# Geopolitics

• Jordi Singla
• José Ramón Díez
• Javier García Arenas
Oriol Carreras Baquer
• ## Global value chains: yesterday, today and tomorrow

catalanspanish

17 Mar 2021

16 Feb 2021

## Have democracies been more lax with lockdowns and testing?

16 Feb 2021

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.

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.

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.

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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## Financial volatility and political uncertainty: who says there is fear?

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September 14th, 2017

Over the past few months, one of the major issues in macrofinance has been the coexistence of financial volatility at an all-time low and high political uncertainty. But should we be surprised by this apparent paradox? Just how closely are financial volatility and political risk related?

The most widely used indicator to measure financial volatility on the US stock market is the VIX, commonly known as the «fear index», which measures the implied volatility of S&P 500 index options. As can be seen in the first chart, the gap between the economic policy uncertainty index for the US and the VIX reached a peak in January, when Donald Trump took office. Since then it has fallen slightly. In fact, this gap is currently narrower than the level reached in two relatively recent episodes: the «fiscal cliff»1 at the end of 2012 and the US federal government shutdown in 2013 after budget negotiations failed. This recent narrowing of the gap is mainly due to a 39% drop in the US policy uncertainty index between January and June. Nevertheless, policy uncertainty is still relatively high.

A more rigorous and sophisticated way of gauging to what extent the VIX is abnormally low given the current levels of political uncertainty is to compare the observed VIX with the VIX predicted by US and global indices of policy uncertainty. When this is carried out, we can see that, since July 2016, the VIX predicted by political factors vastly overestimates the actual volatility observed.

There are two other factors that are also presumably related to the decline in the VIX: macroeconomic and financial conditions. If we carry out the same exercise and compare the observed VIX with the VIX predicted by macrofinancial conditions,2 we can see that the predicted VIX is closer to the VIX observed over the past few months. For instance, the predicted VIX based on political uncertainty had a prediction error of 5.9 points in June compared with an error of just 2.86 points in the prediction made based on macrofinancial conditions.

If we look closely at the trend in the observed VIX and the predicted VIX in the second chart, it seems that, between 2003 and 2007, the predicted VIX based on policy uncertainty was relatively similar to the observed VIX while, since 2012, macrofinancial conditions have predicted a trend much more similar to that of the VIX. To check whether this is the case, we have divided the sample into three periods: from 2003 to 2007, from 2008 to 2011 and from 2012 to 2017. We have also analysed the policy, macroeconomic and financial factors that lie behind financial volatility. 3The findings leave no room for doubt: policy factors accounted for 74% of the explained variance in the VIX between 2003 and 2007 but only 12.5% between 2012 and 2017. The relative weight of macroeconomic factors and especially of financial factors was also greater between 2008 and 2017 than between 2003 and 2007. We should also note the decline in the explained variance of the VIX over the past few years. The explanatory power of political and macrofinancial factors was 76% between 2003 and 2007, and 89% between 2008 and 2011. But this figure was just 47% between 2012 and 2017. This suggests that factors unrelated to political uncertainty, macroeconomic variables or the index for financial conditions currently lie behind a larger percentage of the VIX variation.

These findings may look surprising at first sight but they become plausible when other elements are also taken into account. On the one hand, political uncertainty may have lost some of its influence on financial volatility because, as shown by the Chicago University economists Pastor and Veronesi,4 political news are now less reliable and policy signals have become noisier. The difficulty in interpreting political information accurately might have led investors to react less to political events even when there is greater uncertainty.

On the other hand, financial variables may have gained relative weight over political factors in the period 2008-2017 compared with 2003-2007 due to unconventional monetary policies (for instance, the first US quantitative easing programme, QE1, began at the end of 2008).
The Fed’s massive bond buying programmes have increased liquidity in the financial system, pushing up the price of some financial assets as well as reducing fears of sharp slumps in these prices, thereby decreasing volatility.5

Macrofinancial elements also seem to be related to the decrease in the explained variance of the VIX between 2012 and 2017. In particular, the recent increase in passive management funds6 could have been a relevant factor. These funds track a specific index and therefore reduce the capital bought and sold on a daily basis on the financial markets. One consequence could be that financial volatility has become less sensitive to certain macroeconomic and financial fluctuations.

1. When automatic increases in taxes were coupled with massive spending cuts by the US government to reduce the federal deficit.

2. The macroeconomic variables included are the US business sentiment index (ISM) and a measure of global macroeconomic volatility based on the index of economic surprises for the G-10. Financial conditions were measured using the financial index elaborated by the Federal Reserve of Chicago.

3. The formula for the lineal regression is as follows:

$$VIX_t=\beta\ast EPU_t+\gamma\ast CM_t\ast+\alpha\ast IFC_t+\varepsilon_t$$.Where EPUt is the vector of economic policy uncertainty indices by Baker, Bloom and Davis for the US and the world, CMt is the vector of macroeconomic variables detailed in note 2, and IFCt is the index for financial conditions. Lastly, εt is a random error term.

4. See Pastor, L. and Veronesi, P. (2017), «Explaining the puzzle of high policy uncertainty and low market volatility», VOX Column.

5. For more details, see Mallick, S., Mohanty, M. S. and Zampolli, F. (2017), «Market volatility, monetary policy and the term premium», BIS Working Papers.

6. The passive management of investment portfolios is an investing strategy, for bonds or equity, that replicattes the evolution of a specific index. In the US they account for almost half of the capital managed by investment funds and 14% of the stock market value.

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## Geopolitics

We analyse the major geopolitical trends and how they influence the financial markets and economy.