# How will East Asia's Digital Transformation Change the Global Value Chain?

Date July 1, 2021 Lurong CHEN (Senior Economist, Economic Research Institute for ASEAN and East Asia (ERIA)) INOMATA Satoshi (Senior Overseas Research Fellow, Institute of Developing Economies, Japan External Trade Organization (JETRO)) WATANABE Tetsuya (Vice President, RIETI) OTA Yasu (Columnist, NIKKEI) The wave of digital transformation is sweeping over the emerging economies of the East Asia region, transforming industries and societies in the member states of ASEAN at an even faster pace than in developed countries. At the same time, the US-China confrontation is fragmenting the global economy. What is going to happen next? How do we cope with these changes? In this seminar, global supply chain experts from Southeast Asia and Europe will give us a bird's eye view of what is happening in East Asia's digital transformation and how this may impact global trade. Dr. Lurong CHEN, an expert on the regional economy from Jakarta, will provide a perspective from ASEAN, and Dr. Satoshi INOMATA from Paris will discuss the shape of global value chains under Industry 4.0.

## Summary

### Introduction

WATANABE Tetsuya

This is a joint session hosted by the Research Institute of Economy, Trade and Industry (RIETI) and the Economic Research Institute for ASEAN and East Asia (ERIA). It focuses on the question of global value chains (GVCs) in an age of digitalization and growing geopolitical tensions between China and the U.S., with a particular emphasis on the countries in ASEAN. The two presentations and Q&A session touch on the history of GVCs, changes which are taking place and trends that are likely to be seen in the future, and offer some policy recommendations for ASEAN countries seeking to ensure their constructive participation in GVCs.

### Presentation

INOMATA Satoshi

#### Shift from Uni-Directional to Omni-Directional Supply Chains

The current trend in GVCs is driven by the rapid advancement of the "Industry 4.0," the term coined in the High-Tech Strategy 2020 advocated by the German government in 2011. Supply chain management under the Industry 4.0 is expected to shift from uni-directional to omni-directional configurations. Traditionally, information moves along supply chains via a linear sequence of spot-by-spot transactions, either from downstream to upstream or vice-versa. Accordingly, it may cause some delays in the transmission of information in proportion to the length and complexity of supply chains, and also poses a risk such that tiny misinterpretation at one point of the sequence may snowball throughout the entire supply chains.

With new digital technologies, however, GVCs will form an eco-system in which information is gathered simultaneously, with a help of smart sensors, radio-frequency identification (RFID), Bluetooth or global positioning systems (GPS), together with other relevant metadata such as weather reports, transport information or even social network services (SNS) posting. The collected bigdata is holistically analyzed by centralized cloud computing systems for instantaneous optimization of supply chain performance, with respect to equipment utilization, inventory management, risk control, demand forecasting and so on. As a result, any unpredicted external events (such as traffic jams, natural disasters or cyberattacks) can be swiftly identified and diagnosed, and appropriate measures are implemented immediately.

It also enables highly agile and responsive production arrangements which allow for product differentiation and individual customization, meeting the needs of increasingly diversified consumer preferences.

#### New Realities for Developing Countries Seeking to Enter GVCs

Technological progress has always pushed forward the development of GVCs, as set out in Richard Baldwin's well-known "unbundling" theory. In the last century, the advancement of transportation modes and information and communications services has facilitated the geographical fragmentation of production processes to developing countries, even though the main consumption markets remained in more affluent economies. The dynamics of production cost arbitrage had opened the GVC gate to developing countries, whose cheap labor force served as an "entry ticket." As their wages rose, the competitive advantage shifted to poorer newcomers who then joined GVCs in turn. In this manner, GVCs have expanded over time by embracing more and more countries in the periphery.

The advent of Industry 4.0, however, accelerated automation of production processes, leveraged by the use of smart sensors, big data analytics and autonomous industrial robots. As a result, economic values of simple manual labor declined significantly. Global firms started to consider withdrawing production capacities from developing countries. Cheap labor force as an GVC entry ticket is rapidly losing its validity, making it harder for developing countries to be a part of the global economy.

