• Global value chains: yesterday, today and tomorrow

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    Made in Spain, Made in the USA and even Made in China labels make less and less sense in today’s world. Since firms decided to fragment their production processes and move them to other countries, the label Made in the World probably better represents the nature of most of the manufactured goods we consume. In this article we review the past, present and future of global value chains at a time when pandemic-induced restrictions on travel and supply disruptions have brought them back into the spotlight.

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    The creation of global value chains

    he 1990s saw the beginning of a far-reaching optimisation of production processes beyond the borders of a single country. Companies decided to fragment these processes and carry them out in as many countries (in order to make the most of each country’s advantages of specialisation), giving rise to what are known as global value chains (GVCs). Several factors helped to encourage the creation of GVCs but first and foremost were the advances made in information and communication technologies (ICTs), which enabled the different production stages to be coordinated perfectly. A second factor was the reduction in trade costs, helped by the important free trade agreements reached during that decade,11 as well as by improvements in transportation, especially by air.

    In fact, GVCs have boosted international trade flows to values that were unthinkable a few decades ago: exports of goods and services as a percentage of GDP rose from around 18% in the early 1990s to levels close to 30% just before the pandemic, while the relative weight of GVCs in total trade flows went from around 40% to just over 50% in the same period (see the chart below).12 

    • 11. 1994 saw the conclusion of the largest round of multilateral trade negotiations (the Uruguay Round), in which 123 countries took part. Also in 1994, the North American Free Trade Agreement (NAFTA) was concluded. Both agreements led to a substantial reduction in tariffs worldwide: from levels of around 16% in the early 1990s to 5% today (according to World Bank data, simple averages).
    • 12. The development of GVCs was particularly dynamic between 1990 and the early 2000s, just before the outbreak of the global financial crisis. Since then, the relative importance of these chains in trade seems to have stagnated.

    The importance of global value chains in trade flows

    Last actualization: 04 May 2022 - 09:16
    The pandemic: present impact and future approaches to GVCs

    The COVID crisis has raised many doubts regarding the high degree of globalisation achieved, as well as the adequacy of GVCs. At first, in countries such as Spain, we became aware of the high external dependence (beyond the EU’s borders) of goods which, at that time, were essential.

    In a second phase, with the strong recovery in demand focusing particularly on durable goods and the disruptions in some factories due to the effects of COVID,13 we have been faced with a global supply shortage problem we had not experienced since GVCs were created. And, in this world of global manufacturing, disruption in one stage of the production chain leads to major disruptions throughout the entire process. The longer the GVC, the greater the impact (the bullwhip effect).

    Such disruptions will undoubtedly change people’s minds about GVCs. Although it is still too early to know what changes the future holds, we can suggest some strategic rethinks company directors are likely to pursue in order to increase the robustness of the production chain.

    First, the chains will probably be shorter to avoid the amplifying effect of disruptions. Secondly, they will be more redundant in key components. In other words, there will be alternatives to the production of these components. Thirdly, they will be equipped with new digital technologies that will enable them to detect chain failures early on. And, in terms of logistics, investment in inventories is likely to increase: from just in time to just in case, as stated in a recent article by the Financial Times14 (see the chart below).

    • 13. See the article «Bottlenecks: from the causes to how long they will last» in the Monthly Report of December 2021.
    • 14. See the Financial Times (December 2021). «Supply chains: companies shift from ’just in time’ to ’just in case’».

    Global value chains are likely to be shorter in order to avoid the amplifying effect of disruptions.

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    However, it should be noted that these possible strategic changes, if they occur at all, may be more gradual and less far-reaching than we might have assumed after the shock of the pandemic. One of the reasons is that such changes would entail an increase in costs, with the evident impact on prices consumers would have to pay. In a globalised world, this could mean a significant loss of competitiveness compared with other countries and/or companies. Furthermore, as Harvard professor Pol Antràs has noted, the configuration of GVCs forces companies to incur large sunk costs, which leads to them being extremely rigid regarding strategic production changes.15 

    In other words, the COVID shock will indeed bring about a change in our approach to the configuration of new GVCs and may certainly lead to some rethinking of the existing chains. But, in the latter case, this rethinking might be less radical and rapid than some are predicting.

    • 15. See Antràs, P. (2020). «De-Globalisation? Global Value Chains in the Post-COVID-19 Age». National Bureau of Economic Research, no. w28115.
    The future of GVCs: plus and minus factors

    In addition to the impact of the pandemic, other factors (mostly new technologies) have the capacity to reshape GVCs and we present a brief review (see the diagram below).16

     

    Automation and 3D printing

    Although automation is a process that has been going on for centuries, today’s robots, equipped with artificial intelligence and at a cost that has decreased substantially over the past few decades, represent a full-fledged revolution. The improved productivity of these new robots may result in some of the manufacturing processes which had been moved to emerging countries in order to take advantage of low labour costs now returning to advanced countries. In other words, we would be shifting from an offshoring to a reshoring trend, which would entail a certain reversal in the globalisation of supply chains.

