COVID-19 is a global public health crisis with implications for all aspects of life. In this context, governments are pursuing measures to address health and safety that also have implications for international trade and investment. This note addresses questions related to the impact of COVID-19 on global value chains (GVCs), focussing on economic impacts and consequences for the organisation of production networks. It discusses policies that can help to promote security of supply and ensure a sustainable economic recovery.
COVID‑19 and global value chains: Policy options to build more resilient production networks
Abstract
Key Messages
COVID-19 has re-ignited an old debate about the supply chain risks associated with international production. However, there is no evidence that economies would have fared better in the absence of GVCs, as government lockdowns have also affected the supply of domestic inputs.
COVID-19 has highlighted both the strengths and weaknesses of GVCs, including for the supply of essential products. Past experience suggests that international production networks can be disrupted and play a role in the propagation of economic shocks across countries and industries. But they also help firms and countries to recover faster.
More resilient production networks can be achieved through better risk management strategies at the firm level, putting the emphasis on risk awareness, greater transparency in the value chain and promoting agility. Sourcing strategies may differ across activities depending on the level of acceptable risk, with supplier diversification and ‘just in case’ processes an objective for essential activities.
Governments can support efforts of firms to build more resilient GVCs by collecting and sharing information on potential concentration and bottlenecks upstream, by developing stress tests for essential supply chains and by creating a conducive regulatory environment which is not a source of additional, policy-related, uncertainty.
1. COVID-19 has re-ignited an old debate: What are the benefits and costs of GVCs versus “nationalisation”?
Most international trade and investment takes place within GVCs. 70% of international trade involve exchanges of raw materials, parts and components, services for businesses and capital goods that are used by firms to produce and serve their customers (OECD, 2020a). One-third of world production is done by multinational enterprises and they account for half of world trade (OECD, 2018).
GVCs have brought many benefits by allowing firms to source their inputs more efficiently, to access knowledge and capital beyond the domestic economy and to expand their activities into new markets (OECD, 2013). GVCs have also played a pivotal role in reducing poverty and offering an opportunity for developing countries to grow and catch up with richer countries (Wold Bank, 2019).
However, even before the COVID-19 crisis, there was evidence of a decline in fragmentation of production across borders. Since 2011, the expansion of GVCs has stopped (Figure 1). For each dollar of output in the world, there has been less trade in intermediate goods and services, highlighting that firms are reducing their use of foreign inputs. Indicators measuring the length of value chains confirm that GVCs have become shorter and that only the international part of value chains is affected by this trend (Miroudot and Nordström, 2019).
Figure 1. Global import intensity of production, 2005-2016
Note: This indicator takes into account all trade flows of intermediates inputs used in any stage of the value chain, and expresses their overall value as a share of the final output. Calculated for the world, it measures the overall level of fragmentation of production
Source: OECD TiVA 2016, OECD TiVA 2018, OECD Economic Outlooks, Comtrade, IMF
Structural shifts such as the digitalisation of economies, the servicification of manufacturing (i.e. the fact that manufacturing firms increasingly use and produce services that they combine with the goods they sell) and consumer preferences for more sustainable production processes are important reasons why firms are tending to produce closer to consumers and may rely less on offshoring, while still becoming more productive and providing better products and services. Prior to COVID-19, however, there was also a concern that the trend observed in Figure 1 was also the consequence of trade tensions and rising protectionism, with sourcing decisions of firms also affected by higher trade costs and rising policy uncertainty.
With COVID-19, a different debate has emerged, whereby GVCs are argued by some to create additional economic vulnerabilities during a pandemic or other crisis where international trade is disrupted. The closure of factories in China at the end of January drew attention to the reliance of many manufacturing value chains on inputs from China. The subsequent lockdowns implemented all over the world resulted in a GVC ‘concussion’ (Baldwin, 2020) and re-ignited a debate on the risks associated with international production.
