Global Supply Chains Are Fragile … Will They Break?
by gary hufbauer and euijin jung
gary hufbauer and euijin jung are, respectively, non-resident senior fellow and research fellow at the Peterson Institute for International Economics.
Published October 23, 2020
At the dawn of the 21st century, global supply chains were celebrated for bringing inexpensive goods to consumers everywhere, for opening markets to developing countries and for enhancing productivity worldwide. Today, those same supply chains are excoriated for destroying jobs, making business more vulnerable to the vicissitudes of nature and man, and undermining national security.
While President Trump and Covid-19 can take some of the credit for this abrupt change in the zeitgeist, they are getting a big assist from rising forces of nationalism around the globe. The economic case for supply chains remains powerful. But there is good reason to believe that political headwinds, reinforced by technological advances that facilitate workarounds, will curtail their expansion and reconfigure their shape in the 2020s. Whether these forces will undermine economic growth – and by how much – remains to be seen.
Supply chains are created when stages of production are divided among several locations in response to market forces. Such supply chains dominate goods production today – the era when virtually every part in, say, a Ford F150 pickup truck was made within a few hours’ drive of the final assembly line in Detroit is long gone.
Corporations, which have always had incentives to produce where costs were lowest (assuming quality was adequate), faced an expanding smorgasbord of options by the last third of the 20th century. Indeed, the years between 1970 and 2008 marked a period of rapid growth in the length and breadth of supply chains as trade barriers and shipping costs collapsed, capital flowed easily to where the return was greatest and improved information and communications technology made it practical to coordinate complex flows of parts and raw materials.
Multinational corporations headquartered in high-income countries typically “offshored” the labor-intensive tasks to developing countries in order to reap the benefits of lower wages. Progressive trade liberalization removed multiple trade and investment barriers, allowing firms to chase efficiency on a global scale. Meanwhile, the diffusion of shipping container technology drastically cut the cost of transportation between, say, Guangzhou and Dallas or Stuttgart. By 2008, the share of U.S. imports originating in companies affiliated with the importer – a good proxy for the importance of global supply chains – had inched above 50 percent.
Regional hubs are a hallmark of the supply chain world. Hub countries typically import components from regional partners and export finished goods. Early on, Germany and the United States became regional hubs for Europe and North America, and Japan for Asia. But the rise of China significantly changed the landscape after 2000. By 2017, China had displaced Japan as the regional hub for Asia; indeed, China had become a global supply hub. The new Asian power sharply increased its imports as well as exports of intermediate goods, even as it migrated from light manufacturing to techintensive manufacturing that depends on complex global supply chains.
Many developing countries (most notably, those in Asia) became spokes to the key hubs, and their economies flourished. Take the case of Vietnam, which was left to play catch-up because of the war. Factors contributing to the economy’s success in the past two decades included trade reforms that lowered tariffs, infrastructure upgrades, proximity to regional suppliers of high-value-added electronic components – China, Japan, South Korea and Thailand – and, of course, a large pool of disciplined, low-cost labor.
In 2015, some 56 percent of Vietnam’s exports were delivered to global supply chains (rather than to distributors as finished goods), well above the 41 percent average for developing countries. Currently, Vietnam is the world’s second largest smartphone exporter, manufacturing 40 percent of mobile phones sold by Samsung, the giant South Korean multinational.
The good times naturally sputtered with the onset of the Great Recession in 2008. But signs that supply chains were weakening in a secular (as opposed to cyclical) sense is better reflected in the reality that both merchandise exports and foreign direct investment flows lagged during the economic recovery. Supplychain trade is a major component of merchandise trade, while FDI constitutes the connective tissue of supply chains.
The World Trade Organization now forecasts that global merchandise trade will drop by as much as one-third in 2020, while the United Nations’ World Investment Report (2020) predicts a plunge in global FDI of up to 40 percent this year. Most of this decline, of course, will be linked to the rapid economic collapse in the wake of the pandemic. But even without Covid-19, both trade and direct investment would be under stress.