    On the other hand, 3D printing is a technology that could result in GVCs becoming shorter and, along with this, to the reshoring of part of the manufacturing activity. In fact, with this technology, it is not necessary to send physical products; all that’s required are the computer files to manufacture them! However, there is still no clear evidence in this respect. In fact, a paper published by the World Bank shows a strong increase in trade flows following the adoption of 3D technology in hearing aid production, something we would not expect with a shortening of GVCs.17 Although this is a very specific case, it does reveal some interesting effects that need to be considered. In particular, the hearing aid sector adopted 3D printing for almost all its parts when this became technologically feasible (about 10 years ago) and, since then, trade flows linked to the sector have increased by 60%. The main reason for this growth is that 3D printing has led to a huge reduction in the production cost of hearing aids and an improvement in terms of quality, resulting in a sharp increase in demand for the product. And with greater demand, international trade in hearing aids has intensified.

    • 16. Based partly on Canals, C. (2020). «Revolución tecnológica y comercio internacional 4.0». Geopolítica y Comercio en tiempos de cambio. Published by CIDOB.
    • 17. See Freund, C. L, Mulabdic, A. and Ruta, M. (2020). «Is 3D Printing a Threat to Global Trade? The Trade Effects You Didn’t Hear About». World Development Report.
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    The electric car

    Another case that also warrants particular attention is that of electric cars, which have the potential to alter some of the most relevant GVCs (those of the automotive sector), as well as to considerably reduce international trade. The reason is that classic combustion-engine cars require a large variety of parts and gears that are often manufactured in different countries to maximize the competitive advantages of each location. In fact, the automotive sector is responsible for a substantial part of the world’s trade flows of intermediate goods. However, the electric car, with its much simpler mechanics (far fewer parts that are also less subject to wear and tear) could lead to a reduction in these classic intermediate flows and, consequently, to a radical change in the structure of automotive GVCs.

    The production of batteries, a key component for the new electric vehicles, will also determine the future of numerous trade flows, which in this case will focus on raw materials such as lithium, nickel and cobalt.

     

    Digital technologies and the emergence of new services

    The continuous evolution of ICT, hand in hand with 5G and blockchain technology, will continue to push down logistics costs and, with it, boost the trade flows of goods and services and participation in GVCs. For instance, 5G will support the development of the Internet of Things, which will enable faster and more secure tracking of shipments in the case of goods, and better connections in the exchange of services. Likewise, blockchain has the potential to greatly facilitate international payments.

    On the other hand, these digital technologies will also encourage the emergence of new products, especially services, whose organisation could be decentralised and located in different countries, creating new GVCs in the image and likeness of the chains already established for the production of manufactured goods.

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    History reminds us that technological development and international trade are not independent of geopolitical developments.

    Geopolitics

    Finally, it should not be forgotten that geopolitics has always played an essential role in international trade. In this respect, the USA’s intention to «decouple» from China, especially in the field of technology, could bring about a very significant change in world trade and in how GVCs are managed, especially in the technology sector. Even more so because the US is not alone in wanting to put more distance between itself and other economies. For instance, Europe also seems willing to reduce its external dependence in some technology segments, such as semiconductors, with the European Chips Act.

    In summary, although we do not expect any radical or abrupt change in the form taken by GVCs since they tend to be relatively stable over time, we might see a change in trend in the next few years due to the various 4.0 technologies. In addition to these ongoing trends, factors such as the Coronavirus crisis will further exacerbate certain technological dynamics. However, history reminds us that technological development and international trade are not independent of geopolitical developments. And in this respect, trade-technology tensions between the US and China will play a decisive role.

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2022: return to normality?

The starting point for next year is a global economy that is recovering much of the growth lost during the pandemic, thanks to the success of the vaccines and an extraordinary revival in demand for durable goods that has not been met by supply, creating bottlenecks that have ended up distorting value chains and leading to an unexpected surge in inflation.

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bottlenecks

For much of the crisis that has been crippling the international economy since the beginning of 2020, we have longed for a return to normality and, with it, a recovery in GDP levels and economic trends to those which were present in the now distant Q4 2019. In doing so, we have overlooked the fact that the economic landscape of two years ago was not exactly idyllic either (risk of secular stagnation) and, above all, that COVID is accelerating structural changes which we all saw coming on the horizon but were unable to assign a date to. So, if the question is when will we recover the «economic normality» lost in the last two years, then the answer is probably never. Soon enough, we will be back to producing the same amount of goods and services as we did at the end of 2019 (China, the US and much of the OECD has already done so), and we will even close the gap with where we should have been in the absence of the pandemic based on the long-term trend (see first chart). However, that gross domestic product will be achieved with a combination of different production factors and with a composition, on both the demand and the supply side, which will also differ from that which existed pre-COVID. These differences can be seen in the shape which the revival in employment is taking in countries like Spain, which, in addition to sound economic policy responses (furlough schemes, etc.), clearly reflects the particular idiosyncrasy of the recovery phase in which we are now immersed.