Some scholars and policy-makers have started to suggest that there is a need to rethink GVCs and make them more resilient, for example by diversifying their supplier base or by reshoring some activities (Javorcik, 2020). Some assert that re-nationalising GVCs could to some extent insulate countries from the economic consequences of the pandemic. However, analytical work indicates that the contraction of GDP would have been worse with re-nationalised GVCs, as government lockdowns also affect the supply of domestic inputs (Bonadio et al., 2020).
Against this backdrop, this note describes the impact of COVID-19 on GVCs, draws lessons from past and current experience on the resilience of international production networks and sets out policy options that can promote security of supply, mitigate disruptions in value chains and help promote economic recovery.
2. How are GVCs impacted by COVID-19?
COVID-19 is a global health crisis that has led governments and companies to take exceptional measures to protect the lives of citizens and workers. These measures have either reduced or stopped economic activity, resulting in decreased output, rising unemployment and falling demand.
GVCs are impacted through four channels. First, there is a direct impact when companies operating in GVCs stop producing due to health precautions (because some employees are sick and because of social distancing rules). This direct impact is not specific to GVCs per se, but to locations where the virus has spread. The direct impact of COVID-19 has been felt in most countries and most companies.
Second, there are a range of indirect impacts, which can affect GVCs to differing degrees. There is a supply chain impact, when production in one location requires inputs from another and this other location is directly impacted. Natural disasters are an example of this supply chain risk, such as during the 2011 Tōhoku earthquake and tsunami in Japan or the Chao Phraya floods in Thailand the same year. Companies relying on inputs manufactured in these areas were severely impacted through supply chain linkages.
The supply chain impact can also come from a disruption in international transport networks, where the disaster does not affect the production of inputs but rather the intermediary means of transportation. This supply chain risk is more specific to GVCs as they produce in many places that are potentially at risk and also rely on international transport networks. Domestic supply chains are also vulnerable to such risks to the extent that domestic outsourcing and domestic transport networks are affected.
Supply chain risks materialised at the beginning of the crisis when production stopped in China but continued in the rest of the world. International transport networks have also been impacted during the crisis through restrictions on the movement of people and additional requirements at the border for customs clearance (in addition to the direct impact on workers in the transport industry and border agencies). Moving goods involves people (crews, pilots, workers in ports, etc.) and in the case of air transport, a significant share of air cargo was shipped via (cancelled) passenger flights.
Third, there can be a demand impact, whereby production continues but there are fewer consumers willing to buy the products. A demand impact can also result from a surge in demand, as observed in COVID-19 for some key medical supplies, or a shift in demand (as observed for some food products with the closure of restaurants and hotels). Volatility in demand also affects domestic supply chains but GVCs play a role in the transmission of economic shocks through demand channels, when demand is decreasing in one geographic area and not others. Lower demand for final products in a given country reduces demand for inputs produced in other countries. This phenomenon can affect multiple locations at once when the crisis is global (simultaneous reduction in demand in many countries, as observed with COVID-19).
According to business surveys, the main impact of COVID-19 on GVCs is on the demand side.1 On the one hand, GVCs for medical supplies and medicines have been placed under severe strain due to the enormous surge in demand. On the other hand, the economic crisis, confinement measures, and changes in consumer behaviour have lowered demand for many manufactured goods as well as services (some of them also produced within GVCs). Demand has increased dramatically only for medical supplies, while there has been a significant shift in the composition of demand for food. Demand has decreased for all other manufacturing GVCs.
Fourth, there is also a trade and investment policy risk, as illustrated with export bans implemented for key medical supplies and growing pressure in some quarters to re-nationalise production in the belief that this will promote greater security of supply. While countries have generally committed to keep markets open and to maintain a free, fair, transparent and non-discriminatory trade and investment environment,2 some uncertainty on the future trade and investment regime as a consequence of COVID-19 is also a risk currently assessed by firms and that will impact the organisation of their value chains.