The Trump Shock
President Trump began his trade war against China shortly after assuming office. China retaliated in kind, and supply chains that bound the two economies in myriad ways were badly frayed in the process. To be sure, the United States has legitimate grievances against Chinese trade and investment practices – in particular, the failure to honor intellectual property rights. But unlike his predecessors, President Trump chose blunt-force confrontation rather than diplomacy. In fact, the political rewards of confrontation proved greater than the economic costs to both Presidents Trump and Xi. And the trade war morphed into a cold war, interrupting all facets of commercial, social and political exchange.
As an appetizer to the trade war with China, Trump invoked Section 232 of the Trade Expansion Act of 1962 to restrict steel and aluminum imports, using the dubious argument that imports of these metals undermined national security. Steel and aluminum are, of course, classic supply-chain materials, with intermediate goods often crossing borders multiple times on the way to becoming cars, airplanes or beer cans. Beginning in March 2018, all steel and aluminum imports were subject to 25 percent and 10 percent tariffs, respectively.
The Trump administration badly wished to conclude the U.S.-Mexico-Canada Agreement, fulfilling candidate Trump’s promise to replace Nafta, “the worst trade deal ever.” Canada and Mexico, which account for 25 percent of total U.S. steel imports, used this leverage to gain an exemption from the Section 232 tariffs. Deals were also cut with other friendly trade partners (among them, South Korea, Australia, Argentina and Brazil) that agreed to limit their export volumes in exchange for tariff waivers – a wretched precedent in the view of economists who want markets rather than governments to drive trade flows.
Then, in May 2019, Trump asserted an even more dubious claim: imports of automobiles and parts, he declared, also threaten U.S. national security. But he has not yet im-posed tariffs on those products.
Earlier (August 2017), Trump invoked the broad authority granted by Section 301 of the Trade Act of 1974 to investigate Chinese abuses of intellectual property rights. The outcome was a foregone conclusion, and in July 2018 the U.S. imposed 10 percent and 25 percent tariffs on about $250 billion imports from China. Predictably, China retaliated, and supply chains (rather than finished goods) bore the brunt. As Mary Lovely and Yang Liang of the Peterson Institute explained: “Much of the trade originates in foreign- invested enterprises, the Chinese-based affiliates of MNCs. Any proposal that affects a substantial share of bilateral trade will hit high tech supply chains, which U.S. MNCs utilize to produce high values-added innovative and profitable services and inputs.”
Trump asserted an even more dubious claim: imports of automobiles and parts, he declared, also threaten U.S. national security. But he has not yet imposed tariffs on those products.
U.S. tech giants, including Apple, Microsoft and Google, responded with efforts to dodge the bullets, shifting production of smartphones and tablets to Vietnam and Thailand. Supply chains were reconfigured – but not brought home to the United States as the White House apparently expected.
After name-calling and negotiations, China and the United States signed a “Phase 1” trade agreement in January 2020. China agreed to import an additional $200 billion of U.S.-made goods and services (above 2017 levels) before the end of 2021. In return, Trump agreed not to escalate U.S. tariffs any further. But the ceasefire is fragile. For one thing, the pandemic makes China’s pledge unrealistic in economic terms. For another, China is threatening to walk away if Washing-ton persists in denouncing Beijing’s squeeze on Hong Kong and its oppression of the Uighurs in Xinjiang.
Exploiting the tensions, defense hawks argued that ongoing commerce with China could endanger every aspect of national secu-rity. Thus, at Trump’s direction in April 2020, the Department of Commerce announced new rules to block the export to China of technologies that could conceivably be put to military use.
That covers a lot of ground. The rules require export licenses for sales to military end users and to private companies that support the military in China, Russia and Venezuela. Products subject to export control include semiconductor equipment, aircraft parts and sensors. Exceptions that allowed certain technologies to be exported without a license were eliminated.
Then, in May 2020, Commerce Secretary Wilbur Ross added a new rule directed against the Chinese communications equipment giant Huawei. American companies operating anywhere in the world are banned from using U.S. equipment or software to design or produce chips for Huawei or its subsidiaries – a broad anti-circumvention measure explicitly designed to interrupt global supply chains in the tech industry.
The trade war has thus already had an effect – not so much in bringing production back to U.S. soil as in reconfiguring supply chains to sources elsewhere in Asia and Latin America. And this may be only the beginning; while two-way merchandise trade with China is down, shipments still totaled $560 billion in 2019. And Trump recently insisted that total decoupling of the two largest economies in the world was a viable option.
