technologies and organizational systems such as 4D printing could render supply chains more efficient and sustainable, by making it possible to create objects that not only anticipate but also respond to changes in environmental conditions, thereby enabling self-assembly and creating opportunities for on-demand, customized production.

Third, large firms receiving state bailouts should commit to rebalancing the distribution of activities and benefits within GVCs to ensure that poor countries are not stuck in lower-value-added production. Finally, providing working-capital loans to small businesses – the main source of employment in many economies – would help to improve their position in GVCs and break the current core-periphery pattern of “good” jobs in the Global North and “bad” jobs in the Global South.

The COVID-19 pandemic has brought the global economy to an abrupt halt and highlighted the fragility of existing GVCs. Demolishing these key drivers of international trade and investment would only make a bad situation worse and hurt developing economies disproportionately. The answer to the problem of GVCs is not to break them up, but to make them more diverse and inclusive.

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