Supply chains are more resilient than they appear

Author: Jayant Menon, ISEAS-Yusof Ishak Institute

The resilience of global supply chains in manufacturing has come under scrutiny in the wake of COVID-19 and geopolitical shocks. Global supply chains are robust or resilient when they can withstand economic shocks and continue to produce an unchanged level of output. The operational and localized dimensions of resilience must be appreciated amid calls for the “reshoring” of production, which shortens supply chains by bringing them home to reverse “the export of jobs”.

Disruption to global supply chain operations is used as an excuse to relocate production, but diversifying supply chains actually reduces risk. The ongoing digitization of global supply chains – accelerated by the COVID-19 pandemic – is also increasing resilience while reducing the cost of distance, diminishing the case for reshoring. But the relocation prerogative is so great that it was one of many factors that pushed the United States to start a trade war with China. Japan has also offered generous subsidies to its affiliates to return from China.

COVID-19 has been a global shock that has disrupted production in all countries that have locked down, regardless of their integration into the global supply chain. But it did not matter whether the goods were produced from start to finish in one of these blocked countries or in several of them. The most recent production disruptions may have more to do with the explosion of pent-up demand and the uneven recovery that preceded the war in Ukraine, and associated sanctions against Russia, than with how goods are produced.

The pandemic has in fact demonstrated just how resilient global supply chains can be, with manufacturing output rebounding so quickly after lockdown measures were eased. This was especially true in Southeast Asia, where trade was about 30% above pre-pandemic levels in 2022 despite China’s continued lockdowns.

The vulnerability of global supply chains has been less exposed to global shocks than to national or regional shocks. The 2011 Thai floods and the 2011 Fukushima earthquake in Japan show how a disruption in just one segment of production ripples through the entire supply chain, leading to a sharp contraction in final output. The trade war between China and the United States is another country-specific shock, as discriminatory tariffs only apply to each other’s trade.

Although the bilateral tariffs of the Sino-US standoff are relatively low, ranging from 10% to 25%, their impact on competitiveness can be much greater. While the tariff is levied on the total value of the product, it can be completely canceled by simply removing the share of value added in the country targeted by the tariff.

For example, the domestic value added of total Chinese manufactured exports to the United States in 2018 was estimated at 30%. Imported inputs are $70 of a shirt made in China at $100, while final production processes in China add $30. It follows that a 25% duty on the US$100 shirt is actually a US$25 value-added tax of US$30 in China.

Other countries, such as Vietnam, do receive a “reserve” of US$25. If Vietnam can add the same value while keeping total costs under US$55 – within the safety margin provided by the tax – it would be more profitable to produce there.

This multiplier effect of the discriminatory tariff is called the effective rate of fallout protection because it creates a magnified, unintended advantage for all competitors, not just the United States. This also explains why the relocation of global supply chains could occur in response to a relatively low tariff if the value added share is low.

But in practice, global supply chains as a whole have remained remarkably resilient to disruptions in price rather than quantity. Although there have been shifts in global supply chains from China to neighboring countries such as Vietnam, Thailand and Malaysia, these have mainly involved labor-intensive industries. . The key industries that dominate global supply chains – electronics, transportation equipment and machinery – have not seen much outsourcing. Considering how the effective rate of overflow protection amplifies protection, global supply chains are more resilient than they appear.

The conundrum regarding the effective rate of overspill protection is solved when factor intensity and technology are taken into account. The electronics, transport and machinery industries are capital intensive with high shares of fixed costs. These technologies are generally less divisible, so 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 have to be rebuilt, while training new workers and developing relationships with new suppliers increases costs dramatically. These factors could negate the multiplier effects of the effective spillover rate on protection, which explains the geographic resilience of the electronics, transportation and machinery industries despite trade war tariffs.

There is little evidence that the trade war has led to significant relocation of production. While punitive tariffs have failed to relocate production, direct subsidies have done no better, although subsidies can be better targeted as they can be directly linked to relocation, thus avoiding spillovers to third countries .

But since subsidies are directly linked to value added, they produce no effective rate of spillover to protection-linked multiplier effects, which reduces their power. Evidence provided by Japan shows that companies that took advantage of the subsidies to relocate production quickly returned to China after observing a grace period, which reduced any long-term impact on supply chains.

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

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

Jayant Menon is Senior Fellow at ISEAS-Yusof Ishak Institute, Singapore.