COVID-19’S SHORT-TERM IMPACT ON THE GLOBAL ECONOMY AND GLOBAL VALUE CHAINS
The COVID-19 pandemic continues to create unprecedented disruptions in almost all aspects of life. As far as the global economy is concerned, the short-term impact has been most dramatically seen in the collapse in output growth and global value chains as restrictions are imposed on daily mobility, travel and shipping.
According to the International Monetary Fund (2020), global growth in 2020 is expected to contract by 4.9%, compared to an expansion of 2.9% in 2019. On the supply side, the damage is evident in the sharp drop in global trade activity. The World Trade Organization (2020) forecasts that global merchandise trade will shrink by 13% in the optimistic scenario and as much as 32% in the direst scenario in 2020. The sharp decline reflects not only sluggish growth in aggregate demand but also the widespread disruptions to global value chains that are highly complex and extensive.
Optimised for cost-competitiveness, modern supply chains revolve around the concept of lean manufacturing, which involves the trimming of excess inventory, extensive use of offshore sourcing, and just-in-time operations. While this business model may prove highly profitable under normal circumstances and has grown in popularity in tandem with globalisation, it is highly susceptible to disruptions. In 2011, for example, a massive flood in Thailand forced a number of global corporations in the automobile and computer disk drive industries to halt their global operations for months due to their outsized reliance on parts and components produced almost exclusively in Thailand.
On a greater scale, the current COVID-19 pandemic has brought about widespread disruptions in global supply chains, with countless companies ceasing operations due to lack of input, especially those relying on a handful of suppliers concentrated in a few countries. For example, Vietnam’s textile and garment industry was severely affected by production shutdowns in China and exacerbated by border closure between China and Vietnam during the epidemic, as more than half of the fabric used by the industry originates from China.
THE CONTOURS OF THE EMERGING GLOBAL ECONOMIC ECOSYSTEM
Over the long term, the damage wreaked by COVID-19 is expected to change the shape of the global economic ecosystem. To discern the change, it is necessary to understand how businesses are readjusting their strategies, one of the most crucial of which is the reconfiguration of supply chains with a view to minimising the impact of similar disruptions in the future.
To that end, it is important to first identify the different types of disruptions. Largely considered as exogenous from the point of view of firms, disruptions can be due to natural disasters or man-made, such as geopolitical conflicts. Some disruptions are unforeseen, while others are ongoing and incremental, such as the US-China trade tension or climate change.
The next step is to identify the various vulnerabilities inherent in firms and industries, which can come from many sources, ranging from supplier networks and concentration of factors of production to inventory management. This allows us to understand some of the more visible trends resulting from the different strategies that firms employ to minimise those vulnerabilities, trends that will likely leave a lasting impact on the nature of the global economic ecosystem.
To reduce potential disruptions from excessive geographic concentration, many businesses have begun to diversify their supplier bases.
MORE FLEXIBLE, LESS COMPLEX SUPPLIER NETWORKS AND MORE SUBSTITUTABLE INPUTS
As far as supplier network vulnerabilities are concerned, the geography of a firm’s production network is one of the main channels through which the firm is exposed to major disruptions. When supplies are concentrated in one or a few countries – either to achieve economies of scale or for specialisation – any disruption occurring in the region from which the supplies are sourced can cripple the production line, as evident in the case of COVID-19, where disruptions in the form of production shutdown and cross-border travel and shipping restrictions across the world have brought many factories to a standstill.
To reduce potential disruptions from excessive geographic concentration, many businesses have begun to diversify their supplier bases, including greater use of domestic suppliers, with a view to adding some redundancy that will allow them some flexibility to switch among suppliers. For example, after the Tohoku earthquake in Japan in 2011, Matous and Todo (2017) found that a number of automobile manufacturers in Japan have diversified their supplier bases, moving away from the traditional “keiretsu” model of long-term relationships with a few tier-1 suppliers.
The diversification strategy is not only applicable to unforeseen shocks but also to those that are ongoing and incremental, as is the case with the US-China trade war, which has generated steady flows of relocation and co-location of production away from China toward Southeast Asian countries, particularly Cambodia, Laos, Myanmar, and Vietnam. After the COVID-19 outbreak, this strategy has been championed by the Japanese government, which recently announced that it would provide financial support for the relocate on of over 80 Japanese companies from China back to Japan or to other countries, such as Myanmar, Thailand, and Vietnam, to reduce the manufacturing sector’s dependency on China.