#### New Opportunities

At the same time, the new technologies also create huge business opportunities for individuals and SMEs in peripheral countries. E-commerce enables business matching between clients and suppliers in various locations. 3D printers allow designers from every corner of the globe to participate remotely in interactive prototyping of products. Blockchain technologies enhance traceability and transparency of supply chains, and thereby help to streamline domestic and international logistics operation. For example, the supply chains of perishable commodities become more manageable, helping agriculture-based economies to participate in GVCs.

Further to these, "virtual presence technology," as exemplified by online meetings and remote medical services, will significantly broaden the range of tasks that can potentially be offshored. In the past, "offshorable" tasks were considered to be those which do not require complex communication, but, going forward, the world will increasingly see the variety of tasks being offshored, such as manufacturing services proprietary to craftsmanship or the production of complicated products which require detailed on-the-spot description of product specifications.

### Conclusion

In conclusion, the rise of new digital technologies under Industry 4.0 will sharpen the dichotomy between winners and losers among developing countries. Many ASEAN countries are standing on the edge of this critical challenge.

Lurong CHEN

#### Understanding digital as a "new gene" of GVCs

Digitalization represents a "new gene" of GVCs, as the latest stage of a process in which technological progress has affected the international economy through reducing trade costs (transportation costs, communication costs and people-to-people connection costs), developments that were set out in Richard Baldwin's 2016 book The Great Convergence.

In a process known as the "first unbundling," the application of new technologies in the industrial revolution, especially steam ships and railways, reduced the time and costs needed for long-distance transportation; this enabled the geographical separation of production and consumption (linked by trade) as well as the industry-wide division of labor, mass production and economies of scale. In the 20th century, the "information revolution" continued to drive down transportation costs and communication costs, making it possible and beneficial for firms to fragment and share production internationally. More developing countries could now participate in GVCs as a way of pursuing economic growth and prosperity, and international trade grew rapidly.

Next, with the application of digital technologies, the "third unbundling" of economic globalization extended and deepened global value chains by further reducing the cost of people-to-people connections, particularly that in the cyberspace. Digitization smears out boundary between different links of the value chains and increases the information transparency to all participants. Meanwhile, , the application of digital technologies and related business models into the service sector makes services much more innovative and productive than ever before. For that reason, we see digitalization and servicification are the key feature of the 21st century GVCs.

#### The Need for International Collaboration in GVCs

Digitalization could be a new engine of economic growth, producing new products, new services, new business models, and new markets, and unlocking huge market development potential when combined with new materials and new energy. Cutting-edge technologies that are promising for market prosperity include 3D printing, industrial internet, blockchain and AI (including machine learning, technology for rule-based reasoning, perception technologies and embodiment technology such as autonomous robotics and human augmentation); combining these technologies, furthermore, will give rise to new products and technologies that are even more advanced and complex.

The increasingly detailed nature of such products means that international collaboration via extensive and growing GVCs will be one good solution for meeting the needs of the increasing technological complexity of the digital economy, especially when it is considered how many intellectual properties (IPs) and patents lie behind those technologies. Some low-hanging fruits include robotic processes, automation, video recognition and recommendation systems.

For instance, Industry 4.0 is expected to increase ASEAN's overall productivity by more than $200billion and increase its revenues by over$40billion; however, ASEAN countries must bring together their efforts to ensure growth of these technologies, if they are to enjoy the outcomes that they could bring.

#### Policies for the Digital Economy and Promotion of GVC Participation

Supporting growth of the "innovation economy" will also require innovative policies. The coexistence of different patterns of unbundling offers policymakers a wide range of policy options, including sequential upgrading of the economies and the "leapfrogging" strategy. Embracing new technology in old sectors will also bring opportunities for countries to renew their competitive edge in such domains.

Improving people-to-people connections—the defining factor of the third unbundling—should be a key principle of policy design and is likely to bring considerable market rewards, as seen in the case of Zoom. At the macro level, "digital transformation" includes social transformation of how people live, work and study as well as changes in the economy; as such, it offers opportunities for countries to encourage regional development, including eliminating development deficits and promoting inclusive growth.

Above all, improving data connectivity—a precondition of the free flow of information, capital, goods and services—should be a policy priority. This connectivity is impeded in Asia by substantial development gaps and by the lack of capital, human skills and technology knowhow in many developing countries, but most of all, by the lack of international consensus about trust. While smartphones, the internet and other technologies facilitate the collection, processing, storage and distribution of data, they also stir up growing concerns about data security, safety and privacy, and worries that data might be illegally leaked. These concerns will become more important as data becomes the main carrier of value in GVCs.

