Localisation of production: COVID-19’s medium-term impact

By Dr Linda Yueh, Economist at Oxford University, London Business School, and LSE IDEAS, and author of “The Great Economists: How Their Ideas Can Help Us Today”

This blog is part of a series on tackling COVID-19 in developing countries. Visit the OECD dedicated page to access the OECD’s data, analysis and recommendations on the health, economic, financial and societal impacts of COVID-19 worldwide.

shutterstock_465773663The immediate shock of the COVID-19 pandemic on world trade and investment is apparent in the latest report of the World Trade Organisation (WTO), which expects global trade to fall by an unprecedented 13 to 32 per cent this year.

The WTO points out that all regions will experience double digit declines in trade, which will be worse than during the global financial crisis a decade ago. The global trade body also stresses that there will “steeper falls in products with complex supply chains, such as electronics and automobile products.” This underscores that COVID-19 is both a “supply shock” and a profound demand shock. Finally, the WTO expects a recovery in trade volumes is possible in 2021, but it will depend on the extent of the pandemic and the effectiveness of policy measures to address the shock.

Even as global trade might recover within a year, there are potential medium-term effects from the COVID-19 pandemic, notably, around supply chains and associated cross-border investment. It’s challenging to map out the impact of COVID-19. But the supply chain disruptions are on the back of a tense period of trade restrictions and during a time when additive manufacturing (i.e., 3-D printing) have contributed to an emerging trend towards greater localisation of supply chains.

This pandemic follows the ignition of an US-China trade war, which had put stress on global supply chains. Due to the resultant tariffs and investment restrictions, multinational firms had begun to re-consider their supply chains in order to not run afoul of the additional costs and uncertainty associated with the measures introduced by the economic superpowers. But these decisions are not taken lightly, especially if they are due to geo-economic instead of commercial reasons. There is considerable cost in changing investments in factories and workers as well as new suppliers and distributors. However, US-China tensions are likely to be ongoing and are not expected to be resolved in a short period of time.

Then COVID-19 became a global pandemic in the first quarter of the year. It started as a supply chain disruption for many non-East Asian countries because it originated in China and affected that region first. As Richard Baldwin pointed out, COVID-19 hit the world’s top 10 manufacturing nations pretty much all at once, so it is unlike other shocks in the past century.

It soon became a demand shock. Efforts to contain the pandemic led to a “sudden stop” in economic activity. Demand, including for imports, was hit. Unsurprisingly international trade is projected to decline steeply.

Even though global trade might recover by next year, there may be a medium-term shift in supply chain considerations and associated investment decisions due to this pandemic and these other factors.

On account of the top manufacturers being affected at essentially the same time, it was challenging for any producer to use contingent arrangements. But domestic suppliers were not as affected, including by the travel restrictions imposed to contain the pandemic.

For instance, preparations in the UK for post-Brexit supply chain disruptions were deployed in this crisis. With the potential of a ‘no deal’ Brexit, firms made contingent plans to source from domestic suppliers to avoid cross-border trade. Those plans were used in the COVID-19 crisis by manufacturers of products such as toilet paper.

Depending on the duration of the pandemic, we might return quickly to the previous pattern. But we might not and see greater reliance on domestic supply chains, where feasible, as a way of diversifying suppliers.

Whether we do so will also likely depend on whether this crisis has shifted consumer preferences. There was already a move toward consuming locally and producing more within a nation’s borders on account of environmental considerations, among others. After all, international transport is responsible for 33 per cent of world trade-related emissions. For example, maritime shipment of goods (excluding bulk cargo) to and from Europe produces CO2 emissions that are comparable to emissions produced by the 38 million passenger cars in Italy.

This was not the only trend favouring greater location of supply chains. Additive manufacturing, more commonly referred to as 3-D printing, has been changing the production process. Although it is difficult to estimate precisely, there is already greater use of additive manufacturing in 3-D printing parts in industries such as aviation and aerospace. A 3-D printed part is precisely crafted to fit and replace a component on an aircraft and can be done faster than obtaining it from a supplier. An industry expert estimates that nearly every plane now flying includes a 3-D printed part.

As this technology continues to improve and commercialise, more industries could opt to print their own parts instead of sourcing them even in just-in-time systems that often cross borders. For instance, dental crowns are being 3-D printed by dentists instead of being manufactured and shipped to the dentist’s office.

This suggests greater localisation of supply chains based on technology as well as consumer preferences driven by environmental concerns. The recent geo-political tensions between the US and China have added to this emerging trend.

Greater localisation of supply chains does not mean the end of global value chains or regional ones. But it does suggest that there are technological, environmental, geo-political and diversification reasons to suggest that supply chains decisions may be more localised in the medium-term.

For emerging economies, this is a particularly noteworthy trend. Export-oriented Asian economies may need to adjust to this greater localisation trend, for instance. For other economies which had hoped to grow by plugging into existing production chains, this adds another challenge to the industrialisation process.

But these trends should affect services trade less than manufactured goods trade. Even in 2019 in the midst of the US-China trade war, environmental concerns and technological advancement, the WTO found that services trade grew by 2% in 2019 while goods trade fell by 0.1%.

Of course, services are intertwined with manufacturing. But services trade that is centred on the intangible economy, such as business, education, financial and some aspects of e-commerce, might be accelerated through technological linkages as well.

Services trade requires good digital infrastructure and the removal of non-tariff measures globally, so trade tensions do affect this sector. Due to a lack of comparable liberalisation of services trade as with goods trade, we have yet to see the full potential of services trade which means there are opportunities.

For emerging and indeed all economies, reducing services trade barriers might help with attracting investment and promoting trade. This warrants particular attention as manufacturing trade is under localisation pressure.

The COVID-19 crisis may lead to a number of changes in societies. One could be that it adds to the emerging trend of greater localisation of supply chains in the medium term. All economies, particularly emerging ones, should consider how such shifts will affect their growth strategies.