The Globalization of Value Chains and the Changing Nature of Manufacturing - Evidence, Implications and Policies

My talk will reflect my personal views and not necessarily those of the OECD or its member countries.

Much of the work we do at OECD is driven by demands from member countries. This work in the changing trends in the manufacturing sector was driven by a request from the United States government, who were interesting in having more of an understanding of what was happening globally to the manufacturing sector. We will then look at the globalization of value chains, because that is where some of the critical issues are in trying to understand the role of different countries in the globalization process, where our economies are going, and what some of the impacts for policy are. I will explore some potential impacts of globalization and examine some key policy issues.

This project is for 2005/2006 and so is still a work in progress. The project is mainly in the context of our Committee on Industry and Business Environment, which for the Japanese government primarily concerns METI. We have several empirical areas of work on the way. One is on the changing nature of manufacturing, but we are also doing a lot of work on understanding global interactions where we are using input/output tables and trade data from different countries to see which industries are most affected by globalization. We look at OECD countries and trade flows coming from China, India and other important non-OECD countries to understand what the interactions between different countries are and the impact of these trade flows on different industries. We are doing work on the employment impacts of off-shoring, to understand how large they are, where they are concentrated, which industries are being affected and which types of workers are being affected by globalization. We are doing work with firm-level data where we try to look at the impacts of globalization, primarily on productivity in different countries. We are also doing work also on the nature of manufacturing work to see whether manufacturing is becoming more and more like services; the difference between services and manufacturing is becoming more and more meaningless. There is a lot of work on these issues also going on in other parts of the OECD, so we are trying to put a lot of these things together later this year to feed into a meeting of our ministers in 2007, because that will probably focus largely on the globalization issue.

There are two key policy challenges in this. First is the issue of deindustrialization, which has been around for some time. Some countries feel that this process has accelerated, that more and more manufacturing jobs are disappearing. The question is what does this mean? Is it because of productivity growth? Is it because of jobs being off-shored to different countries? Are we seeing production being moved offshore as the focus of firms is increasingly on high value activities? Can OECD countries do without a manufacturing sector, and what does this mean? Which factors underlie this decline? Related to that is the dimension of globalization, and particularly whether OECD economies can adjust to the rise of countries like China and India which are becoming very important in the global economy. Then, what are the implications for policy?

We shall first look at the trends in the manufacturing sector. Manufacturing employment in most OECD countries between 1990 and 2003 has declined by 10%-15%. The United Kingdom has about 30% decline. There are few countries where employment has increased; these are partly some of the NAFTA, Canada and Mexico which have benefited from some production being moved from the U.S. to these countries, and Spain and Ireland, which have been proven to be effective competitors in some manufacturing industries. Looking in more detail at different sectors of the manufacturing economy, not all of these activities have declined equally. In the G7 countries, until 2001 the main declines are in textiles and partly in metal products. Most other industries are relatively stable, particularly food manufacturing where there is not an enormous amount of international competition. In paper, chemicals, motor vehicles and a number of other industries in OECD countries, the quantity of workers at least has kept relatively stable. It is not an even process of decline.

In the OECD areas in the 1980s there was a growth in employment in high-technology sectors such as pharmaceuticals, aircraft, computers and some electronics industries. At the same time there was a clear decline in low-technology areas such as textiles and clothing. More recently some of the sectors losing employment quite dramatically are high-technology sectors. This is partly because many of the components can be produced in other sectors. There is also a lot of productivity growth in these sectors, so employment is declining there as well. The exception to that is the pharmaceutical sector where there is still a growth in overall employment for OECD countries. If you look across countries it is more complicated than a simple decline in low-technology goods with production being moved offshore. One of the issues which has always been raised is that part of it is moving jobs to China. However, available employment data shows that there has not been a marked rise in recent years. To some extent that is what you would expect given China's productivity growth. There is a strange decline from 1998-1999 which is perhaps not real, just a change in the data or classifications.

Looking at production or value added data there may a decline in manufacturing sector employment, but production is still rising very rapidly in most OECD countries, particularly in the U.S., Canada and Japan. Some of the European countries are a little flatter, particularly from the early 1990s onwards. But overall manufacturing sector production has increased in most countries.

High technology sectors are declining in most OECD countries. In the U.S. economy it has declined from 7%-6% of total value added. It is not simply a change from low to high technology but a more complicated story where certain parts of production are declining in importance. Some countries in the OECD area seem to be benefiting from this process or are still moving into manufacturing. For example, in Ireland and Korea these areas have increased in importance over the 1990s, and in some Eastern European countries where many components are now produced for European countries.