Digital connectivity requires safety and trust in the digital world. This means that countries must work together to build appropriate safeguards in the form of government policies and international rules. As it takes time for countries to establish trust, Asia (which is known for its "market-driven" methods of solving regional integration issues), should start with collaboration for "low-hanging fruit," ie. in field of ecommerce and digital trade, before moving on to deeper cooperation. International rules and vetting will also be required on issues such as intellectual property rights (IPR) protection, consumer protection and competition.

### Q&A

OTA Yasu:
Asia, sometimes known as the "world's factory," faces two major changes: the confrontation between the United States and China, and digital transformation. How will those two shifts change the global value chain involving Asian countries, especially in ASEAN? As these countries will not be able to compete via low wages alone, they will need technological capabilities in order to keep up with the advanced nations. What new values can they offer, and what points of the value chain should they seize? How can they compete?

Lurong CHEN:
One key point is that, regardless of developments in the U.S.-China dispute, the digital transformation of GVCs is an unstoppable trend, and neither the United States nor China can afford to be isolated from GVCs. There are, nevertheless, concerns that this confrontation could lead to GVCs splitting into two separate spheres. While this trend, should it develop, is probably beyond Asian countries' capacity to stop, Asia should at least attempt to make sure that the two spheres intersect at certain points and that these intersections are located in Asia. If Asia is to do this, we need to make sure that we have sufficient economic gravity to play the even more important role in these GVCs.

INOMATA Satoshi:
There are two forces working simultaneously. First, digitally-enabled services such as e-commerce, 3D printing, blockchain logistics and virtual presence will extend the margins of GVCs to peripheral countries, by lowering transportation costs and transaction costs, thereby expanding GVCs in terms of geography. At the same time, growing U.S.-China tensions will incentivize firms to focus on countries that are similar to their home countries in terms of institutions and business environment, due to the risks that the governments of adversary countries may engage in discretionary intervention in business such as the freezing of assets or forced technological transfers.

Therefore, the configuration of GVCs will be driven, not by the wage level differentials between developed and developing countries as in the past, but by the institutional affinity between the countries in question. It follows, then, that GVCs will expand and become more globalized in terms of geography while becoming more localized and fragmented in terms of institutional attributes.

OTA Yasu:
Another question concerns government subsidies and the distortion of markets. The example of electric vehicles (EVs) in Shenzhen shows how policies such as preferential taxation and subsidies can create artificial markets by stimulating demand and subsidizing production. This will affect competitiveness in markets. Furthermore, while governments of countries such as China can afford to engage in such measures, it raises the question of what countries like Indonesia or Myanmar are expected to do. What will happen to fairness in terms of GVCs?

INOMATA Satoshi:
Increasing geopolitical tensions have brought about new recognition of the importance of industrial policies in advanced economies as well as in developing countries, especially when the issue of national security raises its head. As a result, firms can no longer expect that the governments provide level playing fields to them. A certain firms may even benefit from government intervention. Also, some governments are more able than others to finance industrial policies, which will affect the track of each country's development path.

OTA Yasu:
Another question is why the implementation of changes is slower in some countries, such as Japan, than in other ASEAN countries. Dr. CHEN, what is your perspective, from Indonesia?

Lurong CHEN:
It is often observed that the digital economy may grow faster in countries with less of a regulatory framework. New thoughts and new rules are required to govern this very new area. Advanced economies have more comprehensive regulatory systems in place, and some of these rules and laws may be outdated. Upgrading these systems is probably the biggest challenge for policymakers.

However, simply letting the digital economy grow rapidly without any rules is not a desirable situation; regulatory frameworks are crucial for the long-term development of each economy. Policymakers need to adopt a forward-looking framework, including getting input from market players; however, this can potentially lead to bias, and a balance between different market players, not just market leaders but also small and medium firms, is essential when working with the private sector.

OTA Yasu:
Singapore is probably the most comfortable city in Southeast Asia for living and for business, being highly digitalized, efficient and English-speaking; it is often seen as a leader of and a model for ASEAN. Its strategy has hitherto been one of occupying important points in GVCs such as financial services, telecommunications and its role as a transportation hub. However, with the U.S.-China conflict, Singapore increasingly finds itself sandwiched between the two countries, and this is true with the rest of ASEAN. So how will the digital wave and the U.S.-China conflict change Singapore?