3. What can we learn about the resilience of GVCs from past and current experience?
In 2011, two major natural disasters occurred in Japan and Thailand with deep economic implications for firms operating in GVCs. These two events drew attention to the need for resilience in supply chains. Indeed, some Japanese firms were more impacted by the floods in Thailand than by the earthquake in their domestic economy due to supply chain linkages.
The impact of the Tōhoku earthquake and tsunami on Japanese firms
The Great East Japan earthquake, the fourth largest earthquake in the world since 1900, profoundly impacted the Japanese economy in 2011. Several studies have analysed the propagation of the economic shock through supply chains. In particular, the propagation was stronger in value chains where inputs are specific and difficult to substitute. But studies at the firm level also found that Japanese companies were relatively resilient. According to Inoue and Todo (2017), most plants that were directly hit by the earthquake restarted their activity within three months. Todo et al. (2015) find that firms with extensive networks of suppliers made a faster recovery. Because of their complex supply networks, these firms were initially more affected, but these networks became their advantage in the recovery phase. Todo et al. (2015) conclude that the positive effects of supply chains typically exceed the negative effects.
Other studies shed light on how firms have changed their sourcing strategies after the earthquake. Zhu et al. (2017) show that firms in the area affected by the earthquake reacted by offshoring more, which can point to some supplier diversification. In the motor vehicle industry, Matous and Todo (2017) find that, in the wake of the disaster, manufacturers have diversified their suppliers and moved away from the “keiretsu” model of long-term relationships with first-tier suppliers.
The impact of the Chao Phraya floods on the hard disk drive industry
In Thailand, severe flooding occurred during the monsoon season in 2011, with serious implications for the hard disk drive (HDD) industry. 43% of world HDD production was concentrated in the Chao Phraya river basin affected by this natural disaster. But the outcome was different among the main producers (Haraguchi and Lall, 2015). The leading firm in the industry, Western Digital (United States), saw its factories inundated, while its main competitor, Seagate (United States) had factories in the same place, but on higher ground. Toshiba (Japan) also saw its factories inundated, but was able to divert production to the Philippines. Seagate became the main producer of HDD in 2011. But it took only six months for Western Digital to retake the market lead. With the help of Thai navy divers, Western Digital managed to salvage most of the manufacturing tools and restarted production 46 days after the flooding. It was a costly process, but high sales in 2012 compensated for the loss.
While greater diversity in the location of production was expected after the 2011 experience, Western Digital not only continued to produce next to the Chao Phraya river, but even decided to close a factory in Malaysia in 2017 to further concentrate its production in Thailand.3 This underscores that some offshore locations provide significant advantages for manufacturing firms and that reshoring might not be the solution seen as most effective by firms in managing risks in value chains.
Vulnerabilities and strengths of GVCs during the COVID-19 crisis
Many businesses have reported important disruptions in their supply chains during the COVID-19 pandemic. As a consequence of lockdowns implemented by governments, both international and domestic supply have been affected. In this respect, the COVID-19 circumstances are more akin to a natural disaster than to the 2008-2009 financial crisis (during which the domestic part of value chains was less impacted or later when the crisis moved from the financial sector to the real economy).
Notwithstanding disruptions, many GVCs have continued to operate during the COVID-19 crisis (albeit with a lower output), including in activities which may not be regarded as essential. An example is the IT and electronics value chain, with the production of smartphones. Apple has launched a new model (the iPhone SE) during the crisis, sold mostly on-line. While the smartphones were manufactured before the crisis, Apple will also launch four new iPhone models next fall, with production delayed by only one month.4 Its main competitor, Samsung, reported not having any meaningful production disruptions.5 In the case of the food industry (very much an essential activity), food supplies have proven relatively resilient so far. Disruptions in international supply chains to date have been relatively limited, with the most serious bottlenecks observed in domestic processing and retail distribution (i.e. the domestic part of value chains) (OECD 2020b).
