# Global Supply Chains and Trade Policy

Date August 30, 2012 Patrick LOW(Chief Economist, WTO) NAKATOMI Michitaka(Consulting Fellow, RIETI/Senior Advisor to JETRO)

## Summary

Patrick LOW

Global supply chains and rules are important and interesting issues. It is interesting because there is still much that we do not know about this phenomenon, and we are only just starting to understand its importance. Today's presentation will focus on several issues relating to global supply chains. The first is the importance of measuring trade in value added. It is quite surprising in hindsight that we did not start to do this much earlier, and why we are not currently in a better place in terms of having the necessary data to do this effectively. It will take years to accumulate all of the required data in order to be able to measure trade in value added properly, so long as governments decide that such a process is worth pursuing. Second, the basic phenomenon of supply chains is changing in important ways, which has implications on policy and its interaction with supply chains. Details on these changes, drivers of change, and typologies of supply chains will also be covered today. Next, value-added attribution, its mechanisms, and the role of services will be discussed. In particular, services is a field in which we know so little, even though it is vital for production and has become even more important due to the supply chain phenomenon. Finally, I will make a few speculative comments on where policy will potentially fit in with the global supply chains and rules.

There are several reasons for the importance of measuring trade in value-added rather than gross terms. Value-added measures give a different view on bilateral trade balances. There is one well-known story that if you use gross trade measures when the iPod retails for $250 in the United States and only costs$5 to assemble in China, China receives $5 of the value added and the machine looks as if it is made there when it gets to the United States. However, a large proportion of the value added comes from processes occurring in other countries such as Japan, Korea, Germany, and the United States. This creates a problem in that it immediately affects bilateral trade balances and the notion of Chinese trade surplus becomes heavily exaggerated in real economic terms. Gross measures of trade are also distortive in terms of the technology content of trade. If one were to think that the Chinese make the iPod, one would believe it to be a high-tech export from China. However, if you realized that the iPod is only assembled in China, then you would assume a labor-intensive process with very little technological content. Gross measures of trade don't allow for an accurate view of the technology content of trade. Value-added measures of trade also allow for a different view on the true nature of interdependency through trade. A significantly more intimate form of interdependency with trading partners exists if it is involved with supply chain production, including a higher import content of exports. The application of such measures should change how countries view each other in terms of trade relationships. This kind of value-added analysis is necessary in order to gain a better understanding of what trade policy does. The import content of exports appears to be rising globally, and most estimates of merchandise trade flows suggest that intermediate goods trade accounts for about 50%-65% of trade flows, emphasizing the growing role of supply chain production in the world economy. One example of the difference in U.S.-China trade balance figures using gross as compared to value-added measures was conducted by the Institute of Developing Economies, Japan External Trade Organization (IDE-JETRO). Findings suggest that by using value-added measures, the trade surplus figures that China had would have been reduced by 42%. This is significantly different from that found through traditional gross measures of trade. In terms of drivers of change, five elements which are affecting supply chains and will have a consequential effect on policy have been identified. There has been a shifting in patterns of demand such as rising incomes and emerging markets, a rising middle class in China, and increasing consumption levels. This means that emerging markets will become an increasing source of growth, and in the obvious case of China, it will be adding more value to the supply chain. China is no longer simply expected to operate primarily as an assembly operation; the more it sells machines in its own market, the more domesticated the market will become and subsequently result in more value added to the supply chain. On the other hand, production costs can shift supply chains. A current debate taking place in China is whether supply chains will move inland or to other countries such as Vietnam, Cambodia, Laos, and Bangladesh as wages rapidly increase. Another element is the changing consumer expectations. It seems to supply chain operators that consumers are becoming more and more demanding, thus a greater source of risk and greater care has to be taken in consumer preferences. This is the result of the development of communications and information technology—the changing of expectations and different product preferences. The speed of production has also grown in importance. Perceptions and attitude toward risk, particularly for those involved