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24 September 2020 General

The coronavirus (COVID-19) crisis has exposed vulnerabilities in global value chains. For example, the supply of vital goods and product components was disrupted in many countries. This has sparked a public debate – also in the Netherlands – about solutions to make international trade more resilient. Many of these solutions involve government intervention in the production process, such as bringing back production (reshoring). However, the coronavirus crisis is no argument for implementing policies that restrict free trade, as these do not necessarily increase shock resilience. Any initiatives aimed at reshaping the production process prompted by the coronavirus crisis should generally be left to the market itself. An exception applies to so-called vital goods, where government intervention may be desirable to ensure security of supply. A strategic approach at European level is preferable in such cases.

The pursuit of cost-efficiency makes value chains vulnerable

Global value chains have arisen from the relentless pursuit of cost-efficiency. Production processes are now fragmented across a large number of activities that take place in different companies and countries. However, this pursuit of cost-efficiency can lead to vulnerabilities. After all, the likelihood of a supply shock occurring somewhere in the global chain is greater than if production were to take place entirely within one company in a single country. This vulnerability is enhanced by the fact that companies generally hold limited stocks and have little insight into the entire supply chain in which they operate, while governments can impose export restrictions and import tariffs. During the coronavirus crisis, these vulnerabilities were reflected in shortages of goods and disruptions in the supply of production parts.

Organisation of production process should generally be left to the market

In order to make production chains more resilient, three options are frequently mentioned, namely bringing production back to a company’s original country (reshoring), diversifying suppliers and holding larger stocks. On the whole, such changes to the production process are best left to the market itself. Companies are best placed to allocate production factors internationally in the most efficient manner. In this way, international free trade continues to contribute as much as possible to the growth of global prosperity. Free trade in itself can also contribute to greater global resilience to shock, by fostering key technology and knowledge transfer between developed countries on the one hand and developing countries on the other. A prime example is South Korea, which rapidly evolved into the most prominent producer of COVID-19 test kits by importing knowledge and vital parts through its global value chain network. Government intervention in the production process can jeopardise welfare gains and bring about high welfare costs.

An exception for government intervention can be made if trade through value chains is accompanied by external effects that harm public interests. For example, global value chains can be damaging to the climate, while these negative environmental impacts are not included in the price. This can prompt the government to intervene by means of a carbon tax. Public interests can also be jeopardised by supply shortages of vital goods, such as medical face masks. The public interest could warrant government intervention in vital supply chains aimed at safeguarding supply security. Moreover, security of supply is not only about increasing the shock resilience of supply chains, but also about the ability to meet a sudden surge in demand. Not all of the above solutions are suitable for this purpose.

Reshoring does not guarantee security of supply...

Although reshoring reduces vulnerabilities to foreign shocks, at the same time it offers fewer opportunities to absorb shocks. In fact, in an almost entirely domestic regime, it is more difficult and costlier to substitute production parts for affected production lines compared to an economy that participates in global value chains. In global value chains, part of the adjustment to shocks takes place in international markets, but reshoring relies on domestic markets to bear the brunt of such costly reorientations. This affects domestic spending, such as consumption, more than if an economy is part of global value chains (see Figure 1). This reduced resilience to shock can, in fact, undermine the supply security of vital goods.

Figure 1 - Shocks have greater economic impact on fully domestic production than in the event of optimal participation in global value chains

Figure 1 Corona Bulletin

Note: Given the basic static outcome of the two different regimes, the figure reflects the average percentage deviation under a negative shock affecting the economy at sector-country level. The shock simulates disruptions comparable to those during the coronavirus crisis.

... whereas a strategic European approach does

Public policy aimed at holding strategic stocks is a way to ensure the supply security of vital products. This increases both shock resilience to domestic and foreign shocks, while keeping market distortions limited as it leaves the choice of the most efficient organisation (e.g. production site) unchanged. Ideally, such stocks should be held at a European level. This avoids inefficiencies where one Member State has a shortage and another has a surplus of vital goods. It would also prevent countries from imposing mutual export restrictions on each other.

Complementary to stock building, the government can draw up a strategic contingency plan with selected companies to rapidly convert existing production lines for the production of vital goods. This is because stocks may become depleted if a crisis persists for an extended period. Also, not all vital goods can be held in stock for a long time, as is true for instance of medicines, which have a limited shelf-life. In that case, a contingency plan can help increase the supply of vital products.