Friend-shoring global value chains: a model-based assessment

Prepared by Maria-Grazia Attinasi, Lukas Boeckelmann and Baptiste Meunier

Published as part of the ECB Economic Bulletin, Issue 2/2023.

In recent years, geopolitical considerations have started to play an increasing role in global trade relations. While criticism of globalisation pre-dated the coronavirus (COVID-19) pandemic, geopolitical tensions have strengthened, particularly in the face of the pandemic and Russia’s invasion of Ukraine. The global trade disruptions experienced since 2020 have raised concerns over the resilience of supply chains and reinforced discussions about economic security. As a result, some countries have started taking supply chain measures aimed either at “reshoring” (bringing production home) or “friend-shoring” (sourcing inputs from suppliers in allied countries) in order to secure access to critical production inputs (for example China’s “dual circulation” strategy, the US Chips Act, and the European Union’s (EU’s) “open strategic autonomy”).^[1]

A scenario in which global values chains (GVCs) are reshaped in response to concerns about economic security could result in a reversal of global trade integration. In this box we use a stylised, model-based analysis to quantify the potential economic effects of a hypothetical scenario of global trade fragmentation. In line with recent developments in the academic literature and using rising geopolitical tensions between the United States and China as an illustrative example, we consider the decoupling of the global economy into an Eastern bloc and a Western bloc.^[2] In this scenario, countries are mechanically allocated to each bloc according to their voting patterns in the United Nations (UN) General Assembly.^[3] In this fragmentation scenario we assume that trade (as a share of GDP) in intermediate inputs between the two blocs reverts back to the level of the mid-1990s (i.e. before sweeping trade liberalisation policies were implemented).^[4] We target trade in intermediates only, rather than final products, as most of the measures recently adopted by countries have focused on reshoring/friend-shoring GVCs. Finally, we assume that this fragmentation scenario is achieved by means of higher non-tariff barriers to trade between blocs (for example in the form of regulations or standards) rather than tariffs – reflecting the scope of most recent trade policies.

The economic effects of trade fragmentation are quantified using a state-of-the-art multi-country, multi-sector model developed by Baqaee and Farhi.^[5] This model allows the non-linear effects of higher trade barriers to be derived for a sample of 41 countries (or country groups) and 30 sectors.^[6] Our focus is on the effects on welfare, trade in intermediate products and prices, both from a global perspective and for the two blocs.^[7] A key advantage of this model is that, by featuring sectoral interlinkages, it accounts for amplification effects of trade shocks through production networks as well as substitution effects via international trade. The model considers the endogenous reactions of producers and consumers to a trade shock in an interconnected global economy.The transmission operates primarily through the price channel: higher barriers to trade increase import prices. As a result, producers within each bloc substitute away from more expensive “foreign” inputs, thereby generating a demand shock for upstream suppliers, resulting in lower trade flows between the blocs. This also leads to adjustments in production structures within the blocs and changes in the demand for factors of production (capital and labour). As the prices of capital and labour adjust, disposable incomes of households and consumption patterns also change. These substitution and re-allocation channels generate general equilibrium effects on prices, demand and supply, which in turn affect trade, production and welfare in both blocs.

General equilibrium effects can be obtained using two different model setups – rigid and flexible – which can be viewed as akin to the short-run and long-run impacts respectively. The propagation channels of the trade shock discussed above are captured in the model via three main parameters: (i) elasticity of substitution across production inputs,^[8] (ii) ease of reallocation of production factors across sectors,^[9] and (iii) degree of wage rigidity. We calibrate two polar setups. The flexible setup allows for flexible wages and high substitutability of inputs and factors of production, as in the recent literature.^[10] This setup elicits a relatively muted response of the global economy as it allows consumers and producers to substitute seamlessly across products, factors of production to be shifted to sectors that face higher demand, and wages to be adjusted. In contrast, the rigid setup features sticky wages and a low substitutability of inputs and factors of production.^[11] As a result, this setup generates a stronger reaction from the substitution and re-allocation channels, as the ability of a country/bloc to immediately adjust is more limited as a result of low factor mobility and less room to substitute away from more expensive inputs. The resulting drop in domestic production and household income is therefore greater, and so the disruption to the supply of intermediate inputs for downstream sectors and to demand for upstream producers is stronger. This reflects the amplification mechanism of global production networks. In addition, in the presence of sticky wages the economy adjusts to temporary fluctuations in demand (domestic and/or foreign) by shedding employment (not reducing wages), which weighs on consumption. Given that rigidities tend to be more binding in the short term, the rigid setup could be seen as a close approximation of short-run effects, whereas the flexible setup is closer to the long-run equilibrium.^[12] In this respect, the results can also be viewed in terms of the transition from the short-run effects (rigid setup)to the long-run effects (flexible setup). Beyond this interpretation, these two setups also take into account the high level of uncertainty surrounding substitution elasticities in the literature.

