Regional or country-specific shocks are more likely to cause relocations to third countries than reshoring, driven by changes to competitiveness.
The resilience of global supply chains (GSCs) in manufacturing has been questioned following recent global and regional shocks. GSCs are regarded as resilient when they can sustain such shocks and continue producing an unchanged level of output at the same location. The operational and locational dimensions of supply chain resilience need to be appreciated amidst calls for the ‘reshoring’ of production, which shortens supply chains by bringing them home to reverse the ‘export of jobs’ while claiming that it adds to resilience.
The disruption to GSC operations is being used as a pretext to reshore production, although diversifying supply chains actually lowers risk. Furthermore, the ongoing digitalisation of GSCs, accelerated by the pandemic, also increases resilience while reducing the cost of distance, thereby diminishing the case for reshoring or nearshoring. Nevertheless, the reshoring prerogative is so great that it was one of the drivers for the US initiating a trade war with China, while Japan has been offering generous subsidies to its affiliates to return from China.
Are GSCs as vulnerable as claimed? The Covid-19 pandemic was a global shock that disrupted production in every country that locked down, irrespective of the extent of engagement in GSCs. It did not seem to matter whether goods were produced from start to end in one of those lockdown countries or in several of them. Similarly, the more recent output disruptions may have more to do with the explosion in pent-up demand and the unevenness of the recovery than the way goods are produced. On the contrary, the pandemic has demonstrated how resilient GSCs can be, with production bouncing back so quickly after lockdowns were eased. This was particularly true in Southeast Asia, where trade was about 30 per cent above pre-pandemic levels by late 2021.
The vulnerability of GSCs has been exposed less by global shocks than country- or region-specific shocks, such as the 2011 Thai floods or the 2011 Fukushima earthquake in Japan. Those episodes showed how disruption to just one segment of production reverberates throughout the supply chain, leading to a sharp contraction in outputs of finished products. The China-U.S. trade war is another country-specific shock because discriminatory tariffs are applied only between two parties.
Regional or country-specific shocks are more likely to cause relocations to third countries than reshoring, driven by changes in competitiveness. Although the bilateral tariffs of the China-U.S. stand-off are relatively small, ranging from 10 to 25 per cent, their impact on competitiveness can be much more significant. This is because the tariff is not levied based on the value added in the tariff-targeted country but on 100 per cent of the value of the finished product.
The key industries that dominate GSCs – electronics, transport equipment and machinery (ETM) – have not seen much relocation.
Let us illustrate with an example derived from the estimated 30 per cent domestic value-added of Chinese total manufacturing exports to the US in 2018. Based on this value-added share, imported inputs account for US$70 of the cost of a US$100 made-in-China product, while the final production processes in China add US$30. It follows that a 25 per cent tariff on the US$100 product is really a US$25 tax on the US$30 value added in China. Other countries, such as Vietnam, effectively receive a ‘buffer’ of US$25. If Vietnam can add the same (US$30) value while keeping total costs less than US$55 – that is, within the US$25 buffer provided by the tax – it would be more profitable to produce there.
This multiplier effect of the discriminatory tariff is termed the effective rate of spillover protection (ERSP) because it creates an unintended and magnified advantage for all competitors, not just the US. It also explains why relocation of GSCs could, in theory, occur even with a relatively small tariff, if the tariff is discriminatory and the value-added share is small.
In practice, however, GSCs overall have remained remarkably resilient. While there have been shifts in GSCs out of China into neighbouring countries like Vietnam, Thailand and Malaysia, these have mainly involved the so-called footloose, labour-intensive industries – textiles, clothing, footwear, etc. The key industries that dominate GSCs – electronics, transport equipment and machinery (ETM) – have not seen much relocation despite these multiplier effects. Considering how ERSP magnifies protection, which theoretically induces supply chain reconfigurations, GSCs are more resilient than they appear because of the limited amount of relocation.
The conundrum involving ERSP is resolved when factor intensity and technology are taken into account. ETM industries are capital-intensive with high shares of fixed costs. The technologies are generally less divisible such that fewer segments of the supply chain can be separated and transferred across borders. Such complex production processes operate within an ecosystem that is both less divisible and more difficult to recreate elsewhere. Factories must be rebuilt, while training new workers and developing relationships with new suppliers substantially increases costs. These factors could overwhelm the multiplier effects of the ERSP, accounting for the locational resilience of ETM industries despite trade war tariffs, improving operational and output resilience.
Therefore, we should not be surprised to find little evidence that the trade war has resulted in significant reshoring of production back to the US or China. The minimal relocation has involved transfer of supply chain activities to third countries in Southeast Asia. If punitive tariffs have failed at reshoring production, then direct subsidies have not fared any better, even though subsidies can be better targeted because they can be tied directly to reshoring, avoiding the spillover to third countries. Since the subsidies are directly related to the value-added returned, however, there are no ERSP-related multiplier effects either, reducing their potency. The evidence from Japan is that firms that accepted subsidies to reshore were quick to return to China after observing a grace period of sorts, diminishing any long-term impact.
Southeast Asia is heavily dependent on GSCs and reshoring would gravely affect its trade and growth prospects. When reshoring is engineered through discriminatory taxes or targeted subsidies, global welfare is reduced by efficiency and deadweight losses associated with a misallocation of resources. Using resilience as a pretext to promote the reshoring of production are not only likely to fail but will incur costs even if successful.
Jayant Menon is Senior Fellow at ISEAS – Yusof Ishak Institute.