How is trade evolving: from tight coupling to loose coupling.
By Adjunct Professor Alicia GARCIA-HERRERO, Adjunct Professor, Department of Economics at HKUST Business School, and Senior Research Fellow at Brussels-based think tank BRUEGEL
Trade has been bumpy over the last 15 years. There was a massive collapse during the global financial crisis, followed by a rapid recovery and collapse in 2015 as a consequence of falling oil prices and China’s economic woes. COVID-19 has been the third major shock to global trade in only 15 years, and possibly the most important. COVID-19 is a different kind of shock to the other two, as it brings into question the way in which a substantial amount of trading has been organized over the last few decades. This is due to the massive increase in the efficiency of ports, especially in China, especially thanks to the introduction of containerization.
In fact, value chains – loosely defined as the cross-border movement of the parts and components used in production to reduce cost from increased specialization – are a result of globalization, and they explain the massive increase in trade flows. Value chains started to expand in the 1950s with the rise of multinational companies. The persistent fast growth of international supply chains has been supported by the search to achieve production efficiency by pushing a competitive advantage beyond borders.
Effects of the trade war
This process was facilitated in the past few decades by substantial reductions in trade tariffs, as well lower transportation and communication costs. However, these tailwinds have been fading at an accelerated pace since 2008. The global financial crisis of 2008 marked the beginning of a winding down of supply chains globally. The process was slow but steady until recently, pushed by increasing transportation costs as well as environmental shocks like the Thailand floods of 2011 or the Fukushima earthquake and nuclear disaster.
However, Trump’s trade war against China created new challenges to global supply chains, which had become increasingly China-centric over the years. As if this were not enough, the outbreak of the COVID-19 pandemic in January 2020 created big disruptions in the supply chains, and led to shortages of parts and components for manufactured products, especially autos and ITC. On top of that, shortages in medical appliances, including those most needed to combat COVID-19, has further added to the impression that global value chains are not resilient enough to shocks.
The gravity of the pandemic has clearly added a political, and nationalistic, aspect to the debate about the need to reshuffle global value chains. But we should not forget that there are also economic reasons for such a move. In fact, one can think of value chains having been built in the past to maximize efficiency and, thus, increase corporate profit. In other words, a “tight coupling” model has so far been used to build supply chains in as far as a single-entry point has been offered to each of the steps in a supply chain.
That means if one of the entry points fails, the whole chain breaks down. Environmental shocks, the US-China trade war, and the current pandemic has pushed companies to think about changing their operations from “tight coupling” to “loose coupling.
Interchangeable options
In other words, instead of a single point of entry for each step of a supply chain, companies prefer to have several interchangeable options. This, of course, increases the cost of production in the short run, but it increases resilience. Higher resilience might also imply lower costs in the long run, depending on whether major shocks can be avoided. Accordingly, the capacity to keep the production process intact, even when a component is temporarily affected by a disruption in production, has become an increasingly important objective for companies.
Is the debate on the reshuffling of international supply chains being pushed by political factors, or are there also sound economic reasons for it? That is the key question. The answer differs depending on the product as some do have considerations for national security, as seen by the disruption in the supply of crucial medical products during the pandemic. On a more general basis, it is highly improbable that decisions to reshuffle the global value chain away from China, are devoid of economic considerations.
New costs for business
The economic rationale for a company to choose a more complex value chain rather than integrating the production domestically, or within a closer geographical area, might no longer be driven by efficiency considerations only. The resilience of the supply of goods has become particularly important as the costs of disruption have turned out to be very large, as observed in the year following the shuttering of Chinese factories in February.
In addition, within the efficiency rationale behind the decision to offshore the production of parts and components in different locations, many new and relevant costs have appeared which might tilt the equation towards a shorter global value chain. First, security issues (including terrorism and cyberattacks) in several countries have pushed up the bill for maintaining logistics across borders. Second, environmental risks are on the rise worldwide, and so is their potential to generate future disruptions in the supply chain.
Third, protectionist measures have found a breeding ground in the inability of the World Trade Organization (WTO) to ensure compliance with the existing multilateral trading system. Fourth, the increasingly relevant role of technology, and the international fragmentation of its standards and legal framework, can increase the costs of global value chains operating in different ecosystems. Finally, China’s central position in the global value chain has resulted in the excessive concentration of risk in one jurisdiction.
Geopolitical and domestic political reasons may be important when it comes to explaining decisions to reshuffle value chains. But there are many important economic reasons, as described above, which might explain the decision to either re-shore part of the production or, at least, shorten a company’s supply chain to within a closer geographical boundary. That boundary could be physically or more figuratively based on similar standards and legal frameworks.
In other words, moving from tight coupling to loose coupling can be a rational economic decision and not (only) a political one.
