The Coronavirus challenges global value chains

A few weeks ago, we published a comprehensive macro analysis of the German value chain network. As the Coronavirus has started to disrupt global value chains, we were wondering if it tells us anything about Germany’s risk of infection. Turns out, it offers some general clues.

The fever goes up: The Coronavirus takes its economic toll

Evidence is mounting that the Coronavirus (Covid-19) is slowing down global economic activity and growth. Morgan Stanley has forecast that Chinese growth could fall to an unusually low 3.5 percent in the first quarter of 2020. At the G20 finance ministers meeting in Riyadh last weekend, IMF Managing Director Kristalina Georgieva warned that even if the spread of the epidemic could be mitigated, it is very likely to have a negative effect on global economic growth. The fallout was on full display in the stock market on Monday. After the spread of the virus accelerated via South Korea and Italy, shares in Asia and Europe took a hit, and the Dow Jones Industrial Average futures plunged by 800 points.

The infection channel: Global supply chains are disrupted

One important window on how the Coronavirus affects economic activity is global value chains. Most products, particularly manufactured goods such as cars, are no longer produced by one country or even one factory. They result from the skillful assembly of a number of intermediate products that hail from different countries that specialize in their production. Each country produces its share of added value to the final product. Figure 1 schematically depicts such a value chain. If one country, such as China, can no longer produce its added value component and no substitutes are affordable or available, the chain is cut. The economy of globally integrated countries consists of a myriad of value chains, or what we call a supply chain network.

Take-Away #1: Germany looks rather immune…

• At first glance, our study seems not to show too much cause for concern for Germany’s supply chain network. After all, the lion’s share of added value in intermediate deliveries from Germany goes into the final demand of German production.
• As Figures 2 and 3 show, the foreign contribution in intermediate deliveries to German final demand of production and the German contribution in intermediate deliveries to foreign final demand of production both amount to less than 20 percent.
• So, Germany can rely a lot on its own added value in producing final goods. In general, despite all its dependence on foreign markets, internal shocks (say, a Coronavirus outbreak in Germany) have a much higher potential to disrupt economic activities in Germany than external shocks.

Take-Away #2: … but Germany’s infection risk has increased over time…

• Still, Germany’s supply chain network has grown over the past decade. On the export side –– Germany’s contribution ( German added value that is exported for final production to other countries) rose from 13.2 percent in 2000 to 18.2 percent in 2014 (Figure 2).
• On the import side –– The share of foreign added value that is imported for final production in Germany rose from 11.7 percent in 2000 to 15 percent in 2014. In other words: Germany’s dependency on its international supply chain network has increased. So, compared to 2003, when the SARS epidemic disrupted global value chains, Germany’s risk of being infected by an external shock has also increased.

Take-Away #3: … and the infection risk to shocks from China is bigger than often assumed

• A comparison between added value contributions and intermediate delivery contributions reveals that Germany’s exposure to shocks from China, or from overseas in general, is, in fact, greater than usually assumed. Taking a mere intermediate deliveries perspective, the usual import-/export numbers show a strong reliance on other European states as consumers (Figure 4) and suppliers (Figure 5). If we take an added value angle, the picture looks different.
• The relative share of added value in intermediate deliveries from or to oversea is much higher than from or to the European neighborhood. In other words. A lot of Germany’s neighboring countries act as transit hubs for German value-added trade with the rest of the world. Thus, the risk of being infected by adverse developments in China is higher than we would think.

Big Caveat: This is a macro diagnosis. The devil may be in the (micro) details!

These very general conclusions tell us only something about the very big picture of German trade. For a more nuanced analysis, we would have to look at individual industries, firms, or even parts of production. One example to illustrate the point: Germany may rely on 99.9 percent of added-value of product X on domestic intermediate deliveries.

But if the remaining 0.1 percent is essential and cannot be substituted or only substituted at a very high cost, they might still prove fatal for the value chain. Likewise, even if Germany depends 99.9 percent on Chinese added value for producing good Y, that might still be no problem in the face of the Coronavirus… if they can be easily substituted.

Advice #1: Be aware of specific infection channels!

• This caveat brings me to the first advice: The Coronavirus is an important reminder that firms (and governments) need to be aware of strategic import and export dependencies. Who are the suppliers and consumers they are truly dependent on? Here, it is important to take not only an intermediate goods perspective but also an added value approach. Who is the original supplier of added value? Who is the final consumer? Which shocks might hit them and then ripple through the value chain? Should companies mitigate the risk of an external shock by diversifying as a kind of insurance policy that puts a premium on the price but creates a cushion in a crisis?

Advice #2: Strengthen the resilience of supply chains!

• While re-shoring may be advisable as a means of diversification for a company or a country that is overexposed to foreign markets, it is not a panacea for shocks. First of all, while it may mitigate the risk of EXTERNAL shocks, it increases the risks of internal shocks. If China today were the sealed-off country it was during the 1970s, the domestic economic effects of the crisis would likely be a lot worse.
• Second, re-shoring might quickly turn into a general “Buy and Produce Domestic” frenzy that forgoes the numerous positive effects of the international division of labor altogether. So, instead of frantically trying to make their business or economy self-reliant, firms and governments should rather look for new ways to make their value chains more resilient.

Advice #3: Preserve international institutions!

• Yes, the G20 and the WTO are far from perfect institutions. But they are indispensable in a world where global value chains transmit economic shocks from one end to the globe to another. They are important ingredients of resilience. In the financial crisis in 2008 and 2009, the G20 proved an important forum to work out cooperative responses for this seismic shock to the global economic system. In the case of a pandemic, it could take on such a role again.
• As for the WTO: Most people overlook that besides being a forum for negotiation and arbitration, the WTO is a huge resource of information. Its portal on global value chains, for example, provides an invaluable database to better understand and better shape growing economic integration.

Teaser: More information about the impact of the Coronavirus to come

My colleague Thieß Petersen will expand on this value chain perspective on the Coronavirus with a forthcoming blog post on the various economic effects of the disease.