In a trade fragmentation scenario, losses in trade flows between the blocs would not be fully compensated for by trade diversion within blocs, causing net trade losses. Trade fragmentation along these hypothetical geopolitical lines could result in real imports declining between 12% (flexible setup) and 19% (rigid setup), mainly driven by a fall in trade in intermediates (which would drop between 19% and 25%), as shown in Chart A (panel a). Trade in final goods would also decline between 1% and 9%, despite not being the direct target of the trade barriers. This reflects reduced welfare of, and demand from, households and substitution away from foreign-produced, GVC-intensive final goods, whose price has increased, and towards final goods produced domestically or within the bloc. The decline in intermediate trade reflects a recomposition of production input sourcing by companies. Chart A (panel b) presents diversion effects for intermediates inputs. The decline in imports of intermediate inputs between blocs is only partially compensated for by a rise in imports within blocs and domestic sourcing rises more substantially, thereby weighing on trade.

Chart A

Real imports and sourcing of intermediate inputs

Welfare losses can be sizeable, albeit rather heterogenous across economies. From a global perspective, welfare losses, captured by the change in gross national expenditure (GNE), are estimated to range between 0.9% (flexible setup) and 5.3% (rigid setup) (Chart B, panel a). In line with the interpretation discussed above, this suggests that losses could be sizeable in the near term should a sharp correction in trade flows take place (rigid setup). Once the rigidities dissipate, losses are gradually absorbed as substitute inputs of production are found either via increased domestic production or increased intra-bloc trade. This in turn increases employment and reduces the price of foreign inputs, limiting the losses from trade fragmentation in the long run (flexible setup). Chart B (panel b) presents welfare losses for selected countries. Welfare losses vary widely across economies and range between 0.2% and 6.9% in the flexible setupand between 0.4% and 10.5% in the rigid setup. While all countries lose from fragmentation, countries that rely heavily on GVCs and trade extensively with the other bloc experience the largest losses. This contrasts with large economies, such as the United States and China, which see smaller losses even in the rigid setup. Losses in the euro area are also relatively mild as, like the United States and China, its large internal market more easily allows substitution by domestic intermediate inputs after the shock. Nonetheless, its losses are somewhat greater than those of the United States or China owing to the greater trade openness of the euro area. The estimated effects in the flexible setup are broadly in line with the recent literature, which finds muted effects of trade fragmentation in the long run.^[13] In the short run, however, trade fragmentation may also involve significant transition costs (rigid setup) as it takes time to reconfigure supply chains.

Chart B

Change in gross national expenditure

A fragmentation of value chains along geopolitical lines would generate price effects, as producers would have to substitute away from cheaper foreign inputs. The impact on prices is a combination of the import price shock and the reallocation effects discussed above. This is reflected in the cross-country heterogeneity of the price response (Chart C, panel a). At a global level, the increase in the level of consumer prices ranges between 0.9% (flexible setup)and 4.8% (rigid setup), whereas for the United States the range is between 1.7% and 4.9%.^[14] For the euro area the smaller price increases compared to other large countries is explained by smaller upward price pressures from relocation effects. Trade fragmentation also has a distributional impact reflected in the relative evolution of wages for low, medium and high-skilled workers. Chart C (panel b) shows the evolution of wages for medium-skilled workers. In the Western bloc, trade fragmentation redistributes income towards low-skilled workers, whose wages evolve more favourably than those of high-skilled workers.^[15] This reflects the fact that, amid rising trade fragmentation, Western countries would import fewer goods with low-skilled labour inputs from the Eastern bloc, thereby increasing demand and wages for low-skilled labour in the Western bloc. Conversely, in the Eastern bloc, wages of low-skilled workers fall relative to high-skilled labour.

Chart C

Nominal impact of trade fragmentation

The estimates presented in this box are subject to uncertainty, as the future path of trade fragmentation remains largely unpredictable and other amplification effects could materialise which are not considered here. The estimates are strongly influenced by the magnitude and extent of any decoupling scenario. A scenario in which the East-West decoupling is limited to strategic sectors (cars, machinery, electronics, metals) yields a substantially lower impact, with global GNE losses ranging between 0.5% and 2.5%. In contrast, a scenario combining East-West decoupling with an intra-bloc decoupling for strategic sectors would increase the impact by about one third.^[16] The composition of blocs could also differ from our mechanical allocation based on UN voting, notably as some countries could stay non-aligned. In the short term, other factors beyond sticky wages and low substitutability could drive even larger losses, for example the presence of critical inputs that are difficult to substitute (e.g. lithium or rare minerals) which could lead to temporary production stoppages, or financial amplification mechanisms (for example in the form of rising risk premia). In the longer run, transmission channels not considered in this box, such as cross-border knowledge diffusion, could also weigh on growth.

In conclusion, from a purely economic perspective, trade fragmentation would be a lose-lose situation given the costs it entails at both the global and the country level. While the above estimates are subject to both upside and downside risks (depending on the magnitude and scope of any fragmentation scenario), from a purely economic perspective, trade fragmentation would entail sizeable costs in terms of substantially distorted trade, decreased welfare and higher prices. Beyond the results presented in this box, academic evidence suggests that reshoring may increase economic vulnerabilities, since risk-sharing and diversification would be reduced.^[17]

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