One other way to look at the importance of the manufacturing sector in OECD countries is to look at the share of manufacturing in total demand. Despite not being very important anymore in value added and employment, in many countries it still accounts for around 40% or sometimes even more of total demand. Manufacturing is producing a lot for intermediate demand, so it produces many inputs in production.

Nine of the top ten manufacturing countries in the world are OECD countries, with China as the third largest after the U.S. and Japan. China quickly will become even more important in this part of the economy. Amongst larger world regions the main increase in manufacturing from non-OECD regions excluding China is in East Asia, while there is a decline in Latin America and very little change in most of Africa and Mexico.

Looking at the internationalization issue in terms of global linkages, exports are growing quicker than production, meaning that interactions between countries are growing very rapidly. In some countries the export to production ratio was over 100%, partly due to re-exports. Intra-industry trade is also of growing importance, and for many countries trade within the same sector is about 80% of total manufacturing trade. Intra-firm trade is important; a lot of exports of foreign affiliates go back to the parent country. This is a fairly flat situation with no real trend; however the Japanese trend is an unusual decline. Some foreign affiliates mainly produce for export, particularly in Ireland. Companies consolidate production in specific markets to serve other markets.

In many OECD countries manufacturing is still a very important driver of overall productivity growth, particularly in some less developed economies but also in Sweden. There are some concerns about the decline in manufacturing as it impacts productivity growth. In a few countries the service sector also contributes significantly to productivity growth, but in many countries such as Spain and France it is stagnant.

In most countries manufacturing is the most important contributor to overall R&D efforts, so there is concern that a decline in manufacturing will result in a decline in R&D expenditure. One reason for manufacturing R&D decline is the reclassification of manufacturing R&D companies as service companies. Additionally much innovation in certain areas now comes from services companies. It is not a straightforward story and there are big differences across countries. In the interaction between manufacturing and services, manufacturing is becoming more like services. In a country like the Netherlands about 60% of the total manufacturing workforce is in services functions. Of the sales of manufacturing companies a large part is still manufacturing sales, but a growing part is sales of services such as distribution activities and financial services.

Currently innovation in manufacturing, in R&D and patents, remains dominated by OECD countries. China is involved in much patenting, but not high-technology areas yet. The challenge is to adjust to this change and to look at whether production is still very important for OECD countries, and if so how that can be maintained.

The second question is about globalization of the value chain. This is the growing integration of production, increasingly at the global level. Which functions do firms outsource, domestically or internationally? At the same time production is increasingly fragmented, with many stages in the production process. Trade in intermediate inputs across countries is growing. Firms increasingly focus on their core competencies, outsourcing other functions or putting them elsewhere. There are two main theories in this area. Firstly, a decision must be made on which functions to keep in-house based on the costs of coordinating activities across the firm's borders. Also there is an issue of control; putting things outside a company allows influence and control over the contract and certain functions. In practice firms carefully weigh costs against benefits.

What is our evidence that this is happening? Inter-firm trade is already important; there are large trade flows between parent companies and foreign affiliates, which have a large impact on trade balances. Intermediate products account for a growing share of trade flows, so many components are traded across borders. Imported intermediate inputs are growing in importance for total inputs. Certain countries like Belgium and the Netherlands import about 60% of inputs in domestic production. Also trade patterns and sources of intermediate inputs grow in complexity, with more and more companies involved. There is more reliance, also in terms of security issues, on production abroad.

Some key drivers include: competitive pressures to improve efficiency and reduce costs; the growing efficiency of transport and communications; the growth of new markets offering scope for expansion; a focusing on core company strengths; access to factor inputs such as skilled workers; an increase in fixed costs leading to growing concentration and cooperation; and finally a growing complexity in production meaning that not all competencies or technologies may be available within the firm.

There are four important impacts of globalization on employment. The first is a short-term loss that can happen if domestic activities are off-shored. This impact is the most visible and so gains the most attention in policy and political discussion. Less clear are short-term gains due to companies locating within OECD economies. An indirect impact is that firms may focus on core strengths, enabling them to grow in those areas. A longer term indirect impacts is where much off-shoring happens because firms expect to improve productivity growth, impacting price and wealth which therefore may impact demand and so employment. Available empirical studies suggest that the overall impact of globalization on employment is relatively small. However there can be large impacts in specific regions that are heavily concentrated on declining sectors such as the textile industry; and also on worker groups, particularly manufacturing workers who, having worked in a company for a long time, have difficulty finding new work as they are specialized. One of the reasons political focus is on this issue is because these worker groups can be very vocal. Also the impact is more significant for specific OECD countries that are very concentrated on industries which might move offshore.