The COVID-19 Complication
The virus greatly amplified the Trump shock to global supply chains. Indeed, lockdown policies in China, Europe and the United States revealed the vulnerability of the system to catastrophic events. For example, automakers, including Nissan and Hyundai, had to halt production in Japan and South Korea when they ran out of parts imported from China. Suddenly, supply chain diversification became the watchword.
Further fueling the crisis, as Covid-19 cases rose, many countries restricted or banned exports of medical products, notably personal protective gear, mechanical respirators and key pharmaceuticals. According to the Department of Homeland Security, China purposely concealed the gravity of Covid-19 in early January and hoarded medical supplies. DHS concluded that China’s personal protective equipment exports declined significantly in January and February 2020, compared with the same period in 2019. Supporting the DHS argument, China’s net exports of masks to the world dropped by 24 percent during this period relative to the previous year. Since China is the primary global supplier of PPE, China’s stockpiling escalated the shortage of medical products at a global level.
To be sure, China was not the only country to restrict medical exports during the pandemic. The European Union and the United States, among others, swiftly adopted export controls. Global Trade Alert found that, all told, 156 export control measures had been imposed in 89 countries. These export control policies disrupted supply chains, caused shortages and price increases, and may lead many countries to abandon supply chain efficiencies for the foreseeable future.
Protectionism in the name of amorphously defined national interests has not been restricted to the United States. Japan, Australia and others have stressed “reshoring” policies to lure firms back from China.
Protection on the March
Protectionism in the name of amorphously defined national interests has not been restricted to the United States. Japan, Australia and others have stressed “reshoring” policies to lure firms back from China. Considerations of cost and efficiency have been noticeably absent.
Before the pandemic, opposition to offshoring and outsourcing had already become a staple of the populist agenda. (The terms are used interchangeably, but offshoring refers to the wholesale relocation of business operations abroad, while outsourcing refers to importing inputs from foreign suppliers.) Now, these activities carry the political burden of closed factories and lost jobs. Sensible macroeconomic analysis of employment gets shoved aside.
During the 2016 U.S. presidential election campaign, both Donald Trump and Bernie Sanders attacked U.S.-based multinationals for robbing jobs from American workers. But their case is, at best, weakly supported by the evidence. A widely cited 2016 study by David Autor (MIT), David Dorn (University of Zurich) and Gordon Hanson (Harvard) did find a statistical correlation between rising imports from China and U.S. job losses. But other research showing a strong positive correlation between firms that invest abroad and their employment growth at home was given short shrift – as were studies directly disputing the Autor et al analysis.
Within the Trump administration, Trade Representative Robert Lighthizer and all-purpose White House advisor Peter Navarro have played cheerleaders for the false promise of “bringing jobs back.” In his recent Foreign Affairs article, Lighthizer claimed that Trumpstyle mercantilism enhances the “dignity of work.” Globalization, Lighthizer says, displaces American workers and decimates the U.S. manufacturing base.
Navarro, for his part, insists that the companies should produce both intermediate and final goods through domestic supply chains and contends that job and wage growth would follow. Costs and productivity losses do not enter his calculus.
The pandemic gave Navarro another opening to “strengthen U.S. manufacturing and bring jobs back home,” starting with the pharmaceutical sector. As the coordinator of the Defense Production Act, he sought the repatriation of pharmaceutical supply chains. In May, at Navarro’s instigation, the administration awarded a $354 million four-year contract to the newly minted Phlow Corporation to manufacture generic drugs, including their active pharmaceutical ingredients, at its U.S.-based facilities.
Lawmakers in both parties are eager to assist the U.S. semiconductor industry, now that it is barred from selling to Huawei, by providing a $37 billion subsidy for R&D and facility construction.
The campaign against supply chains does not stop with pharmaceuticals. Both the Trump administration and Congress are exploring options to lure U.S. firms home from China. The administration’s proposed “reshoring fund” would allocate $25 billion to “essential” U.S. firms to shift component production to the United States – a move that would both encourage inefficiency and violate WTO rules.