Concerns about the medical supplies and devices industry, however, have fuelled some frustrations related to GVCs during the COVID-19 crisis. Shortages of supply in face masks and, more generally, in personal protective equipment (PPE), as well as key respiratory medical devices such as ventilators, triggered concerns about the high trade interdependencies observed in this industry (OECD, 2020c). As face masks were mostly produced in China before the crisis, the inability to source them when China was hit by COVID-19 was seen as highlighting the risks of foreign sourcing. A closer examination of the situation with face masks, however, suggests that the global shortage resulted from an unprecedented demand shock. China itself, despite being the main producer, faced a shortage (OECD, 2020d). Such shortages are not the result of supply chains, as domestic production would face similar difficulties in the face of such a demand surge. This suggests that future planning should include both the anticipation and re-evaluation of different risks (with stockpile strategies) and international co-operation to increase overall supply. Ultimately, the shortage in face masks was solved by China ramping up its production by a factor of 12, supplying face masks to all countries in need.
In the case of COVID-19 test kits, the experience of Korea also suggests that GVCs are more often a solution than a bottleneck for the supply of essential goods during a crisis. No country could produce COVID-19 test kits before the identification of the virus and Korea was not among the main exporters of in-vitro diagnostic tests (the generic category for such products). But in less than three months and leveraging its GVC experience, Korea became one of the main exporters, with 40 companies serving more than 100 countries.6 Rather than trying to create domestic production capacity, especially in the face of confinement strategies, many countries turned to GVCs to address shortages and to increase supply.
4. What can firms do to improve the robustness and resilience of GVCs?
The management literature highlights that it is at the level of firm strategies that resilience in supply chains can be achieved. The first step in supply chain risk management is the identification and evaluation of risk (Manuj and Mentzer, 2008). Firms need to classify and assess the likelihood and likely impacts of different risks. For example, COVID-19 involves a supply risk (e.g. inputs not delivered), a demand risk (a drop or surge in demand) and an operational risk (e.g. a breakdown of operations because workers are exposed to the virus). Until recently, such pandemics were largely considered to be low probability, potentially high impact, events.
The second step is the design of risk management strategies. Examples of such strategies include: avoidance (for unacceptable risks), postponement (e.g. producing or shipping goods once customer orders are received), speculation (the opposite of postponement, such as producing or shipping goods before orders arrive), hedging (e.g. diversifying suppliers and locations of production), control (e.g. through vertical integration with ownership of main suppliers), sharing risk (one objective of outsourcing and offshoring) and enhanced security (e.g. sensors for shipments at risk).
To find the right strategy, information on the supply chain and the level of risk at different stages is key. It is important to ensure transparency in the value chain, with sufficient information on suppliers – and the suppliers of suppliers – all along the value chain, including possibly assessment of inventories for critical inputs. The most advanced firms have ‘control towers’ that allow them to follow, in real-time, flows of inputs and to anticipate disruptions. Digital technologies (such as the Internet of Things) can reinforce the capacity of firms to identify and respond to risks in their supply networks.
When anticipation fails or when information suggests that a disruption will take place, firms mitigate the impact through what is described in the business literature as agility or reactivity. This can be defined as ‘the ability to sense and respond to changes in an organisation’s internal and external environment by quickly assembling resources, relationships and capabilities’ (Gallagher and Worrell, 2007). This requires processes and a management structure that allow for a swift shift to alternatives. Since the nature of the next risk or disruption is often unknowable, developing agility is an important part of resilience strategies.
As with many other aspects of business life, there is no one size fits all approach for managing supply chain risk. First, there are firms for which the robustness of GVCs, i.e. their ability to continue to produce and serve consumers during a crisis, is a priority (Brandon-Jones et al., 2014). This is the case for firms that supply essential goods (such as key medical supplies, pharmaceuticals or food) and firms whose production processes cannot be restarted again easily once stopped (e.g. furnaces in the steel industry or nuclear reactors in the energy industry). These firms will spend more resources to mitigate risks and ensure ongoing security of supply and this will be reflected in their sourcing strategies.