Foreign affiliates are of growing importance for employment in the manufacturing sector in OECD countries. For a country like the U.S., foreign affiliates count for about one quarter to one third of total productivity growth in the manufacturing sector. This is also true for the service sector in many countries.

The next globalization impact is on productivity. The expectation is always that globalization will enhance productivity in firms and economies because firms will be able to specialize on their core activities; they often outsource mainly to enhance efficiency and reduce costs. A more indirect effect of globalization is to increase pressure to innovate and become more efficient.

The evidence comes from several areas. We have evidence that foreign affiliates have direct and indirect impacts on productivity growth. Direct because these companies are often large and use skills and technology from parent companies to improve productivity; indirect because foreign affiliates functioning in domestic markets put pressure on domestic companies to improve productivity. The second area is more econometric work using detailed firm-level data to show that globally engaged firms have stronger productivity. That can be because they are already engaged multi-nationally, but can also be because they represent import and export. Firms often become an exporter when they are already strong. What is new from this work is that we found in some countries firms increased productivity by sourcing inputs from abroad even when they were not exporting multinationals. Finally, there is good evidence that globalization has increased real wages, which is often linked to productivity.

In sum, looking across this evidence it is clear that globalization is having considerable impacts: in changing trade patterns and comparative advantages of OECD and non-OECD countries; in creating a larger global market; in improving productivity growth and increasing wealth and incomes; and in negatively affecting employment in some regions and worker groups, although the impact appears to be rather small.

There are probably three policy challenges across countries. One is to try to adjust, enable structural change and move into new areas of economic activity or build on strengths which already exist in each country. Policies are well known: one is competitive product markets, allowing resources to be allocated from growing to declining sectors of the economy. Regulations across OECD countries are very different, with some countries having a lot of regulations in place in certain parts of the economy and also sometimes focusing on the entrance of foreign companies, meaning that competition is probably not as large and resources may not be reallocated as quickly as they are in some other OECD countries. Another policy is well-functioning labor markets, key to finding work elsewhere in the economy for people who are losing their jobs. Finally, well-functioning financial markets and sound macroeconomic policy.

The second policy implication is trying to move up the value chain. Innovation is necessary because innovative products eventually become commodities producible anywhere. Policies here are fairly well known: innovation and technology policies; how to move into new areas of economic activity; cluster policies; upgrading human resources; enhancing attractiveness, protecting IPR; and a level playing field. Countries may have unique strengths such as natural resources allowing them to compete internationally, but most OECD countries do not, so competition also means moving up the value chain across countries. These policies accept that globalization is happening and has overall benefits to OECD and non-OECD economies.

There is policy debate, particularly in countries like France, on whether globalization is beneficial, whether you can protect yourself from the process. So far, from our analysis protectionist policies will probably reduce the benefits of globalization and you may get to the situation where you will still have the costs without the benefits. For example policies which penalize companies which engage in off-shoring will probably lead to reduced efficiency, raised costs for these companies and make it even more difficult to compete internationally. Other policies discussed in some countries such as reducing wages are only short-term solutions: it is not about reducing wages as much as improving productivity growth. Finally a very important policy area is avoiding a political backlash against globalization. In several OECD countries there is much concern about the globalization process and policymakers must think about dealing with this, primarily in helping those workers who are most affected by globalization, by having well functioning labor markets and social safety nets, training policies etc. Secondly, spreading the benefits of globalization as widely as possible using trade, investment and development policies to create greater opportunities for countries which may be left behind, particularly Africa. Then there is a range of global concerns such as environmental which make globalization a threat for many groups and societies.

C: Usually the value chain is the procurement of parts to the final sales. Our idea is for an innovation chain from knowledge to producing new commodities. Supply chain means a mass production chain, usually for offshore production. In the case of an innovation chain, recently some kinds of research or development will be off-shored and managed from other sources, so there are two divisions. Those phenomena were also found in Japanese companies. The most value-added portions of work go to the home country. What is the role of the home government and nation? It is to collect labor in the home country, and to collect corporate tax.

