Trade Policy & Global Value Chains I

As part of my Masters in Public Administration (MPA) program at National University of Singapore (NUS), I am undertaking a course on Trade Policy and Global Value Chains, conducted by Prof. Razeen Sally and Prof. Alex Capri. The professors have provided us with some exciting reading material. In this essay, I summarise the reading material of Week 1.

In The Oxford Handbook of the Political Economy of International Trade, Lisa Martin has listed out few broad theories derived from economics and political science disciplines to explain how trade policy works. These theories are:

• Heckscher-Ohlin model: It states that countries decide on what best to import and what to produce locally based on the factor endowments they have in abundance. The original model had described three factor endowments: land, labour, and capital. Modern adherents of the model divide capital into capital for investment and human capital. Rich countries are abundant in capital and scarce in labour in comparison to poor countries. Hence, rich countries can produce goods using capital more efficiently, while poor countries can produce goods using labour more efficiently.

Aside: Unfortunately, this is the world order. I had made it out even before being acquainted to the model. However, the world order does not have to be like this. There are some factor endowments in which a poor country can build capacity quite fast, if its institutions work properly. For example, USA promotes immigration of talent from around the world and develops its IP capital on the back of university talent and good patent laws. A poorer country in Africa can also compete in exporting human capital if it gives good education to its citizens. Good news is that good education is now affordably available over the internet. So developing human capital for a country with the willpower and human population is not difficult.

• HOSS Model: Heckscher-Ohlin (H-O) model was further improved upon by Stolper and Samuelson (S-S). Their new model is called H-O-S-S model. HOSS argues that 'abundant factors within a country will benefit from increased trade, as resources will flow into sectors that use abundant factors as trade opens and new export markets become available.' HOSS model predicts that those in control of abundant factors in a country will lobby for freer trade, while those in control of scarce factors will demand trade barriers. For example, tech companies in USA tend to lobby for free markets, so that they can export their technology-intensive products to other countries. Whereas, labour in USA demand barriers, so that their jobs are protected from cheaper labour in China. This model is, however, too simplistic and does not accurately predict all behaviour of politicians.

Aside: Capitalists in USA drive the logic of open markets, so that they can earn export income from their financial capital and tech capital. Labour in USA demands barriers so that they do not lose their jobs to cheaper labour in Asia. The capitalists were winning till Mr. Trump came to power, and USA was the beacon of free trade in the world. But labour organised politically in 2016 and instated Mr. Trump as POTUS. Since then, labour's demands are being given high priority by the government. An alternate way of looking at it is that the trade off equation for USA has changed. Earlier, it had abundant capital relative to developing countries of Asia; while it had scarce labour relative to developing countries of Asia. Now, its capital relative to China and other emerging countries is still more, but relative abundance has decreased. So its capital exporting capacity has reduced. It sees a costly trade-off between exporting capital and protecting jobs.

• Ricardo-Viner Model: A major drawback of HOSS model is that it does not differentiate between different types of labour or different types of capital. It presumes that (for example) if one sector is under pressure from imports, then capital will immediately shift to another sector. If labourers in toy manufacturing in India lose their jobs to cheaper toys from China, then they would immediately move to pharma or textile sectors where India is a net exporter. But the assumption is flawed. Skilled labour is not that elastic. Nor is capital invested into a sector that elastic. Hence, a new model by Ricardo and Viner that discusses the dynamics between 'specific factor endowments' rather than broad factor endowments.
• New Trade Theory: This theory was developed by Paul Krugman and others in 1970s. This theory confronts a key assumption in both HOSS model and Ricardo-Viner model, that a country should produce only goods in which it has competitive advantage. Competitive advantage of a country increases if goods are produced in bulk. If goods are produced in bulk, then the country's industry saves costs from economies of scale. This makes the country's production facilities more competitive. Scale leads to higher productivity, which leads to more efficiency. Country A may not have competitive advantage in a certain good if it does not have the industry to manufacture the good in bulk. But if it stops manufacturing the good, it loses the opportunity for all times to come and has to rely on imports. If the country, on the other hand, develops capacity to manufacture in bulk, then it may be able to harness competitive advantage from the good. This model provides justification for government protection to new industries.

Aside: This theory brings a necessary perspective to Ricardo's competitive advantage theory. Ricardo's theory is taught in Economics 101 as a gospel truth. As a result, many policy analysts believe that borders should be completely free. That's wrong. Borders need to be freer, but there is a continuum between completely closed markets and completely open markets. A country needs to decide where it wants to stand on the continuum. China, for example, developed industry clusters by providing subsidies and preferential support to its domestic industries. As a result, China produces goods at a very low value. It has developed many value-added capacities with regards to goods it exports. Even now, when Chinese labour is no longer cheaper than competitors in South-East Asia and Africa, it retains its competitive advantage in most industries where it has clusters. New Trade Theory is more important to understand than Ricardo's competitive advantage.

