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Supply chains are more resilient than they appear

06/07/2022    49

The resilience of global supply chains in manufacturing has been under scrutiny following COVID-19 and geopolitical shocks. Global supply chains are robust or resilient when they can sustain economic shocks and continue producing an unchanged level of output. The operational and locational dimensions of resilience need to be appreciated amid calls for the ‘reshoring’ of production, which shortens supply chains by bringing them home to reverse the ‘export of jobs’.

The disruption to global supply chain operations is being used as a pretext to reshore production, but diversifying supply chains actually lowers risk. The ongoing digitalisation of global supply chains — accelerated by the COVID-19 pandemic — also increases resilience while reducing the cost of distance, diminishing the case for reshoring. But the reshoring prerogative is so great that it was one of many factors that drove the United States to initiate a trade war with China. Japan has also offered generous subsidies to its affiliates to return from China.

COVID-19 was a global shock that disrupted production in every country that locked down, irrespective of their global supply chain integration. But it mattered not whether the goods were produced from start to finish in one of those lockdown countries or across several of them. The more recent output disruptions may have more to do with the explosion in pent-up demand and the unevenness of the recovery that preceded the war in Ukraine, and associated sanctions on Russia, than the way goods are produced.

The pandemic has actually demonstrated how resilient global supply chains can be, with manufacturing production bouncing back so quickly after lockdowns were eased. This was particularly true in Southeast Asia, where trade was about 30 per cent above pre-pandemic levels by 2022 despite China’s continued lockdowns.

The vulnerability of global supply chains have been exposed less by global shocks than by country or region-specific shocks. The 2011 Thai floods and the 2011 Fukushima earthquake in Japan highlight how a disruption to just one segment of production reverberates throughout the supply chain, leading to a sharp contraction in final output. The China–US trade war is another country-specific shock because discriminatory tariffs are only applied to each other’s trade.

Although the bilateral tariffs of the China–US stand-off are relatively small, ranging from 10 to 25 per cent, their impact on competitiveness can be much greater. While the tariff is levied on the total value of the product, it can be completely negated by simply removing the share of value added in the tariff-targeted country.

To illustrate, the domestic value added of Chinese total manufacturing exports to the United States in 2018 was estimated to be 30 per cent. Imported inputs account for US$70 of a US$100 made-in-China shirt, while the final production processes in China add US$30. It follows that a 25 per cent tariff on the US$100 shirt is really a US$25 tax on the US$30 value added in China.

Other countries, such as Vietnam, effectively receive a ‘buffer’ of US$25. If Vietnam can add the same value while keeping total costs less than US$55 — within the buffer provided by the tax — it would be more profitable to produce there.

This multiplier effect of the discriminatory tariff is termed the effective rate of spill-over protection because it creates a magnified and unintended advantage to all competitors, not just the United States. It also explains why the relocation of global supply chains could happen in response to a relatively small tariff if the value-added share is small.

But in practice, global supply chains overall have remained remarkably resilient to price rather quantity disruptions. While there have been shifts in global supply chains out of China into neighbouring countries like Vietnam, Thailand and Malaysia, these have mostly involved labour-intensive industries. The key industries that dominate global supply chains — electronics, transport equipment and machinery — have not seen much relocation. Considering how the effective rate of spill-over protection magnifies protection, global supply chains are more resilient than they appear.

The conundrum involving the effective rate of spill-over protection is resolved when factor intensity and technology are taken into account. Electronics, transport and machinery industries are capital-intensive with high shares of fixed costs. These technologies are generally less divisible such that fewer segments of the supply chain can be separated and transferred across borders.

Such complex production processes operate within an ecosystem that is both less divisible and more difficult to recreate elsewhere. Factories must be rebuilt, while training new workers and developing relationships with new suppliers adds substantially to costs. These factors could overwhelm the multiplier effects of the effective rate of spill over protection, accounting for the locational resilience of electronics, transport and machinery industries despite trade war tariffs.

There is little evidence that the trade war has resulted in the significant reshoring of production. If punitive tariffs have failed to reshore production, direct subsidies have not fared any better, even though subsidies can be better targeted because they can be tied directly to reshoring, avoiding the spill-over to third countries.

But since the subsidies are directly related to the value added returned, they yield no effective rate of spill over protection -related multiplier effects, reducing their potency. The evidence from Japan is that firms that availed of the subsidies to reshore production were quick to return to China after observing a grace period, diminishing any long-term impact on supply chains.

When reshoring is engineered through discriminatory taxes or targeted subsidies, global welfare is reduced by a loss of efficiency due to a misallocation of resources.

Using resilience as a pretext to promote the reshoring of production is not only likely to fail, but it will incur costs even if it is successful.

Source: East Asia Forum