in supply chains, have changed greatly since 2000. Major disasters are disruptors of supply chains, therefore supply chain operators and governments are showing new attitudes toward risk and the increasing tendency to look for a backup plan in the event of emergency. The question of what governments can do to manage risk depends on the kind of risk being discussed. In turn, there is a trade-off between managing risk and emphasizing the speed and efficiency of supply chains. Sustainability is another difficult issue in which significant government policy is involved. Environmental sustainability including issues such as CO2 emissions and global warming, and the scarcity of resources have all raised the question of whether or not the Asian growth model can replicate what has been done in Japan and the West, and whether or not different models need to be created to support sustainability. In terms of social sustainability, the Foxconn effect provides a good example of changes in this regard. Poor working conditions, wage levels, the absence of holidays, and pressure to meet unreasonable deadlines were highlighted, which resulted in an increase in wages for Foxconn workers. Governments have an important role to play in policy developing with regard to such rising issues. Advances in technology have also acted as drivers of change. As an example, 3D printing is a relatively new technology which has concerned several supply chain operators. As this technology develops, it could potentially wipe out the downstream part of several supply chains. The digital revolution has also altered how supply chains operate. There is now a greater choice of location and more emphasis placed on the distinction between trading in goods and that in tasks. There are several typologies of supply chains, which emphasize the level of their difference, and how drivers of change and policies have various impacts. In many supply chains, it is hard to know exactly where they start and end. As an example, if the product is a jet engine, it must be serviced regularly during the course of its lifetime. As such, it is difficult to determine where the chain ends. In resource-based typology, it is easier to see where the chain begins and ends. The chain is demand-driven and location-determined. Processes involved in this typology include mining, extracting, growing, and harvesting. Varying technological components may be involved, and the issue of where value is added exists. Cost minimization typology tends to be buyer-driven, have a high volume of consumer goods and commodities, have low margins and technology, be speed-oriented, and lean toward commoditization. Mass customization typology is the ideal standard of every mass producer, in which there are still buyer-driven characteristics in high volume, but with higher margins due to market differentiation of branding and trademarks. Other characteristics include a higher level of technology, speed orientation, and a level of market dominance. Product differentiation typology tends to be producer-driven and thrives on product differentiation at lower volumes and slower speeds, with higher margins and technology as another characteristic. Such typology often involves one owner across all levels of the chain and less competition. Unintended functionality, whereby an individual along the supply chain gains access to information on the constituent components and procedures involved in making the product, is often treated as a risk factor. It is important to understand the predominant role of services in supply chain production by breaking down the sources of value added. It is also important to know who acquires the value added and the process involved in climbing up the value chain. The role of services is tremendously important in global supply chains. As an example, a gentleman's coat costs$425 off the shelf in the United States. This $425 is broken down into manufacturing costs and wages, which account for only$9. The remaining \$416 are referred to as invisible assets, which comprise services such as retail, logistics and banking, intellectual property, profits, and other unknown factors. This kind of pattern will likely be seen in all consumption goods and is certainly the same as that of the iPod and iPad. Also, although the label on the coat may suggest that the item is made in China, 86% of the value added is actually generated in the United States, with the remaining 14% attributed to various Asian countries. This is one example of the issue in relation to the role of services.

The content of today's presentation is, for the most part, a project, of which it would be useful to implement certain parameters as a basis to continue this work. At present, it would seem worth revisiting whether the current frame of thinking about and the designing of trade policies, intellectual property regimes, and services in the contemporary global economy is adequate or not. A recent developing argument is that agreements such as the General Agreement on Trade and Services (GATS) and the Intellectual Property (IP) regime are not designed in a way which accurately accounts for the current operation of supply chains. Investment decisions, merchandise, services, and the role of intellectual property are all intimately linked and questions must be raised in order for the World Trade Organization (WTO) to operate as a useful instrument in the world of global supply chains.