A: I agree on the role of government and I think those are two important factors but I do not think they are the only ones. There are many countries where, for instance, infrastructure is used. The tax climate is definitely important but also the regulatory climate, the IPR climate, what the market is like, even demand issues can play a role in decisions which companies are making in terms of where they are locating. Particularly when trying to develop innovative products it can be helpful to be in a market where demand is very novelty-driven; for instance a company may not want to develop certain products in countries that are very conservative in their tastes.

C: Three comments. The sharp decline in Chinese manufacturing employment in 1997 may be due to the massive layoffs that may have taken place. The reduction in share of intra-firm exports in total exports of foreign affiliates in Japan can be explained partly by Japanese companies' recent movements to bring back some of their overseas operations. I think one missing key globalization driver is that there are those, such as the Chinese who study overseas, who return to their country and claim the role of liaison.

A: I was giving a presentation two years ago and somebody from Google said that one of the reasons they were setting up a lab in India was that they needed specific skills that they could not find in the U.S. I believe that is true in certain areas.

On skilled migrants as key drivers, we have seen from previous work at the OECD that, for instance, many of the companies established in Silicon Valley in the late 1990s were established by Chinese and Indians. After 2001, and even before to some extent, a lot of these people have returned, and a lot more people are thinking of staying in China or India because the climate to set up a company there and do very well has increased.

Q: Do you think governments need to slow down or contain globalization and are protectionist policies possible that would allow the government to control globalization?

A: There are several governments in the OECD who think that they can slow down globalization at the national level, or try to insulate their country from the globalization process, often leading to protectionist policies. There are costs involved in doing that that may show up in lack of activity growth and high unemployment, whereas some of the countries which have become more open over time have probably gained more of the benefits of the globalization process. But doing that requires a fairly wide range of policies. One problem in Europe is a labor market that is quite inflexible, which means that we see areas where unemployment is fairly high in some countries. I think if you really want to benefit from globalization you have to think about a wide range of policy. Countries that try to protect themselves end up still having the cost and not having the benefits. There have been proposals from quite a few people to try to slow down the globalization process, for instance the most famous one is probably the Tobin tax on financial flows, because there is an issue of adjustment. Also people cannot really adjust to the increasing speed of technological and social change. So there is an issue there.

C: One thing about this kind of debate is that there has been too much emphasis on jobs being threatened by cheap labor in China or in Asia. But if you look at the structure of say computers or semiconductors then the labor force accounts for often less than 5%. So I think it is probably a bit of an exaggeration to say that they are losing jobs to cheap labor. I think it is more because there are good engineers out there than just cheap labor.

A: I agree with that point. As you say it is not clear what to make of that, because in many industries labor costs are not that important any more and account for a very small share of total cost. Then if you look at the more specialized areas where labor costs are important and the difference between countries are actually smaller. You will see that for certain high-technology areas or if you really need a skilled researcher in China India the cost difference will be smaller already. We are doing some separate work on the globalization of R&D, of where countries are locating R&D labs, and why. Again it is often not a cost issue but gaining access to skills and researchers and to develop R&D and products for specific markets, so again it is more need to do so.

Q: You mentioned that some countries have unique strengths that enable them to compete internationally. Every country has its own unique strength, not only limited to natural resources but also its own environment, a lot of human resources or some technological accumulation. Will the OECD conduct much research on the OECD countries' own unique strengths that can generate more work in that country?

A: There are countries that may not need to move up the value chain. Every country does have its own strengths. The Netherlands' unique position in Europe means that distribution is something we can be good at. Ultimately it is up to countries to find out what their unique strengths are, but the OECD can definitely try to assist them.

Q: It was mentioned that Japan is very bad at using foreign affiliates or making foreign direct investments to promote productivity in Japan, based on calculations from the data between 1995 and 2001. Actually, after that the Japanese companies have improved productivity over the prior year, so I hope that in the next presentation of this kind of analysis foreign contribution is bigger. My question is will this data be revised?

A: The data on foreign affiliates is, in principal, updated every year. Usually such data is only available with a delay, so it is never very up to date. I do not believe the data would be available for 2004 for many countries. There is a working paper on this available on our website that looks at trends over time in different countries.

Q: If the government is opposing international firms, when they see the companies going abroad is there any way for them to stop it?

A: There is debate on some of these things. It is very important that governments talk very carefully with their companies to find out why they are going abroad. I think it is often because a company needs to expand and move into new markets. But there may be other reasons where policy can probably do something. If a company is going abroad because it has difficulties in its own market then the government can help it. In the long term I do not know how to prevent companies going abroad. Although it may not formally happen, they might start up a branch elsewhere and expand there. Then they are expanding abroad and shrinking at home.