Lurong CHEN:
Visualization and the shift towards services are the two main features of the 21st century. We have seen a move towards providing services rather than selling products, and Singapore has hitherto offered a model for many countries, by providing services as part of GVCs. It will be not good news for the country should these GVCs divide into two spheres. Singapore is therefore likely to do whatever it can to keep GVCs integrated together, by either side-stepping the disagreements between the United States and China or agreeing to disagree.

OTA Yasu:
Who are the winners and losers in this transformation or alteration of GVCs in ASEAN, or in Asia in general?

INOMATA Satoshi:
Many ASEAN countries are standing on the edge of this important challenge, but it is not necessarily the case that there should be a pair of winners and losers within ASEAN; it is certainly possible that all of these countries will manage to escape from the middle-income trap and move on to the next stage. This, however, will depend on how well the countries cooperate with each other. Singapore is quite likely to be a winner, thanks to its people's mindset about efficiency and speed that had brought economic dynamics to this country, as well as its geographical advantages, Chinese networks, English proficiency, and so on. The question, however, is whether other ASEAN countries can ever emulate the Singapore model.

OTA Yasu:
The next question is about the new regime of free trade: free trade agreements, purchasing power parity (PPP), the World Trade Organization (WTO) and so on. Liberalizing markets benefits the world as a whole, as lowering barriers brings economic benefits. However, what will this process look like in the era of the digital economy? Perhaps we should redefine the meaning of "digital free trade."

Lurong CHEN:
When setting rules for the digital economy, some issues are relatively easy to settle among different countries, while others are harder. A positive trend is that countries are now starting to reach agreements in areas such as ecommerce (for which a chapter has been included in the Trans-Pacific Partnership (TPP)) and IPR protection, where it is easier for countries to see the benefits of setting rules. My proposal is that we put more joint effort to solve the easier issues—ecommerce, cybersecurity, cross-border consumer protection, and then move on to more difficult issues (such as data-handling) later, after trust and communication have developed among the different countries.

OTA Yasu:
My first question is about freedom and national security during the COVID-19 crisis: how governments can control people and companies while ensuring their freedom. Secondly, it appears that China seeks to enhance its national security by using digital technology, while the United States, based on claims of democracy and liberalism, is trying to get China out of its supply chains (especially in terms of digital matters and semiconductors). So how can ASEAN survive when caught between these two countries, and what role can ASEAN play to build the international order and create stable GVCs?

INOMATA Satoshi:
There is an imperative need for establishing a multilateral framework to monitor and control the process of US-China decoupling. This is a critical issue because it relates to the question of free trade and national security in the Asia-Pacific region, for which Japan and ASEAN countries are big stakeholders. Neither the United States nor China wishes to fully decouple because they can still obtain substantial economic benefits from each other. However, given the rise of security concerns, a roadmap should be carefully drawn for a "partial" and "stepwise" process of decoupling in the areas of national security, just to avoid military contingencies and open a path to "soft-landing." Japan and ASEAN should play a leading role in this way forward.

OTA Yasu:
Dr. CHEN, please share your views from Jakarta on the decoupling of the United States and China, and on the issue of freedom in China.

Lurong CHEN:
Cybersecurity needs to be treated as serious as homeland security, given that digital technology is such an integrated part of people's daily lives. Basically, the world's countries need to sit down together to set out international principles, create a baseline, and draw up international standards for conduct.

As for policies during the COVID-19 pandemic: because a pandemic is a global emergency, good policy during the COVID-19 pandemic is not necessarily good policy at normal times. Conversely, a country which, even during a pandemic, continues with the same policies that it would exercise during normal times, may lose opportunities during a time of emergency. As Asian countries, we need to bear in mind that this question depends on timing and conditions.

WATANABE Tetsuya:
I think we are living in difficult times of geopolitical tensions and technological transformation. But as we have seen from today's questions, there are also many opportunities, and I think we can learn a lot from what is happening in ASEAN and other parts of Asia. Let us continue to discuss these matters further with a focus on this region.

*This summary was compiled by RIETI Editorial staff.