One possible solution would be to categorize global trade and supply chains through the aforementioned different typologies. The WTO actually had a positive input in the telecommunications sector by recognizing and addressing the unique properties of this sector which determined the conditions of competition in the markets. Although there is potential risk, such issues need to be considered in terms of the interface between governments, the financial sector, and the economy at large. If we won't allow governments to run the economy, then we had better have them make an input so that the economy runs as it should and to the benefit of the country.

In terms of rules of origin, if you use the value-added definition of exchange, the rule of origin has to go on the value-added part. Non-Tariff Measures (NTMs) have also become increasingly important in trade relations partly because tariffs have become gradually less important and partly because public policy issues have multiplied. An important point must be made on policy and its effect on supply chains. A supply chain involves several countries, and different components go from one country to another while accumulating value added. Each time a tariff is imposed, a trade cost due to a customs regime is forced to be incurred, or a non-tariff measure which fulfills the same role is used, the impact is multiplied. In other words, if a product or service is carried into different parts of the chain across international frontiers, its impact will be much greater. Therefore, there can be unwarranted and unintended effects on the costs of doing business in supply chains simply by not taking care of the policies being used and their costs.

NTM standards and anti-trust policies with regard to competition could also be an important issue in some supply chains. There have also been several reports that anti-dumping policies and countervailing duties simply shift the supply chain to a less efficient location at a rapid rate, especially in the mass consumption supply chains. There are several problems associated with this if it is being driven by contingency trade policy. This also suggests that contingency trade policy effects won't be as originally intended by those who imposed such measures.

Finally, an interesting issue which is only recently starting to emerge in literature is that of uncertainty and unpredictability as a trade cost. The possibility of policy intervention through institutionalized mechanisms in order to reduce uncertainty as a way of reducing trade costs is starting to be discussed. One thing which this leads to in terms of organizing thoughts about regimes is whether or not it would be possible to have one which accounts more for uncertainty as a variable. This is another concept which would need to be analyzed in concrete terms as we come closer to understanding how we should be thinking about policy in relation to the global supply chain.

It is true that this world is changing. If this discussion wasn't focusing so much on Asia, it would be useful to spend time analyzing what is happening in the United States in terms of the value-added debate, the manufacturing sector debate, and the notion that all services which are not tradable have to be low-technology. All of those issues are risk factors for supply chains which will have to be addressed eventually in the future.

Q1: In this current world, we can see a situation where trade regimes are helping to create supply chains. For example, if you look at the North American Free Trade Agreement (NAFTA), you can see that the supply chain has been created within it. Could the opposite happen, where supply chains being formed could actually help create new trade and investment regimes?

Patrick LOW
Yes, it can definitely go both ways. However, sometimes policy design may leave a little bit to be desired. It is true what you are saying about NAFTA, but in order for it and its supply chain to prosper, Mexico has to use domestic content defined as NAFTA content. If the fabric doesn't come from the United States, Canada, or Mexico, then it doesn't get included in the supply chain. Whether this is good or bad is debatable.

Q2: With regard to new perceptions of risk, you described examples. However, between 9/11 and the Fukushima disaster, we had the Lehman Brothers bankruptcy. Is there any reason why you didn't include this with regard to disruptors?

Patrick LOW
You are absolutely right. There is also something else in general missing from here, which is the financial supply chain and the different ways in which it reacts. The effects of the Basel III rules on trade finance show that this is a very important part of global supply chains. Financial risk is also of great importance in relation to global supply chains and rules.

Q3: I have two questions. The first question is methodological. You mentioned a U.S.-China value-added basis for trade volumes. Do you have a comprehensive country-by-country database of value-added trade? If there is such a kind of database, it would be very useful and informative in enabling us to grasp the reality of interdependency of world trade. Can the WTO or some other organization provide such a database? The second question is on policy implications. The government of Japan has never utilized this terminology, but my understanding is that in many Free Trade Areas (FTAs), it promotes supply chain trade liberalization. Do you expect the WTO to promote such a trade agenda focusing on the supply chain, or do you expect regional arrangements to come to the forefront?

