Trade Policy Implications of Global Value Chains

International trade increasingly involves global value chains (GVCs) where services, raw materials, parts and components are exchanged across countries before being incorporated in final products that are shipped to consumers all over the world. Exports from one country to another are now reflecting complex interactions among a variety of domestic and foreign suppliers and create income for firms and workers in widely separated locations. Trade is even more than before determined by international strategies of firms that engage in foreign outsourcing, foreign direct investment and carry out their activities wherever the necessary skills and materials are available at competitive cost and quality. In order to better account for the internationalisation and fragmentation of production, new trade statistics have been developed that can identify the value added by each country in GVCs (http://oe.cd/tiva). The OECD has undertaken comprehensive work that aims to shed light on the scale, nature and consequences of international production sharing. This note explores just one aspect – the implications of GVCs for trade policy and trade agreements. The growing fragmentation of production across borders highlights the need for countries to have an open, predictable and transparent trade and investment regime as tariffs, non-tariff barriers and other restrictive measures impact not only on foreign suppliers, but also on domestic producers. It also highlights the importance of an ambitious complementary policy agenda to leverage engagement in GVCs into more inclusive growth and employment.

Global value chains have transformed world trade

Trade policymakers need to take stock of the reality of business in GVCs. Over the last two decades, there was an important shift in world trade. Both the structure and patterns of trade have changed, leading to a re-assessment of traditional trade policy objectives.

Trade consists mostly of intermediate and capital products

When we think about international trade, the traditional view is that each country is producing finished products that are exported to consumers in another country. This type of trade represents only one quarter of total trade in goods and services. Today, three quarter of international trade is about firms buying inputs and investment goods or services that contribute to the production process (Figure 1). Protection measures against such imports increase costs of production and reduce a country’s ability to compete in export markets and to participate in GVCs. Similarly, currency interventions which may aim at creating a competitive advantage for exporters lose relevance, as any export advantage gained from a cheaper currency is at least partially eroded by the cost of more expensive imported inputs and capital goods or services.

Trade is becoming more global

While the focus of trade policy since 1995 has been on the negotiation of preferential trade agreements – often on a regional basis – companies have increasingly diversified their sourcing strategies and have increasingly imported inputs from emerging economies, thus leading to an increase in the share of extra-regional value added in the exports of Asia, Europe, North America and South America (Figure 2). It is only in the European Union that the share of intra-regional value-added remains higher than the share of extra-regional value-added. But the trend has been similar; EU companies are relying more and more on extra-EU inputs.

What trade policies for engagement in GVCs?

The globalisation of supply chains calls for a more coherent view of trade and trade-related policies. The fragmentation of production has created potential new opportunities for developing economies and for small and medium-sized firms to access global markets as components or services suppliers, without having to build the entire value chain of a product. At the same time, GVCs place new demands on firms, in particular as regards the need for strong coordination and efficient links between production stages and across countries.

Tariffs: Removing barriers at the border that are cumulated along the value chain

After more than a half a century of trade liberalisation, nominal tariffs on manufactured products in developed economies are generally low, and the overall trend has also been towards lower tariffs in developing countries. But in a world characterised by GVCs things are not so clear-cut: tariffs and other protection measures at the border are cumulative when intermediate inputs are traded across borders multiple times. As shown in Figure 3, adding the tariff on final exports to tariffs on inputs (including all tariffs on inputs more upstream in the value chain) can lead to high average ad valorem tariffs in some industries. Moreover, where foreign investment is a driver of export capacity, the cumulative effect of a number of seemingly small costs may discourage firms from investing, or from maintaining investment, in the country – and may lead them to take production facilities, technologies, and jobs elsewhere.

Trade facilitation: Transforming border bottlenecks into global gateways

As goods now cross borders many times, first as inputs and then as final products, fast and efficient customs and port procedures are essential to the smooth operation of supply chains. To compete globally, firms need to maintain lean inventories and still respond quickly to demand, which is not possible when their intermediate inputs suffer unpredictable delays at the border. A country where inputs can be imported and exported within a quick and reliable time frame is a more attractive location for foreign firms seeking to outsource production stages. As such, trade facilitation measures are crucial to foster integration into global production networks and global markets.

The OECD Trade Facilitation Indicators (TFIs) correspond closely to the provisions of the WTO Trade Facilitation Agreement and measure the potential impact of implementing the Agreement. The potential cost reduction of all the trade facilitation measures combined totals up to 17.4% for some countries, with the greatest gains for lower income countries. The TFIs also enable countries to identify priority areas for reform. As shown in Figure 4, harmonising and simplifying documents, streamlining border procedures and automating processes are among the most beneficial areas for many countries.

Standard setting: Avoiding unnecessary restrictions

The rising number of quality and safety standards is in part driven by concerns about information, coordination and traceability which are more acute in a world dominated by GVCs. While the need to protect final consumers through appropriate quality standards should not be understated, their complexity and above all their heterogeneity has become one of the main barriers to insertion into GVCs, in particular for small- and medium-sized enterprises. Upstream firms supplying intermediate inputs to several destinations may have to duplicate production processes to comply with conflicting standards, or to incur burdensome certification procedures multiple times for the same product. In agro-food value chains, meeting public and private standards has been identified as the main obstacle to participation in GVCs. Increasing international regulatory cooperation, including via the convergence of standards and certification requirements and mutual recognition agreements, can go a long way to alleviate the burden of compliance and enhance the competitiveness of small-scale exporters.