• Grossman-Helpman Model: This model, also called protection-for-sale, describes the negotiation between a government and its industries on trade defence measures. Opening up the economy increases aggregate welfare of a country. Protectionism increases welfare of the specific industry that could be affected by imports. The government has to decide, on the basis of many factors, the trade off between freeing the market or erecting trade barriers. It gives many interesting insights on lobbying. For instance, organised sectors can lobby better with government for erecting trade barriers. Governments that value aggregate welfare more than the sector-specific benefits will open up markets. Thirdly, protection will be higher for goods for which demand is inelastic - because quantity consumed does not change much even if price is high. Democracies tend to support free trade as the political party in power has to cater to a more broad constituency. It will naturally value aggregate welfare more than sector-specific benefits.
• Impact of trade treaties: A last point to be made to understand national behaviour on trade policy is the impact of trade treaties: Free Trade Agreements (FTA) and Preferential Trade Agreements (PTA). FTAs are signed on the basis of reciprocity. Its a give-and-take. There is a complex web of bilateral and multilateral agreements, which determine how open a country is to other countries. If a country decides to withdraw from a FTA, the costs are high for it. If a country does not participate in major FTAs, it may lose out on access to new markets. On top of this, there is a Most Favoured Nation (MFN) clause in many treaties, that bind a country to give the same concessions to MFN partners which it gives to a new partner.

Aside: FTAs and PTAs do affect trade relations. For instance, the auto industry has moved from China to Mexico after the US-China trade war started, primarily because of Mexico's many FTAs that are beneficial to global value chains.

Economist Special Report: The world is not flat

This special report points out some recent trends in global value chains (GVC) and how a host of protectionist measures in the West have affected the GVCs. Key ideas are:

1. Richard Baldwin had argued in his book The Great Convergence that western industrial know-how and Asian manufacturing muscle had converged to fuel hyper-globalisation of supply chains. This is changing now due to many geo-political reasons.
2. Asian manufacturing mostly refers to cheap manufacturing in China. China is now moving higher up on the value chain. At the same time, its labour is becoming costlier. As China is competing with the West for supremacy over new technologies, the cooperative and symbiotic relationship between China and the West has now been replaced by intense competition.
3. GVCs were getting longer because MNCs kept looking for cheaper locations to source their goods from. Components were sourced from multiple locations, depending on where the component can be manufactured at the lowest cost.
4. After getting longer for many decades, GVCs are now contracting. This primarily due to two reasons: (a) There are risks associated with stretching supply chains thin just to reduce costs, and (b) a large component of value addition in global trade is contributed by services now.
5. The risks involved in sourcing from the cheapest geography are political in nature. As US has initiated a trade war against China, and has initiated measures against many other countries, supply chains from these countries are getting distorted. Another reason is changing need of consumers: many MNCs now need faster supply chains rather than cheaper supply chains.
6. The value of services in global trade has increased disproportionately over the value of goods. Trade in services grew more than 60% faster than trade in goods in the decade before 2016 (as quoted in the Economist report). MNCs are now establishing bases wherever consumers are, so that they can give quality services, and implement innovations in services, effectively.
7. Globalisation is becoming regionalisation. While the trade war has affected China's exports, its own internal demand has risen in recent years. As a result, the impact of trade war on its industry is ameliorated to a large extent. China's share in high-value added goods remains intact. For example, the clothes-exporting industries have migrated from China to Bangladesh and countries of South East Asia due to the cheap labour there. But textiles used for clothes-manufacturing are still made in automated factories in China. China still exports the fabrics to Vietnam which Vietnam uses to produce export-worthy clothes.
8. Different industries have seen different kind of disruptions in their supply chain. The Economist has found that '[the] car industry is coalescing around regional hubs', while electronics manufacturing remains rooted in China due to the high-end hardware innovations in China over the years. Interesting trivia here is: Mexico's four dozen FTAs with other countries allow it to export cars to many countries free of customs duty. As a result, it is now a favourite destination for contract manufacturing of automobiles.
9. Digitalisation is changing supply chains in big ways. IOT, blockchain, and other digital innovations are helping giants like Amazon, Alibaba, and Walmart automate their supply chains. Their focus now is on speed rather than cost. They want to use new technologies to effect last-mile-delivery as soon as possible. Amazon prime customers are now being promised 2 day delivery. Amazon is targeting 1 day delivery for its prime customers, while Walmart plans a 1 day delivery for all customers.
10. Data science is also being used in a big way in optimising supply chains. Data analytics is being used in predictive stocking of inventories. Feedback about consumer choice helps FMCG companies stock the right goods. As a result, inventories are being replenished sooner. This saves warehousing cost and increases productivity.
11. The big challenges now are to redesign supply chains such that they can respond to geopolitical instability quickly; strike a balance between low cost sourcing and local sourcing; and, develop cyber security measures against hackers and malware.