For example, robust GVCs require some degree of supplier redundancy. Dependence upon a single supplier creates risks of interruption, so these firms need to have a range of alternative suppliers for each of their inputs. This imposes additional costs on firms, as they need to invest in multiple suppliers to tailor inputs and to make sure that parts and components from different manufacturers fit together (which also can sometimes entail costs in adjustments to production processes). Some scale economies are also lost in the process.
The geographic distance to suppliers also plays a role when building robust GVCs, and is a relevant consideration in the context of domestic and international supply chains. When there is a trade-off between reducing costs and improving delivery time, firms for which the latter is more important naturally shift to shorter supply chains. But firms generally try to combine the advantages of domestic supply with the opportunities offered by offshoring and international trade, in particular in the context of supplier diversification.
As robustness is a costly objective, firms also have strategies to improve their resilience, i.e. their ability to return to normal operations in an acceptable period of time after being disrupted. Firms that value resilience over robustness focus more on the speed of recovery. For example, these firms can favour long-term relationships with single suppliers. Instead of switching to other suppliers and possibly incurring sunk costs, the trusted relationship with the same supplier can lead to higher investment by the supplier in avoiding or mitigating disruptions and ensuring rapid recovery. There is empirical evidence that supplier diversification is associated with slower recovery from supply disruptions at the firm level, while the use of long-term relationships is associated with faster recovery (Jain et al., 2016).
For some activities, firms might prefer to operate in a relatively vulnerable environment and accept a trade-off between efficiency and costs, on one hand, and higher vulnerabilities on the other. “Just in time” and “lean production” is a strategy that has worked well for many companies (Pisch, 2020). Risk management is precisely about distinguishing activities for which robustness is a priority (where the approach is “just in case” instead of “just in time”) as opposed to activities where risk is acceptable and the level of acceptable risk. Cisco, for example, was one of the companies best prepared for the 2011 earthquake in Japan, and suffered almost no revenue loss while implementing the “Cisco lean model” (Sáenz and Revilla, 2014). The company had effectively integrated risk awareness at all levels in the value chain and put in place monitoring mechanism for resilience, with an index to assess the time to recover for all its suppliers.
5. What can governments do to promote security of supply and economic recovery?
COVID-19 could be seen as having 3 stages, which can be described as crisis, recovery and new normal. Table 1 provides specific policy recommendations for each of these stages.
During the crisis, the focus is on ensuring the provision of essential products, such as medical supplies and medicines, and on increasing supply where there is a surge in demand or a shortage in the provision of such goods. Maintaining the operations of essential GVCs is the main challenge, as disruptions occur and transport and logistics have to adjust to the crisis.
In the recovery phase, GVCs can play an important role in ensuring supply by reducing the time needed for production to reach pre-crisis levels. Maintaining an open trade and investment environment is critical, while also addressing the requests of firms that may need specific and time-limited support to recover. The value chain is as strong as its weakest link and bottlenecks can appear if specific firms in specific industries or within industries take more time to recover. If the virus is still a threat during the recovery (as is likely to be the case with COVID-19), there is an additional challenge related to how to restart the economy while maintaining necessary health measures.
Finally, the new normal should be understood not only as the period where the virus is no longer a threat and economic activities have largely resumed, but also as a period where governments and firms should prepare for the next crisis (which may be very different from a pandemic) and have time to take the necessary steps to be better prepared. Most efforts will be at the firm level, as previously highlighted, but governments have an important role to give incentives to firms to integrate risk awareness and develop risk management and resilience strategies.
