Regional integration does not ensure production in value chains

By Renato Baumann, Co-ordinator, International Co-operation, IPEA, Brazil

Developing economies often face a common challenge: after a period of rapid growth they experience a slowdown in both growth and productivity, falling into what has come to be known as the ‘middle-income trap’. Signing preferential trade agreements and participating in global value chains are two common recommendations presented to countries facing the middle-income trap, and are often seen as intertwining processes. Moreover, regional integration is gaining momentum as an enabler of value chains. However, although regional movement of goods facilitated by regional integration might be necessary, it is not the only condition to ensure production in value chains.

Following their participation in value chains, developing countries can benefit from basic sources of gain including the possibility to diversify their export bill, to absorb gains from scale, and to experience the corresponding increase in employment in the export sector. Furthermore, exporting more elaborate goods with (presumably) higher income-elasticity of demand, may also provide gains through improved terms of trade.

“Although regional movement of goods facilitated by regional integration might be necessary, it is not the only condition to ensure production in value chains.” #DevMatters

Participating in (global or regional) value chains means more ease of movement of final and intermediate goods. The more open an economy the bigger the chances that it might have access to production goods at low prices, and hence participate in a value chain. Being part of a value chain requires a good deal of specific domestic conditions. There is no ‘application form’ for a country to become a candidate. Potential investors have to consider a specific country as a good opportunity to invest in; this means free access to imported inputs, stability of rules for the free inflow and outflow of resources, good infrastructure, qualified labour, and a number of other conditions.

The geographical dimension tends to gain importance in this process. Technicians and managers having to frequently travel among different productive plants, as well as transportation costs, suggest that production stages are more profitable when the distance among different plants is small. As a result, the relation between value chains and regionalism has gained momentum. Preferential agreements can be instrumental in this sense. A preferential trade agreement (PTA) eliminates trade barriers among its members and signals policy transparency and predictability; the basic conditions to attract foreign investors and the cement in a productive chain.

The links between preferential trade agreements and production growth operate through the concept of ‘trade creation’. By reducing the barriers faced by the products of one country to access another country’s market, preferential treatment allows for new opportunities and stimulates domestic production. Furthermore, the impact of preferential trade agreements on domestic production increases when there are gains from scale of production. And preferential trade agreements might stimulate investment by reducing risk and uncertainty, because of the larger market now open to producers.

Stronger links among countries, such as custom unions, shelter the domestic economy from external competition, via common external trade policy. This should allow for domestic producers to benefit from gains from scale. At the same time, there is presumably a free flow of products within the union. This means that from the perspective of productive chains, two of the basic conditions to attract foreign investors, are being met: bigger scale of production and free movement of goods among union partners.

The more intense the intra-group trade in intermediate products, the bigger the chance that exports from the group have a higher component of products fabricated in a ‘sliced’ manner. Ease of regional movement of goods however, is a necessary but not sufficient condition for production in value chains. Economies involved in an integration process must also have the capacity to produce or assemble the various parts into final products. This can be visualised as the ratio between the amount of intra-regional trade in regionally fabricated producer goods and the total value exported by the countries in the group. The bigger this ratio the more intense the involvement of the group of countries with chain production.

“Participation in value chains is by and large more dependent on the set of domestic policies that signal favourable conditions to potential investors.” #DevMatters

An exercise with several groups of countries with different degrees of commitment to regional integration in 2000-20171 shows that the involvement with value chains is for the most part rather limited. Competitiveness stemming from these sliced production patterns remains a characteristic of only a few economies, and regional integration does not appear to be a sufficient condition. This has significant consequences for the overall trade scenario, as well as for the set of policy prescriptions with regards to the middle-income trap. Most customs unions fail to have significant value-added production, whereas some of the most successful examples of integrated production chains do not adopt common tariffs. Belonging to a customs union is, therefore, not a sufficient condition to participating in a value chain.

The usual policy recommendations to an economy that wants to actively participate in global value chains as a means to overcome the middle-income trap, are promoting openness to trade and creating a business-friendly domestic environment. This might be facilitated via preferential agreements, but participation in value chains – both the initial involvement in a productive chain as well as maximising the gains from that participation – is by and large more dependent on the set of domestic policies that signal favourable conditions to potential investors.

1. For details see Chapter 14 of José Antonio Alonso, José Antonio Ocampo (eds), Trapped in the Middle? Developmental Challenges for Middle-Income Countries, Oxford University Press, 2020