Cumulative change in real GDP up to Q3 2021

In this regard, at the end of the crisis there will be winners and losers and we will not return to the exit gate, as the classic process of creative destruction which occurs in any recession is proving even more acute this time. This is the case both due to the particularly disruptive nature of the pandemic and because it is coinciding with the disruption caused by digitalisation and the need to improve the sustainability of our production model. If a crisis occurs when «the old is dying and the new cannot yet be born», then there is no better definition to describe the current moment, which is especially convulsive and complex, given that we are witnessing the biggest mismatch between supply and demand since China joined the global production chain. The peculiar nature of this crisis, as an economic shutdown linked to mobility restrictions rather than a drastic adjustment in financial or real asset prices (balance-sheet recession), has led to an intense recovery in demand after the lockdowns, and this has pushed value chains to their limits while also showing us that, sometimes, sophistication also comes with fragility.

Thus, while the underlying trends that will characterise the post-COVID economy are gradually taking shape (changing consumption patterns, reconsideration of the role of the public sector, new central bank strategies, etc.), economic activity over the next 12 months will continue to depend on: how the pandemic evolves and how it affects mobility, the restoration of supply chain functions and, finally, the adaptation of economic policy to this new phase of the economic cycle. In other words, the dynamics of the recovery will be determined by the rebalancing of global supply and demand, which in turn will depend on how flexible production proves to be in adapting to a demand that will continue to be stimulated by extremely expansive financial conditions as well as by the constraints of the fiscal stimulus plans set in motion on both sides of the Atlantic. Everything rides on the capacity of supply to respond, having been hampered for the past decade both by the absence of reforms to make the economic structure more flexible and by weak public and private investment. If the adjustment occurs in the first half of the year, then the latent macroeconomic imbalances will be absorbed and we will return to a reflation scenario, albeit with the global economy making a soft landing as it converges towards its potential growth rates.

In this baseline scenario, the world economy will continue to show buoyant growth in 2022 (4.5%), albeit some 1.5 pps lower than this year. Much of the slowdown will be explained by the loss of momentum in both the US (3.5% in 2022 vs. 5.4% in 2021) and China (5.7% vs. 8.3%), both of which will already have left the period of recovering the GDP lost during the crisis well behind them and will be gradually approaching their long-term trend levels of growth. In the case of the euro area, the cruising speed will not change much (4.7% vs. 5.1%), both because of the maintenance of the monetary and fiscal stimuli (with NGEU funds) and due to the «rebound effect» which can be expected in countries of the region which performed relatively worse in the latter half of 2021 (Germany and Spain), assuming that industry and tourism recover as expected.

Beyond the potential for new variants of the virus such as Omicron to distort economic activity, the outlook will ultimately be shaped by how inflation behaves, the central banks’ exit strategies and how the financial markets assess the suitability of the financial conditions that are in place at any given time. The biggest risk is that the supply chain problems persist throughout the coming year, or that the disruptions in labour markets such as that of the US become more than a temporary feature. In that case, it is very unlikely that the price rallies in the more volatile components of the consumer price index will remain contained without filtering down to the other components to some extent, given that industrialised countries will be very close to closing the output gap by the end of next year. This would call into question the hypothesis being defended by many monetary authorities, namely that the current inflation rally is of a transitory nature.

With real interest rates at historical lows (see second chart), if we are to avoid threats to financial stability it is essential that the credibility of the central banks is upheld at all times. This will involve keeping a close eye on inflation expectations, and thus avoiding falling behind the curve for too long. However, differences in countries’ cyclical position (the recovery is proving highly asymmetric), as well as in the very credibility of the central banks themselves, are already resulting in very different rates of monetary normalisation between emerging and developed countries. This lack of monetary coordination could end up causing mismatches in exchange rate behaviour, another potential medium-term risk. The key, therefore, remains to keep the financial channel free from potential tensions in order to avoid the problems of the Great Recession of 2009.

Real yield on 10-year sovereign debt in the US and Germany

In short, the starting point for next year is a global economy that is recovering much of the growth lost during the pandemic, thanks to the success of the vaccines and an extraordinary revival in demand for durable goods that has not been met by supply, creating bottlenecks that have ended up distorting value chains and leading to an unexpected surge in inflation. The economy, like football, is a short blanket. If you prioritise growth at all costs, you will most likely end up with economic imbalances if your supply lacks the capacity and flexibility to respond. So, on the cusp of a new year, we cannot rule out the possibility that the ingredients laid before us will expose us to unexpected emotions: new mutations of the virus, inflation above central bank targets, mismatches between supply and demand, bottlenecks in a production chain that we thought was infallible, rising inequality, accelerated digitalisation, very high levels of debt, etc. In that sense, it does not look like we will be returning to the old normal. And as is well known, exceptional times call for exceptional measures.

 

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