Efficient services markets: Improving competitiveness behind the border

Global production networks rely on the logistics chain, which requires efficient network infrastructures and complementary services. There would be no GVCs without well-functioning transport, logistics, finance, communication, and other business and professional services to move goods and coordinate production along the value chain. Trade flows in value-added terms reveal that services play a far more significant role than suggested by gross trade statistics: accounting for the value added by services in the production of goods shows that service sectors contribute 55% of total exports in OECD countries and 42% in the People’s Republic of China. The value created by services as intermediate inputs represents over a third of the total value added in manufactured goods, as shown in Figure 5. More efficient service sectors enhance the competitiveness of manufacturing firms and allow them to better participate in global production networks.

The OECD Services Trade Restrictiveness Index (STRI), which covers the major services sectors and suppliers, is a practical tool for diagnosing where reform might be most needed and how desired reforms might be best achieved. It allows governments to take a comprehensive cross-country view and to explore concrete options to improve services sector performance, whether at unilateral, plurilateral or multilateral levels. Figure 6 depicts the highest, the lowest and the mean STRI scores across 40 countries and 18 sectors, illustrating both the level and the dispersion of restrictions across sectors. No country is either the least or the most restrictive in all sectors, suggesting that all countries stand to benefit from targeted services sector reforms.

How can trade agreements help firms enter and grow in GVCs?

Multilateral and regional trade and investment agreements need to reflect the fact that many goods and services are now produced in complex global production networks that involve firms from many different countries that are at the origin of flows of goods, services, people, capital and technology.

A stronger case to move from reciprocal “concessions” to unilateral responses

With the emergence of GVCs, the mercantilist approach that views exports as good and imports as bad, and that views market access as a concession to be granted in exchange for access to a partner’s market, is even more clearly self-defeating. Domestic firms can of course benefit from export opportunities, but they also depend on reliable access to imports of world class goods and services inputs in order to improve their productivity and their competitiveness. Responses to this reality can be undertaken unilaterally, and have indeed led to unilateral liberalisation in recent years. “First movers” in liberalisation can also be the first to gain from specialisation and improve their position on international markets in downstream industries.

And a stronger case for multilateral and plurilateral agreements

But the gains are even greater when more countries participate and markets are opened on a multilateral basis. GVCs strengthen the economic case for advancing negotiations at the multilateral level, as barriers between third countries upstream or downstream matter as much as barriers put in place by direct trade partners and are best addressed together. A good illustration of this approach is the 1997 Information Technology Agreement (ITA), whose success lies in covering as many products and as many countries involved in the IT value chain as possible. The ITA also highlights the benefits of applying the Most Favoured Nation principle in plurilateral agreements, which eliminates “red tape” related to rules of origin and their potential distorting impact on trade.

Designing regional agreements for GVCs

Sound economics is one thing; political feasibility is another. While multilateral agreements are widely accepted as the best way forward, most of the liberalisation outside of purely unilateral opening has occurred at the regional level in the past two decades. RTAs of the future should be careful to avoid the pitfalls of distorting firms’ choices and losing the connection with the rest of the value chain. More liberal rules of origin, for example, would make RTAs more GVC-friendly and increase their impact on firms’ productivity. In the longer term, consolidating and multilateralising RTAs would help turn the “spaghetti bowl” of preferential agreements into a clearer and more efficient trading regime for all actors in GVCs.

A broad approach

Trade agreements have the largest impact if they cover as many dimensions of GVCs as possible. While abolishing tariffs is a starting point to offer companies new trade opportunities, the value chain also requires efficient services as well as the possibility to move people, capital and technology across countries. Policy should thus address obstacles at all points of the value chain. Multilateral agreements covering not only goods but also services, investment, competition, intellectual property and the temporary movement of workers are likely to create an environment where firms can build efficient supply chains. Such a comprehensive approach would amplify the impact of trade liberalisation on investment, growth and job creation.

Complementary policies: Towards more inclusive growth and employment

Facilitating the adjustment to a GVC world

Trade policy is not the economic policy equivalent of waving a magic wand: complementary policies are needed to draw the benefits of GVCs for inclusive employment and income growth. Not all economies are equally prepared for the changes their firms and workers have to face as GVC participation increases, and an effective integration strategy necessarily takes into account adjustment conditions and country specificities. The process of GVC-induced growth entails the reallocation of workers to more productive activities, and this can mean that, even as average employment conditions improve, some workers may experience unemployment or may see their real wages decline. Facilitating the adjustment process is crucial, and requires well-designed social policies and a well-functioning labour market. Effective re-employment services and training programmes can help dislocated workers take advantage of new job opportunities. More generally, enhanced involvement in GVCs is more likely to deliver large gains in job creation if it is accompanied by a broad package of labour and product market reforms, along with adequate social safety nets. Public and private investments to upgrade supply side capabilities, and the ability to exploit new market opportunities generally, are also needed. Developing countries, in particular, may need to consider the sequencing of reforms and invest in capacity building to maximise the benefits of GVCs on their domestic economies. But in all economies, the fact is that a large number of jobs is now related to export activities of firms (Figure 7).

Investing in people

Investments in people are particularly important for engagement and upgrading in GVCs: education and skills training are key ingredients in an effective package of complementary policies. Without sufficient investment in skills, involvement in GVCs may not translate into productivity growth, and countries may no longer be able to compete in an increasingly knowledge-based global economy. An effective skills strategy should address the challenges of developing the skills relevant to the GVCs in which countries are involved, but also maintaining and upgrading those skills throughout life so that people can collaborate, compete and connect in ways that drive economies forward.