In addition to geographic distribution, complexity of the supplier network is another key factor that can expose a production line to sudden disruptions. In most cases, a firm is not only connected to its tier-1 suppliers but also to those that provide inputs for tier-1 suppliers (i.e. tier-2 and lower-tier suppliers). Often based on productivity-boosting specialisation and cost minimisation, this type of interconnectedness is characteristic of industries that rely on a multitude of inputs, such as the aerospace and automobile industries. According to McKinsey (2020), Airbus has 1,676 publicly disclosed tier-1 suppliers and over 12,000 tier-2 suppliers. When a disruption occurs, however, a firm may find itself caught off-guard by scarcity of inputs to the extent that it does not fully grasp the entire scope of its supplier network. In fact, a study by Elliott, Thomas, and Muhammad (2019) finds that more than one-third of supply chain disruptions originate from suppliers at the second or lower tiers.
Kuala Lumpur, Malaysia
Malaysia’s economy contracted less than expected in the third quarter in 2020, shrinking 2.7% from the same period in 2019, leading Malaysia’s central bank to offer a more positive outlook for growth in 2021. Photo: Abdul Razak Abdul Latif / Dreamstime
In this regard, many businesses are restructuring their supplier network to be more horizontal, which can make it easier for them to spot emerging risk from suppliers.
Also, having a sufficiently broad spectrum of tier-1 suppliers is another strategy often employed to prevent a particular tier-1 supplier from wielding excessive control over supply lines.
Another type of vulnerability that can emerge from a firm’s supplier network is the degree to which its production relies on customised inputs that are not easily substitutable. While customisation may be quality-enhancing in normal times, it may pose a challenge during periods of disruption, when customised inputs cannot be procured on time. To mitigate this risk, greater use of substitutable parts will be an increasingly important feature of the global economic ecosystem in the future.
Labour-intensive industries such as apparel and furniture are susceptible to disease-driven disruptions, such as the current pandemic, that directly affect employees’ ability to work together in factories.
MORE DISPERSED PRODUCTION SITES AND HIGHER INVENTORY BUFFERS
In addition to potential disruptions arising from the supplier network, the nature of a firm’s factors of production can also pose challenges in the event of a shock. For example, labour-intensive industries such as apparel and furniture are susceptible to disease-driven disruptions, such as the current pandemic, that directly affect employees’ ability to work together in factories. Capital-intensive industries such as semiconductors, on the other hand, are particularly vulnerable to natural disasters, which can cause significant damage to critical equipment and machinery. For this reason, many businesses are now dispersing production sites to lessen risks stemming from concentration of factors of production.
Furthermore, inventory management is one of the channels through which firms are affected by unforeseen disruptions. Largely developed in Japan in the 1960s and 1970s, the concept of justin-time manufacturing in essence features a low inventory level that helps reduce inventory costs and wastage. Having discovered that keeping low inventory-to-sales ratios could lead to efficiency gains, countless firms have adopted this method and applied it liberally even as they outsourced production offshore. However, this strategy crucially relies on timely arrival of supplies. When this condition is not satisfied, such as during the COVID-19 pandemic, the assembly line can quickly come to a halt. Going forward, some businesses will likely maintain a higher level of inventory to balance efficiency gains with reduction in disruption risk, while others may supplement their lean inventory management with some of the aforementioned strategies to ensure minimal supply disruption.
Ultimately, the ongoing recalibration of supply chain strategies will leave lasting marks on global trade patterns. Some industries may experience a pickup in cross-border shipments as firms disperse production sites or add new suppliers to their network, while others may witness a decline in global trade activity as supplier networks are reconfigured to be less complex or to rely more on domestic sources. Perhaps thanks to the disruptions caused by the pandemic, the global economic ecosystem that emerges post-COVID-19 will likely be more resilient than what we have today.
REFERENCES
- International Monetary Fund (2020). World Economic Outlook Update, June 2020.
- McKinsey (2020). Risk, Resilience, and Rebalance in Global Value Chains, August 2020.
- Matous, P. and Y. Todo (2017). Analyzing the coevolution of interorganizational networks and organizational performance: Automakers’ production networks in Japan, Vol. 2/5, pp. 1-24.
- OECD (2020). COVID-19 and Global Value Chains: Policy Options to Build More Resilient Production Networks, June 2020.
- Rachael E., C. Thomas, and K. Muhammad (2019). Supply chain resilience report 2019, Business Continuity Institute, 2019.
- Washington Post (2020). Japan helps 87 companies to break from China after pandemic exposed overreliance, July 21, 2020.
- World Trade Organization (2020). Trade falls steeply in first half of 2020, Press Release, June 2020.
DR JADE VICHYANOND
Dr Jade Vichyanond is the country desk economist for Vietnam at the ASEAN+3 Macroeconomic Research Office (AMRO) and provides support for surveillance on Indonesia and Thailand. Prior to joining AMRO, Dr Vichyanond worked at the International Monetary Fund (IMF), where his responsibilities included macroeconomic surveillance on Malaysia, Laos, Fiji, Italy and San Marino, as well as research work on international trade and capital flows. Dr Vichyanond holds a Ph.D in Economics from Princeton University.
DECEMBER 2020 | ISSUE 7
Future-Proofing Our Recovery