Table 1. Main policy recommendations for GVCs
Firms are in the best position to develop risk management and resilience strategies, but one issue can be the asymmetry of information in the context of complex GVCs. For example, studies suggest that even when first-tier suppliers are diversified, it is difficult for firms to know what happens with second-tier and third-tier suppliers. The supply chain can have a diamond shape with many first-tier suppliers but with a single supplier (often of raw materials) located at the beginning of the value chain, upon which all downstream suppliers depend (Sheffi, 2015).
Governments can collect and share information on potential concentration and bottlenecks upstream in supply chains and can work with the private sector to address such issues. Trade and investment policy-makers have a role to play to review the network of trade agreements and investment regimes beyond direct partners to assess the incentives and barriers to supplier diversification. This effort is also related to investment in, and promotion of, digital technologies that can improve information systems for risk management, such as the Internet of Things. More generally, knowledge sharing platforms to facilitate discussions among companies, governments and civil society can help to identify best practices to mitigate risks and build resilience.
As was undertaken for banks after the 2008 financial crisis, a further option is for governments to develop stress tests for specific supply chains (Simchi-Levi and Simchi-Levi, 2020). Such an approach could be particularly useful for critical supply chains, such as pharmaceuticals or personal protective equipment. These tests could be undertaken in the context of policies related to creation of strategic stockpiles in order to correctly assess the inventories and buffer stocks needed to prevent shortages in the future. Risk mitigation can also be part of government procurement procedures for essential goods, with specific criteria to select firms on a non-discriminatory basis.
Moreover, governments should create a conducive regulatory environment which is not a source of additional, policy-related, risk. GVCs are complex structures with “lead firms”, i.e. firms that have some degree of control on the organisation of the value chain (Gereffi et al., 2005). But ultimately, the organisation of supply chains is the result of many interactions among networks of different firms in different countries. No government can control the value chain, even when nationalising its lead firm.
Moreover, tools that are available to implement reshoring policies include subsidies, tariffs, local content requirements, and investment restrictions. Such measures are known to introduce economic distortions reducing the income of countries and the welfare of citizens. As re-shored companies become less competitive, there is further risk of a second wave of protectionism, triggering retaliation across countries and further income and welfare loss. Where governments are then tempted to increase fiscal incentives or to relax labour or environmental standards to compensate for additional costs, there is also a serious risk of a race to the bottom.
Ultimately, given the lack of evidence that domestic supply chains fared any better than international supply chains during the COVID-19 crisis, the additional economic and social risks of extensive reshoring policies and nationalisation far outweigh any perceived gains in terms of security of supply. To the extent that governments do opt to pursue measures in an attempt to nationalise supply chains in certain products for heath or security reasons, such interventions should be transparent, targeted and take fully into account associated costs, trade-offs and risks.
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Notes
← 1. See the surveys conducted by the Institute for Supply Management (www.instituteforsupplymanagement.org) and the data collected on firmlevelrisk.com.
← 2. See, for example, the G20 Trade and Investment Ministerial Statement (https://g20.org/en/media/Documents/G20_Trade%20&%20Investment_Ministerial_Statement_EN.pdf) or the statement by APEC Ministers of Trade on 5 May 2020 (https://www.apec.org/Meeting-Papers/Sectoral-Ministerial-Meetings/Trade/2020_trade).
← 3. The Register, “Western Digital Formats Hard Disk Drive Factory as Demand Spins Down”, Chris Mellor, 17 July 2018.
← 4. The Wall Street Journal, “Apple Delays Mass Production of 2020 Flagship iPhones”, 27 April 2020.
← 5. Financial Times, “Inside Samsung’s Fight to Keep its Global Supply Chain Running”, 12 May 2020
← 6. Pulse by Maeil Business News Korea, “Korean-made COVID-19 testing kits demanded by over 100 countries”, Kim Byung-ho, Kim Si-gyun and Minu Kim, 9 April 2020. Korea also became one of the main exporters because the country was less affected by the pandemic in the first wave due to its greater domestic preparedness.