In a similar spirit, Sen. Josh Hawley, Republican of Missouri, not only wants to shut down the WTO (which, in theory, deters unilateral protectionism) but also wants investment subsidies for domestic production. Taking another tack, Sen. Marco Rubio, Republican of Florida, introduced a bill in May that would raise taxes on the income earned in China by U.S. firms. Lawmakers in both parties are eager to assist the U.S. semiconductor industry, now that it is barred from selling to Huawei, by providing a $37 billion subsidy for R&D and facility construction.
While the White House’s foremost goal is to bring supply chains back to American soil, second prize would be to sever supply chains that originate in China. Feeling the political winds and rediscovering the value of diversification against unforeseen risks, some firms are already cutting ties with China. It remains to be seen how much this affects productivity and growth.
Few developing countries can match Chinese workforce skills and infrastructure, but Southeast Asia and Latin America are in the running to supplement Chinese operations. Vietnam, Indonesia and Thailand have attracted foreign investment in automotive parts, electronics and textiles, while Singapore rivals Hong Kong in financial services. Firms that want to completely escape the Chinese orbit find Mexico, Turkey and Eastern Europe better candidates.
The Wall Street Journal has reported several U.S. firms moving pieces of their production chains to the Philippines, Vietnam and Mexico. Omnidex, an industrial pump maker, moved some production from China to Vietnam. GoPro, the action-camera maker, shifted production to Mexico while retaining its China operation to serve other markets.
Universal Electronics found a new partner in the Philippines and expanded its operation in Mexico. Intel was a foreign investor hero in Costa Rica until it shut down its operation in 2014. Now, Intel has decided to reopen its Costa Rican facilities and add capacity.
But despite such examples, the fact that many firms are retaining their supply chain base in China speaks to the heavy cost of moving. When supply chains are impervious to Trump’s political denunciation and his 25 percent tariff, observers can conclude that the cost of relocation is indeed steep.
The Technology Shock
Not to be forgotten in the era of Trump and Covid-19: the influence of technological advance on supply chains. Robotics, the “internet of things,” 3D printing, cloud computing, artificial intelligence and other information technology are all contributing to finer fragmentation of global production. At the same time, technology is eroding the advantage of low-cost labor, whether skilled or unskilled. For example, robots with versatile uses in manufacturing can compete on cost with $8 per hour human labor, one-third the cost of manufacturing labor in a typical middle-income country.
When low labor costs are no longer a source of comparative advantage, firms capable of automated production may make more at home.
Automation and reshoring are particularly important in high-tech sectors, where much of the value of the finished product is intellectual property. Note the wheels within wheels here, though: Advanced technology enables finer degrees of production fragmentation, creating new supply chains not anchored in differences in labor costs. This is particularly true of services such as health, education and finance, where digital technologies are creating vast new supply chain net-works that span the globe.
Technological advance predated the election of Trump and Covid-19, but politics and the pandemic may reinforce decisions to mitigate the risk of global supply chains.
Technological advance predated the election of Trump and the emergence of Covid-19, but politics and the pandemic may reinforce decisions to mitigate the risk of global supply chains involving merchandise. It would be a mistake, however, to forecast a surge in manufacturing jobs (as opposed to manufacturing output) in the United States or other advanced countries. Over the medium term, new technology will, on balance, probably reduce the demand for labor in U.S. manufacturing, whatever the magnitude of reshoring. In one plausible scenario offered by the McKinsey Global Institute, 15 percent of the U.S. workforce (manufacturing and services combined) could be displaced by automation by 2030.
Down but Not Out
Strategies to lower costs and ensure manufacturing resilience in the face of shocks are bound to vary between sectors and countries. Firms that rely on high-quality infrastructure and skilled labor will pay a premium to remain in China. Firms that seek less dependence on a single supplier will diversify from China to sources in Southeast Asia, Latin America and elsewhere. And firms that prosper or wither on the impulse of protectionistminded politicians will at least make a show of bringing the factories home.
Yet there’s little doubt that history is on the side of global economic integration. The business case for fragmenting production and sourcing components from low-cost, reliable locations is too powerful to ignore. Technology will increase firms’ choices of what to make and where. But Trump and even Covid-19 are no match for the great forces that drive specialization in the world economy.