Patrick LOW
On the first question, there is a very serious lack of information on value added. The WTO has been trying to build a global input-output table with the Organisation for Economic Co-operation and Development (OECD). The data covered will account for some 90% of economic activity. However, this is a very laborious procedure which also involves merging methodologies and systems. It will be very valuable to have this information, and it should be available by the end of 2012. Case studies can also be beneficial, although we have to find satisfactory methodological approaches to recognizing their limitations and yet be able to enrich the reality of our analysis by using them.

With regard to the second question, it is often asked of the WTO whether it will adjust trade policy in order to benefit supply chains, and what will it do for the rest of the economy. It is important to focus on the structure of a tariff at the national level, and not just whether it is benefitting inputs into the supply chain production. Focusing exclusively on supply chain production policy will result in the distortion of the economy and overdependence on the supply chain. The best trade policy isn't one that necessarily increases the variance of your tariff.

Q4: How will China react to this study, especially regarding its domestic industrial policy and its trade policy?

Patrick LOW
What's clear is that this is a very important issue for China, and it is surely thinking hard about its next stage. With the competitiveness of its assembly operations in mind, there seems to be a strong productivity-wage relationship. This ratio will shrink if productivity doesn't change and wages rise, which is the current trend. As a result of this, the Chinese are trying to improve productivity, although the debate is whether they will move supply chains inland where wages might still be lower, or shift operations to other Asian countries such as Vietnam or Cambodia. It is likely that both will happen. This could bring benefits such as increased domestic demand and some supply chains ending in China. A very interesting example of this revised way of thinking is that at the beginning of the iPad cycle, there was already demand in China for iPads, but there was no regime for managing this. Therefore, iPads had to be sent to Hong Kong before they were imported back to China. This meant that Chinese consumers had to pay more for iPads. These kinds of issues are now being addressed, and China is attempting to get out of a bonded, export-based regime and into one which is linked to the domestic economy.

Q5: What is the hottest topic in relation to the global trade chain?

Patrick LOW
It depends on what supply chain or country you are in and the government with which you are dealing. It appears that most people working in supply chains share a common sense of change occurring at the moment.

Q6: What is your view on the implication of your analysis of the recent worsening of the trade balance in Japan?

Patrick LOW
I would need to look at the composition and trends before being able to answer that. We are quite compartmentalized, and we don't tend to do much of that kind of work at the WTO.

Q7: The global supply chain is very important for Japan, and we are supporting WTO activities. How are you planning to materialize your studies from now in collaboration with industries and countries?

Patrick LOW
At the moment, we are working on projects in the WTO and also on joint projects with the Fung Global Institute. The projects which we are working on with the Fung Global Institute involve case studies which need the support of individual corporations. We already have four or five partners who are contributing to the work both financially and by also providing access to their expertise and information on their supply chains. The Fung Global Institute has other projects on financial architecture, sustainability issues, and growth models in India and China, and it is expected that these will cross over into other projects. The WTO is expecting to create policies and rules for each of these issues. In the longer term, a role for multilateralization on the basis of critical mass decision making would be desirable for the WTO.

NAKATOMI Michitaka
Regarding the harmonization of rules of origin in the WTO, this appears to have been hindered by protectionist acts by many countries. Harmonizing rules of origin in general terms seems to cause serious domestic difficulties. At the same time, the WTO reports seem to express the relevancy of rules of origin. How do you view this situation?

Patrick LOW
It is clearly going to take time. If some countries use value-added criteria, with others using product description of tariff heading criteria, it would be hard to harmonize all of them. It seems that the only way of moving forward is to consider how to make the harmonization of each rule less important in terms of its impact.

*This summary was compiled by RIETI Editorial staff.